Game for more

Vijay Mallya’s decision to sell his family silver bodes well for the company that we are talking about. I expect a big re-rating for United Spirits now that Diageo PLC has bought a 27.4% stake in it. The deal is a win-win for the buyer (Diageo), the seller United Breweries Holdings (UBHL) and the minority shareholders.

So, what does Diageo get from the deal? It clearly benefits from a much sought-after lead position in a key emerging market, a lead it can hope to maintain over its global rival, Pernod Ricard, which has tasted huge success in India. The valuation multiple of 20 times trailing Ebitda seems quite reasonable in view of the company’s current margin profile. The acquisition would also provide a fillip to Diageo’s international spirits business in India because it could leverage United Spirits’ distribution and manufacturing abilities even though it’s not going to be merged with United Spirits. 

Prima facie, it may look like United Breweries has parted with a significant value driver, but I feel the value creation potential with Diageo is higher, given United Spirits’ weak balance sheet. UBHL’s 14.9% stake will be far more valuable in the future compared with the 27.8% it held in United Spirits without Diageo.

The biggest beneficiary of this transaction, doubtless, is the minority shareholders because a significant part of the total consideration (that is, ₹3,300 crore of the ₹5,700 crore) will be injected into United Spirits, which will delever the balance sheet smartly and improve return ratios. United Spirits’ shareholders have also been spared the potential risk of royalty payment to United Breweries.

I also see a very high probability of the deal going through on the regulatory side. It will, in all likelihood, be a Form 1 filing with the Competition Commission of India. The deal will also require the UK Fair Trade Commission’s approval where queries on Whyte & Mackay (W&M), which United Spirits acquired five years ago, may be raised. But Diageo has stated that W&M — one of the largest bulk Scotch suppliers — is not the swing factor, and that it would go ahead with the deal in the current form without W&M, if necessary. Diageo’s key driver of valuation here is the domestic market potential, and it continues to pursue its own plans for bulk Scotch supplies.

The deal and its dimensions

Diageo will acquire 12.8% interest in United Spirits’ share capital from United Breweries and other members of its group; 6.5% from the UNSP Benefit Trust; and preferential allotment of new shares amounting to 10% (on post-issue share capital). If the preferential allotment does not ensure Diageo gets a minimum shareholding of 25.1% in United Spirits, additional shares may be acquired from United Breweries.

Diageo would be required to launch a mandatory open offer for 26% of United Spirits’ public shareholders at ₹1,440 per share. If Diageo’s stake is less than 50.1% after the above transactions, the share purchase agreement obliges UBHL to vote in favour of all United Spirits resolutions proposed by Diageo for four years.

The benefits for United Spirits and UBHL are more apparent but Diageo will also gain immediately and immensely as the acquired entity will reflect in the consolidated statement and boost the valuations of Diageo PLC. The deal is value accretive in the medium to long run thanks to its focus on premium brands. In fact, of late, United Spirits has been focusing on growing its premium portfolio instead of chasing growth in its ‘regular’ portfolio. The company reported 7% y-o-y volume growth for FY12, with the premium segment outgrowing the company at 15% y-o-y. It is true United Spirits has seen a 1% y-o-y volume decline for Q2FY13 even as the premium segment grew 14% y-o-y but now with Diageo coming on board, I expect the focus on premium brands will gather momentum. I believe the company will temper its overall volume growth target to 6-7% (instead of 12-13%) by defocusing from the regular segment. 

Also, Ebitda margins should expand 3.4% over FY12-15 led by better gross margins and other cost synergies with Diageo.  The prices of extra neutral alcohol (ENA) — a key ingredient — has increased by only 3.5% y-o-y in H1FY13. Hence, the company could see some improvement in gross margins on account of lower inflation in ENA prices, and get benefits of full ramp-ups at its own distilleries. Overall, there is a potential for Diageo to improve margins as cost synergies kick in to around 18-20% over the medium-term. 

More steam left

Global distillers trade at 20-25 times forward P/E owing to low capital intensity and a strong brand franchise. It’s United Spirits’ dominance in the Indian market, and scope for margin and return on equity (RoE) expansion, that makes me believe it will trade at a premium to its global peers — I estimate United Spirits to generate RoEs of over 20% in the near term. Given that the stock is already up 300%, the downsides could be around ₹1,700-1,800 levels in the short term but, our interim target is ₹2,100 with possible upside to ₹3,600 levels in 2-3 years. We believe the market will focus on the margin potential and scope for stake sales in W&M and UBHL. In short, there’s enough spirit left in the stock.