United Spirits Limited (USL) is the largest Indian beverage alcohol company, and the world's second-largest spirits company by volume. Founded in 1826, it is a subsidiary of Diageo, involved in the manufacture, sale and distribution of beverage alcohol. Having leading brands across all categories and price segments, USL produced and sold nine crore cases in the financial year 2017. McDowell’s No. 1 Soda is a famous Indian brand manufactured by the company.
Its portfolio includes 18 million brands of the nearly 140 brands that company owns. Headquartered in Bengaluru, the company has a strong distribution network and point of sale coverage and is represented in 81000 outlets across India. It has over 78 manufacturing facilities across 23 states and three union territories in India. The company exports its products to over 37 countries. As of March 2013, USL has more than 140 liquor brands, of which 15 brands each sell more than one million cases annually while three brands each sell more than 10 million cases annually.
United Spirits has an aggressive acquisition strategy. It acquired the second largest Indian liquor manufacturer Shaw Wallace, French winemaker Bouvet Ladubay, and, the fourth largest Scotch whisky player in the world, Whyte & Mackay. Its subsidiaries include Pioneer Distilleries and a small wine company called Four Season. Apart from this, there are 16 to 17 non-operating companies.
In 2013-14, Diageo plc acquired a 54.8 per cent shareholding in United Spirits, making India one of its largest markets. Diageo increased its stake in the company to 54.78 per cent through open offer which mandated USL to sell off Whyte & Mackay to Emperador (for GBP430mn).
For the first quarter of 2018, United Spirits revenue fell by 12.7 per cent year on year basis (YoY) with 19 per cent YoY volume dip and EBITDA decreased 26.2 per cent YoY. The metric have been below the estimates impacted by highway ban and one-off impact of transition to the franchise model in popular brands. Adjusted for this one-off, sales and volumes fell 7 per cent and 10 per cent YoY, respectively.
USL also faced destocking by customers during the quarter; the impact of down stocking led to 3 to 4 per cent decline in volume.
Across cities, Mumbai has been faring well, however, Maharashtra as a state has seen some major volume impact and there has not been any price hike in Telangana yet.
Margin
USL’s sustained focus on productivity initiatives and select price increases have led to an underlying gross margin improvement of 116 basis points (bps) and the price improvement has led to gross margin jumping of 150bps YoY, leading to 2.65 per cent expansion in the gross margins, largely helped by shift to the franchise model.
The continued marketing investments and increase in other overheads negatively impacted the EBITDA. EBITDA margin declined 1.62 per cent impacted by lower operating leverage due to impact on volumes.
USL wants to increase its advertising and promotion (A&P) expenses, it will spend on the popular brands for products which are not franchised. Thus, per cent A&P spent on popular brands will be much smaller. Diageo’s focus on improving marketing spending and controlling promotional spends will give better returns by way of brand visibility, but it will hit margins.
The company did not face any business disruption due to migration to GST, however, it expects to be able to mitigate GST impact on margins in the next two to three years.
The Highway Ban
The Supreme Court had said that liquor vendors within 500 metres of national and state highways will have to shut from 1 April, 2017.
The court had given some exemptions to Sikkim, Meghalaya and Himachal Pradesh. It also held that areas with a population up to 20,000 may have liquor vends at a distance of 220 metres from the highways. Nine districts of Uttarakhand have recently joined the exemption bandwagon.
The apex court also gave ruling permitting states to denotify particular stretches of highways within city limits, which has enabled opening up of windows for a few outlets again. The company acknowledged this to be encouraging and is confident that there will be a shift in consumption from stores which are open.
Impact of Ban
The Supreme Court’s favourable ruling of allowing sale of liquor on state denotified highways is definitely positive, but prohibition of sale of liquor on highways will continue to impact volumes. Though, the impact will recede quarter on quarter (QoQ) for a couple of quarters. The highway ban’s impact has more been on the on-trade channels such as hotels, bars, pubs, et al. The first quarter performance was impacted by the highway ban which led to lower consumption due to reduction in the number of retail outlets.
Due to the highway ban, USL has seen 30 per cent shrinkage in its outlets. Post the denotification, about 10 per cent stores have reopened. About 15,000 stores are still closed; of these 2/3rd are on-trade and 1/3rd off-trade. However, new stores are opening gradually and there’s been an increase in the issue of new licenses in different states.
The company expects the impact of highway ban to continue in the second and third quarter of fiscal 2018; however, to a lesser extent. By end of the next two quarters, USL expects things to normalise, that is the performance to reach pre-highway liquor ban issue levels.
To GST or not to GST?
The implementation of GST effective from July 1, 2017 has resulted in additional taxes on input materials and services which will result in stranded taxes and will impact margins. GST remains a key monitorable as the sector is out of the GST realm. It remains an overhang on the stock with the alcohol industry being out of its purview— liquor companies will not be able to take the credit of GST paid inputs—which is likely to impact margins, however, the extent of impact is not yet clear.
However, clarity is required on the treatment of potable alcohol under GST. USL is working with state governments to seek clarity on some state specific taxes and also approaching them for appropriate price hikes. Additionally, the company continues to work to minimise the impact through internal measures. It expects to have better clarity on the financial implications of GST over the next few months and does not see any disruption in business due to GST implementation.
IT has smoothly transitioned to the GST regime. A few states have denotified some state taxes. With balance states, the company is in consultation. State taxes include local body tax, entry taxes, etc. In a few states where apart from GST there are still some levies, the company will look at hiking prices.
Prestige and Above (P&A) segment
The Prestige & Above segment constitutes 47 per cent of total volumes and 61 per cent of total net sales, up by 5ppts and 3ppts, respectively, compared to last year. The divisions’ volumes and sales declined by 9 per cent and 8 per cent YoY, respectively, owing to the anticipated highway ban. P&A brands have gained market share in the first quarter of 2018 and also over the last 12 months.
The strategy of Diageo to focus on its premium segment has started bearing fruits, reflected in market share gains by McDowell’s. McDowell’sNo 1 Whisky variants’, excluding Platinum, has posted better performance despite its net sales declined one per cent.
The Signature brand has been re-launched and recorded strong performance despite highway ban. Itcontinued to show positive momentum supported by successful renovation and net sales grew 14 per cent.
The company has also re-launched Antiquity, which commenced towards the end of the first quarter in select states with early signs of positive consumer trade response and should start to show results in terms of strong growth.
Royal Challenge’s net sales slipped 11 per cent YoY. The net sales of USL’s scotch portfolio in the premium and luxury segment sales tumbled 24 per cent YoY.
The management’s strategy of re-launch and focus on key brands remains in the right direction, however, in the short-term it will impact volumes of other brands in core franchise such as McDowell’s Diet Mate. These brands are being defocused to concentrate on core brand, though a better strategy will drag volumes in P&A segment.
USL’s strategy of launching brand extensions like McDowell’s Silk, McDowell’s Luxury, Royal Challenge Bolt, et al., will help to create a buzz in the brand.
Popular segment
The popular segment constitutes 53 per cent of total volumes and 36 per cent of total net sales, dipping by 5ppts and 4ppts, respectively, compared to last year.
Reported net sales declined 20 per cent with 5ppts positive price and mix negatively impacted mainly by operating model changes. Moreover, the net sales of priority states declined 7 per cent.
The operating model change in popular brands resulted in 26 per cent YoY dip in the segment’s volumes with 20 per cent YoY sales fall; excluding this one-off impact, sales dipped 8 per cent YoY.
During the quarter, strong performance of Hayward’s 5000 was offset by decline in rest of the brands. It had low base quarter which has helped in strong performance in the quarter.
Franchise agreement
The company is moving towards the franchise model in the popular segment, which is already operational in 13 states. It will ensure margin stability in the segment, reduce working capital requirement for these brands and increase focus on the management to the higher margin P&A segment.
As the franchise model in the popular segment is already implemented in 13 states, going forward, the company will look at other states provided they get better partners.
During the first quarter of 2018, Rs 142 crore sales were lost owing to the move to franchise model. In the financial year, owing to the franchise agreement, volume impact could be one crore cases and sales impact could be Rs 650 crore.
For fiscal 2018, royalty income is expected to be in the range of Rs 140 to 160 crore and for the quarter, has received Rs 25 crore royalty income. From the profit and loss perspective, royalty income is added to net sales.
Exceptional items
Employee cost had one-off impact of Rs 13 crore. During the quarter, there was factory closure which resulted in exceptional items. Going forward as well, the company will look at exiting high cost factories.
Debt and balance sheet items
The company has shifted its borrowing profile to commercial paper and refinanced bank loans, leading to the interest rates tumbling 2.30 per cent over the previous sequential year. Over the last 12 months, the debt level has reduced by Rs 500 crore.
A slight increase in overall depreciation rate can be expected.
Outlook: Sluggish improvement
United Spirits remains the best play in India’s liquor industry in the listed space by virtue of robust market share and benefits ensuing from management control of Diageo. Diageo has initiated steps to turnaround the company, which includes changes in management – it recently appointed new CFO, changes in distribution levels, revamping its brand promotions strategy, enhancing efficiency in supply chain, focus on lean portfolio, engaging with the government and improving work culture.
However, GST (alcohol outside purview) and impact of ban on liquor sales on highways remain key monitorables. The volumes are expected to recover gradually as the impact of highway ban recedes QoQ basis.
Despite the regulatory challenges of the highway ban, the long-term consumer opportunity remains strong for spirits. USL continues to focus on strategic priorities to capture this opportunity and achieve its medium-term target of growing top line in double digit and improve margins to mid-high teens.
USL will be a prime beneficiary over the long term of the recovery in the urban growth, which will enhance disposable incomes, further aided by GDP revival; favorable demographics – as 64 per cent population will be in working age group by 2020; low per capita consumption and steady conversion from country liquor to Indian-made foreign liquor (IMFL) volumes. The IMFL volumes surge 1.5 times when the GDP growth revives.
Major Risks
USL’s profit margins can be highly impacted by further price hikes in molasses, extra neutral alcohol (ENA) and glass prices. The company is exposed to changes in pricing by state governments. Nearly 50 per cent of sales volumes are generated from regions where state governments control prices. These can also impact the profitability. The challenges for the company which can hit USL majorly includes increase in taxes, changes in the distribution structure, prohibition of liquor in any state.
