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Buy Varun Beverages Ltd For Target Rs.1,145

Sharp recovery paving way for growth

VBL has multiple levers in place to drive its long-term growth strategy. We expect volumes to bounce back and support its overall growth led by: a) faster recovery of the business in the backdrop of the COVID-19 pandemic, b) strong demand traction across geographies and product segments, c) a gradual gain in market share, with increased penetration, and d) ramp-up of operations in new regions (South and West India). Key insights are highlighted below:

Demand drivers in place to drive near term growth

* During the latter part of CY20 and in 1QCY21, VBL witnessed a strong demand recovery. In the initial phase of COVID-19, demand was impacted. This recovery was primarily driven by: a) pick-up in volumes in the newly acquired territory of South and West India, b) strong demand for newly launched products (Mountain Dew – Ice), and c) re-working of the formulation of the PepsiCo brand concentrate, which resulted in higher retention of CO2. Higher retention of carbon dioxide led to a reduction in sweetness. The product has seen higher acceptance and demand post that.

* HORECA segment (current revenue share at 6-7%) is another channel whose performance is expected to improve. Lower occupancy in theaters and travel restrictions due to COVID-19 are affecting HORECA volumes. Going forward, the management expects a strong recovery in this segment, with a gradual lifting of lockdown restrictions across India.

* New product launches (Mountain Dew – Ice), ambient temperature dairy beverages, etc., are some of the products gaining traction. With the lifting of lockdown restrictions, VBL aims to aggressive distribute and market these products.

* VBL's market share (in handling PepsiCo’s India volumes) increased to ~85% in CY20 from 80% in CY19, which is primarily due to increasing penetration in the newly territories as well as existing ones. We expect a similar trajectory to lead to 28% volume CAGR over CY20-22E.

Initiatives across segments and regions to provide all round sustainable growth

* PepsiCo acquired 'Rockstar', who is the leader in the Energy Drink segment. VBL aims to launch this product in the domestic market in the next few years.

* In the NCB segment, the management aims to ramp-up operations at the new Pathankot facility and aggressively distribute its product. This is in line with its long-term strategy as the management was not able to ramp up the plant due to imposition of the COVID-led lockdown.

* At the time of acquisition (in CY19), the south and west region recorded volumes of 135m units. Two years prior to that, these regions did 205m units (when PepsiCo undertook bottling and distribution). VBL plans to achieve similar volume numbers in the next 1-2 years. Post that, its focus will be to increase penetration levels, which in-turn will support volume growth.

* VBL's market share increased to 13% from 6% in Morocco. On the back of increased demand, it plans to add a glass line in CY21, which is expected to further drive volume growth. It also plans to double water capacity in Morocco over the next 2-3 years.

* Zimbabwe volumes have doubled in the last couple of years on the back of market share gains, which is difficult from here on as the company has 50% market share in the region. Growth from here will be driven by expanding the market and launching new products. The management plans to backward integrate (setting-up preform/caps machinery) in Zimbabwe in CY21, which is expected to benefit margin in the near-to-medium term.

Major capex behind, focus is on cash generation; expect VBL to generate FCF of INR27.9b over the next two years

* Due to COVID-19 and subsequent lockdowns, the company reduced capex outflow with respect to expansion in new territories and spending on plant and machinery. In CY22, VBL plans to spend cash, which will be more or less equal to its depreciation outflow in CY21 and CY22. Organic capex in the last seven years was 0.9x consolidated depreciation (excluding inorganic capex).

* It sees inorganic acquisition opportunities in Asia and Africa. The management’s current focus is to grow its market share in the newly acquired territories and drive efficiencies. It expects cash generation in CY21 to be used for debt repayment and intends to reduce debt by INR8b. Lower capex outflow is expected to increase free cash flow generation, which in turn would aid in debt reduction.

* VBL plans to rationalize operations and aims to dispatch products from large plants where the cost of production is lower. The shift from smaller plants is expected to boost margin, with economics of scale kicking-in.

Valuation and view

* We expect VBL to maintain its earnings momentum, led by: a) increased penetration in newly acquired territories of South and West India, b) higher acceptance of newly launched products, and c) ramping-up of operation in domestic as well as international territories on the back of growing demand.

* With a ramp-up in operations due to increased demand and impact of COVID-19 gradually subsiding, we expect operating leverage to kick-in and complement margin expansion. Lower capex intensity in coming years and higher profitability is expected to improve cash flows and reduce debt.

* We expect revenue/EBITDA/PAT CAGR of 28%/36%/64% over CY20-22E. We value the stock at 31x CY22E EPS. Our TP of INR1,145 per share implies 15% upside. Maintain Buy.

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