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The story of the beleaguered liquor baron and his company reads like a Bollywood masala — debt piling on, hundreds losing their jobs, mud-slinging and hysterical news anchors. In came a knight in shining armour — the world’s biggest distillery by sales — Diageo. Its long-standing interest in buying controlling stake in United Spirits worked as a lifeline for Vijay Mallya and UB Group. 

Mallya sold 14.98% stake in United Spirits to the British multinational and, with this Rs.20 billion deal, the latter became the owner of premium whisky brands in the country such as McDowell’s and Royal Challenge. Completed in July 2013, the deal looked like a happy ending for all parties involved and Diageo became the largest shareholder with around 25% stake. But, like any interesting plot, there came a twist.

The takeover wasn’t smooth — from cleaning up the books and forcing Mallya to resign to replacing his allies from the top spots— Diageo had to fight at multiple fronts between 2012 and 2016. It finally cut ties with Mallya and had just put internal squabbles to bed when, almost immediately, demonetisation and Goods and Services Tax (GST) rollout entered the scene. It was another setback, followed by the ban on alcohol sale within 500 metres of state and national highways. If Diageo was a believer, it would have gone shopping for a good-luck charm. Instead, the new management at United Spirits put its shoulder to the wheel and handled these crises admirably.

Rebuilding from scratch 

Led by Anand Kripalu, the team has scripted a turnaround story with sales growing at five-year CAGR of 22.42% to Rs.288 billion in FY19. This was achieved by revamping nearly all functions — marketing, supply chain, governance, cost structure and brand portfolio. But analysts believe the strategy that has led to a sharp improvement in the company’s performance is Diageo’s decision to focus on the premium prestige-and-above (P&A) segment (See: Premiumisation drive). It includes well-known brands such as McDowell’s No.1, Signature, Royal Challenge and Antiquity Blue, along with Diageo’s global brands Johnnie Walker, VAT 69 and Black & White. “The focus on the premium end is bearing fruit, and is reflected in McDowell’s’ performance,” notes Abneesh Roy, executive VP - institutional equities, Edelweiss Securities. 

While the earlier management, headed by Mallya, adopted a volume play, Diageo was compelled to change tack. It decided to compete in the high leagues, with scope for higher margin growth. Today, United Spirits’ nearest competitor is Pernod Ricard, a company that owns a truly premium P&A portfolio with Chivas Regal, Absolut and Ballantine’s. 

During a Q1FY19 conference call, Kripalu told investors that they would continue with their strategy despite facing “aggressive price competition”. In line with that, P&A’s revenue contribution has increased from 47% in FY15 to 67% in FY19.  

The company that seemed to be headed for doom had to be dismantled and pieced back anew by Diageo. The name and the brands remained, but it is not the same organisation left behind by Mallya. Apart from premiumisation, Diageo also started making operational changes such as adopting the franchise model for some of the popular brands including Bagpiper and Director’s Special in 13 states. “As the popular segment has lower profitability, they are making it asset-light by implementing a franchise model,” says Siddhant Chhabria, analyst – institutional equities, HDFC Securities.

Under this model that was started in 2014, the company receives a fixed income from the franchise partners for manufacturing and marketing United Spirits’ brands. That income increased to Rs.1.8 billion in FY19 from Rs.1 billion in FY15. According to the management, this will not only ensure the stability of margins in the segment, but also reduce working capital requirements. It has allowed United Spirits to reduce its number of factories from 88 to 50 and employees from 6,797 in FY15, to 3,546 in FY19. “Through this restructuring, they can improve profitability,” says Chhabria.

Diageo’s strategic shift has helped improve its gross and operating margins. While the gross margin rose from 40% in FY15 to 48.9% in FY19, Ebitda margin improved from 8.40% to 14.3%. Besides, Diageo focused on lowering its debt, thus reducing interest cost and increasing profitability (See: Paring debt). With the improvement in credit profile, they were also able to seek more economical sources of debt, as stated in the company’s FY19 annual report. Interest as percentage of total debt has gone down from 13.78% in FY15 to 8.22% in FY19. 

Means to an end 

United Spirits may be set on the growth path, but that doesn’t mean it has steered clear of temporary speedbumps. Challenges such as policy changes and high input cost are likely to hurt financials, at least in the near term. While Maharashtra government raised excise duty on India-made foreign liquor by 20% in January this year, the price of glass needed to bottle the alcohol also inched up in Q1FY20 by 15% YoY. 

To negate the rising input cost, United Spirits hiked prices of certain bottled in India (BII) scotch brands including VAT 69 and Black & White by up to 15% in 10 states over the past six months. “Maharashtra, by the way, is a free pricing market. So, the day we feel that the environment is ripe for taking a further price increase, we can do that [hike prices],” Kripalu stated in the investor con call.

The current price hikes haven’t been enough to protect the margins, according to analysts. “Gross margin has dropped this year due to insufficient price hikes in the state. The company is holding price hikes for McDowell’s (which is its key brand) to remain competitive,” says Chhabria. The general sentiment is that there is room for further hike in prices without hurting sales, since the focus of the company is now on premiumisation. “If they take minor price hikes in small quantum for premium products, then a high-end customer might not downgrade as he/she has the capacity to pay. But customers in the lower brands are price sensitive and may look for some other option,” says Bharat Chhoda, AVP- research and advisory, ICICI Securities. 

The spirit of alcohol companies has been flagging in the recent years, with several state governments cracking down and banning liquor consumption. One of the risks facing United Spirits today is YSR Congress’ election promise earlier this year. The Andhra Pradesh government is planning to implement an alcohol ban in a phased manner in the state, which contributes around 3-4% of the company’s revenue. The state is planning to eventually move towards total prohibition on alcohol by 2024.

But analysts and the company are not too worried. “After prohibition on alcohol is imposed in a state, sales in neighbouring states start picking up, mitigating the overall impact,” says Chhoda. Besides, excise duty on liquor is one of the most significant revenue contributors to a state’s coffers. Hence, governments end up making some concessions. For instance, if Andhra were to impose a blanket ban, it would lose nearly Rs.60 billion in annual excise revenue. 

Despite sobering changes, the company’s Ebitda margin expanded from 12.6% in Q1FY19 to 17.8% in Q1FY20. Besides lower employee cost and other expenses, the company also reduced advertisement and promotional spends to 7.8% of sales. But rising competitive intensity from Pernod Ricard means USL has to make its brands more visible. Chhoda says, “United Spirits is likely to maintain marketing and advertisement spend of 9-10% as it continues to invest in increasing its brand strength.” The French alcohol manufacturer is going all in when it comes to India, naming it as its third strategic market. Its sales grew by 20% (the company’s financial year runs June to July), whereas USL’s P&A sales rose to 13% in FY19. 

“For any consumption brand, visibility is essential. If Pernod Ricard increases its ad spend, then United Spirits will also have to follow suit,” predicts Roy. 

Value bet 

Challenges notwithstanding, analysts are not ready to dismiss the feat Diageo has achieved with United Spirits. They remain optimistic about the company’s prospects and believe the stock remains a good long-term bet. Focus on premiumisation and cost-saving measures are expected to further boost profitability, and long-term consumption growth will remain intact. “It will inch up due to the increase in urbanisation and more female consumers. In the next three to five years, United Spirits will be able to improve margins as they foray deeper into premiumisation,” says Roy. He is of the view that the McDowell’s maker does not have to win against Pernod Ricard necessarily. “It’s a two-player market, and both can co-exist and have differential growth rate,” says Roy. 

The positives are already factored into the stock, which is trading at 42.5x FY21 earnings, but near term challenges will likely hurt the valuation. Hence, analysts advise investors to be patient and pick the stock when it corrects.

“Last year’s base in terms of sales and profit is high for United Spirits over the next two quarters. Besides, near-term challenges like the slowdown in consumption and increase in raw material cost are looming large. We don’t expect them to repeat stellar FY19 performance,” says Chhabria. But, he remains constructive on the stock, adding, “Restructuring drive and deleveraging will continue to drive healthy earnings growth in FY20.” 

With an eagle-eyed strategy, United Spirits is well set to accelerate its growth. It may not be immune to short-term hurdles, but the management seems to have found the recipe for the right cocktail, to deliver high returns for its investors.