>United Spirits (IDFC SSKI)

Tracking the market momentum, recovering from the knee jerk reaction post the poor financial performance in Q3FY09 and triggered by the ongoing talks with Diageo for stake sale in United Spirits (USL), USL’s stock is up by ~70% from the bottom. However, at the CMP of Rs730 and trading at a valuation of 16x (net of treasury stock), we see a strong trading ‘short’ opportunity given the pressure on near term profitability (rising prices of molasses) and continued uncertainty over the ‘stake sale’ transaction. While USL’s growth momentum remains robust (sold 90m cases - 88.5m cases in USL and 1.5m cases of W&M in FY09 – 20% growth), we see increasing pressure on the near term profitability as molasses prices are set to stay over Rs5200/ ton (25% higher yoy), less likelihood of material price hikes (given the election period) and limited scope for portfolio uptrade (first line brands account for 93% of the business now). We see continued gross margin erosion in USL’s domestic business in FY10 (expect 200bp). Globally too prices of Scotch whisky could see correction as economic recession hits consumption, thereby limiting the upside gains for W&M as and when the contracts come for renegotiation. Besides operationally, there could be likely GBP5-10m risk on numbers on account of pension scheme provisioning in FY09. All these factors pose a risk to our earnings estimates in FY10. Also, while USL is in talks with Diageo and various private equity players for stake sale, there could be likely delay in the completion of the transaction. Citing all these risks, maintain our Neutral stance on the stock with a near term trading ‘short’ opportunity. Global liquor majors – Diageo and Pernod Ricard have seen 20-25% correction in their stock price since December 2008 (while broader markets have moved up) and are trading at PER of 11x.

USL – 70% up from the bottom
After the dismal performance in Q3FY09 (860bp of margin contraction), USL’s stock had corrected to Rs425 in January 2009. However the stock has since then seen 70% uptick to current market price of Rs730. This was driven on three counts – the fall, we believe, was sharper than expected and was a knee jerk reaction to the dismal performance (margins below 12% after a span of 7 quarters) and hence the recovery, secondly on account of strong market momentum (25% from the bottom) as indeed the ongoing talks of stake sale to Diageo and deleveraged the company balance sheet (net debt of Rs61bn).

While Q4FY09 numbers expected to be better than Q3FY09…
In Q3FY09, United Spirits saw the sharpest of the margin contraction for the past many years – EBITDA margin contraction of 860bp and gross margin contraction of 940bp. This was primarily on account of sharp increase in molasses and ENA prices (accounting for 40% of material cost) and glass prices. Effective molasses prices had increased from Rs290/quintal in Q3FY08 and Rs460/quintal in Q2FY09 to Rs525/quintal in Q4FY09 (80% higher yoy and 14% higher qoq). ENA prices too were higher by 50% yoy at Rs31/ltr. With cut down in sugarcane cultivation, molasses and ENA prices have remained higher. However, the scenario improved in Q4FY09 (effective molasses prices were down to Rs480/quintal and ENA prices were at Rs28/ltr in Jan-Feb 2009), with slow down in economy resulting in slow down in ENA and molasses consumption for industrial purpose. This, we believe would help improve upon the margins in Q4FY09 over Q3FY09. While the sales growth remains robust (expect 17% growth yoy), EBITDA margins are expected at 14.4% (310bp higher qoq, but 340bp lower yoy).

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