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Emerging headwinds; fair valuations – downgrade to Neutral

United Spirits (UNSP) has been the second best performer in our Coverage Universe since our upgrade to Buy rating in Jan’21 (only marginally below Titan), with the stock price moving up nearly 60% since. It has also comfortably outperformed its other largecap alcobev peer, UBBL, since our upgrade. a) The strategic refresh under the new CEO as well as b) the ongoing strategic review of the Popular portfolio (to be concluded by Dec’21) offer scope for sustained double-digit volume-led topline growth as well as sharper margin improvements going forward. However, to a large extent, these are already a part of our forecasts. Thus, valuations at 62.3x on a standalone basis leave little room for an upside. Even when adjusted for the potential valuation of ~USD1b of Royal Challengers Bangalore (RCB), the P/E multiple is not cheap at ~56.5x FY23E EPS. These valuations may appear cheaper than the other discretionary stocks under our coverage. Nevertheless, the government-dependent nature of the Alcobev sector with regard to procurement, pricing, distribution, and receivables prevents us from increasing our target multiples for UNSP. We maintain our forecasts and TP and downgrade to Neutral.

Other relevant factors beyond valuations

Material costs – Ongoing recovery in on-trade is great news from a sales and mix perspective, especially in the third quarter – weddings and other celebratory events such as Christmas and New Year’s Eve, and the onset of winter are crucial for UNSP. Despite this, headwinds are emerging on the material cost front in the form of higher ENA and glass bottle prices, which could have a bearing on earnings growth over the next year. The new Ethanol blending policy is scheduled to be unveiled this month and could lead to disruptions in availability and/or higher ENA prices over the next few quarters (even as the longer term availability is likely to be ensured). Similarly, higher crude costs are also leading to inflation in bottling costs.

Excise increases – We believe that with all the key states choosing to reduce excise/VAT on fuel over the last weekend, the specter of excise increases looms over the Alcobev sector for the next few months. Importantly, this comes on the back of negligible increases over Jan–Apr in the current year, which meant less disruption in demand and healthy profitability in recent quarters.

Near-term ramifications in Popular segment strategic review – The company is conducting a strategic review for half of its Popular portfolio (a third of total sales), a process that is likely to conclude by Dec’21. The potential sale or franchising of a significant portion of the company’s portfolio is a highly positive prospect for longer term profitability (taking the company closer over the longer term to the operating margins of Pernod Ricard India in the mid-20 levels). Nevertheless, this could lead to sales and earnings cuts in FY22E and FY23E EPS.

Deleveraging now almost completed – The company did well to grow earnings by ~30% in the last five years before the pandemic. However, this was primarily driven by margin improvement (~8% in FY15 to ~16% steady-state levels currently) and, more importantly, deleveraging (debt down 87% at end-1HFY22 from FY15 levels). This led to interest costs declining from 67%/203% of EBITDA/PBT in FY15 to ~4%/5% in FY22E. With deleveraging unlikely to drive incremental earnings growth, it becomes even more important for the company to grow the topline in the double digits (v/s a ~3% sales CAGR over FY15–20). However, this may take time, especially if potential excise increases (always unpredictable) throw a spanner in the works.

Potential upside surprises – Some events that could be positive developments for the company going forward include a) stronger-than-expected recovery in the ontrade channel, b) meaningful price hikes granted by various state governments in light of the inflationary environment, c) accelerated contribution from the profitable P&A segment, resulting in sharper-than-expected margin improvements, and d) easing levels of cost inflation for ENA and glass bottles.

Valuation and view

* The UNSP stock has been achieving new highs in recent months and has been the second best performing stock under our coverage since our upgrade in Jan’21. We note that this performance is entirely attributable to an expansion in the multiples offered to the stock given that our FY23E EPS estimates are ~10% lower than at the time of our upgrade note owing to the second Covid wave.

* We are enthused by the announcements about the new CEO as a part of the strategic refresh and eagerly await the results of the ongoing strategic review. Valuations at 62.3x FY23E EPS (standalone) and 56.5x FY23E when attributing a value of USD1b to the RCB franchise adequately capture an upside from a oneyear perspective. Unlike other discretionary top picks such as JUBI and TTAN, it is difficult to justify these high multiples with a structural growth argument given the government-dependent nature of the business – which impacts growth, profitability, and ROCEs.

* The sales outlook continues to improve as the on-trade channel recovers to normal levels ahead of the crucial Christmas, New Year’s Eve, and winter period for spirits. Despite this, headwinds are emerging on the material cost and regulatory front. Ethanol blending policy-related disruptions on ENA and the crude-related impact on bottling costs could dent earnings going ahead. Moreover, most states absorbing the excise reduction impact on fuel opens up the possibility of sharper excise increases on alcobevs, against the negligible increase in state budgets for FY22.

* We maintain our EPS forecasts and target multiples and downgrade to Neutral.

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