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Buy United Spirits Ltd For Target Rs.975

Recovery evident, longer term prospects remain attractive

We interacted with the management of United Spirits (UNSP) for an update on overall market conditions. Here are the key takeaways:

* Recovery has been strong in recent months, with on-trade re-opening and off trade demand remaining healthy. Especially heading into 3QFY22 (a historically important quarter for spirit consumption), the recovery is encouraging.

* The ‘strategy refresh’ to be highlighted by the new CEO in its 2QFY22 result could entail positives on topline growth, an area where UNSP has lagged expectations, even as it has done a commendable job on margin expansion and deleveraging.

* Activation of the Scotch portfolio in ~2,000 outlets across India, resulted in better availability and wider range in these outlets. This could result in healthy demand for BIO and BII Scotch, when overseas travel and higher duty free sales (booked as part of Diageo global revenues) resume.  We maintain our Buy rating on the stock.

Demand recovery on track

* For UNSP, the recovery after the second COVID wave has been faster than that after the first wave. Around 70% of outlets were operational till midAug’21.

* On-premise has been operating at full capacity since mid-Aug’21, with preCOVID footfalls, wherever access has been permitted by regulatory state bodies.

* While the recovery in on-trade channels has been good, night/weekend curfews and restricted timings are affecting sales, with last orders being accepted at 8-9pm in select geographies.

* Off-trade has also done well as home occasions and celebrations pick up.

* Muted global travel has acted as a tailwind rather than a headwind as it led to duty-free demand converting to duty paid. The management is focusing on the modern off-trade channel to cater to this demand. It activated 2,000 outlets for Scotch over the last one year. Due to this initiative, it expects a significant part of this demand to sustain once overseas travel returns to normalcy.

Focus on the margin accretive Scotch portfolio

* Black Dog is now available in 3-5 markets.

* The relaunched Signature, which was present only in West Bengal, Haryana, and Telangana, will be present in 70% of the country over the next 2-3 months.

* The Scotch portfolio is hugely gross profit accretive. The cash conversion cycle is also better at 75-90 days v/s 120-130 days for the overall portfolio.

* RoCE is highly accretive for bottled in origin (BIO) Scotch.

* At present, Scotch contributes 5-6% of overall sales by volume.

* The strategic review of the Popular portfolio is on track.

Granted price hikes to partially offset commodity inflation

* Price hikes were granted to a few players towards the end of 1QFY22 as prices for glass bottles experienced inflation.

* The management is watchful of the ethanol blending policy, which is expected to be announced in Nov’21.

* Cost savings/productivity and price increases would be the key levers used to combat RM and overhead cost inflation. The two other levers – operating leverage and premiumization – will be used to expand margin.

* The management is on track to meet its 1.5% cost savings target.

* A&P spends will remain in the 8-10% range of net sales.

* Working capital was 35-38% of net sales 4-5 years ago. With a focus on improving productivity, it is now stands at 23-24% of net sales.

Likely to start paying dividends

* The management said it has no major capex planned.

* It has plans to reward shareholders through dividends starting either FY22 or FY23 as the company is now almost net debt free.

* There are no exciting M&A opportunities, but the management is open to the same if something were to come up.

Other key takeaways

* While topline growth has always been a key focus area for the management, a multiplicity of priorities may have led to lower topline growth in the past, which is not expected to be the case going forward.

* Details of the strategic refresh will be unveiled by the new CEO in its 2QFY22 conference call.

* The new excise policy in New Delhi is a positive for the industry.

* UNSP is not apprehensive about competition from smaller players increasing as it believes it will help expand the market.

* The management would like to bolster its third-party colocation manufacturing and bottling network, which is currently at 50% v/s 25% three years ago. The aim is to move this closer to 70% over the next 2-3 years. This arrangement helps save on freight, ensure a steady flow of ENA to manufacturing plants, and also saves on certain levies such as VAT to some extent.

Valuation and view

* Recovery post the second COVID wave has been faster than that in FY21 and continues to improve, given: a) easing restrictions enabling better mobility, and b) the nationwide vaccination drive, which is chugging along at full steam. We had upgraded the stock to Buy in Jan’21 after adopting a cautious stance on the Alcobev industry prospects for most of CY20.

* While its valuations (~57x FY23E EPS) are not cheap, they are at a sharp discount to its discretionary peer range (in our coverage) of 70-81x FY23E EPS. In the five years before COVID-19 impacted FY21, UNSP reported a strong (18% CAGR) EBITDA and over 30% CAGR in PBT/PAT.

* The outlook appears promising with: a) on-trade channel returning to normalcy; b) increased occasions for home indulgence; c) the ongoing strategic review of half of the Popular portfolio to be concluded by Dec'21, which would offer further primacy to the Prestige & Above (P&A) segment; d) potential success in the P&A segment in terms of both growth and margin (24-25% EBITDA margin already demonstrated by Pernod Ricard in India); e) the new CEO (with a demonstrated growth focus) taking over earlier this month; and e) faster-than-expected deleveraging.

* There is no material change to our estimates. We maintain our Buy rating, with a TP of INR975/share (55x Dec’23E EPS).

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