On 10 April 2017, Madhya Pradesh (MP) became the fourth Indian state (after Kerala, Bihar and Tamil Nadu) in past two years to announce a ban on liquor.
- We note that (i) the prohibition is only partial in Tamil Nadu and likely to be repealed in Kerala; (ii) liquor prohibition has not lasted for more than two years in any Indian state other than Gujarat and (iii) MP makes up a small proportion (~3%) of national sales for both the large listed alcohol players – i.e. United Spirits (UNSP) and United Breweries (UBBL).
- However, we believe more such bans (even if temporary in nature and by smaller states) could lead to significant near-term damage for the alcoholic beverage companies. Other near-term headwinds include: (i) lingering impact of demonetization, (ii) Supreme Court (SC) ban on liquor outlets located within 500 meters of state/national highways, (iii) uncertainties over inclusion of alcoholic beverages in GST and (iv) delay in discretionary consumption recovery.
- We have cut our FY18 PAT forecasts by as much as 26% for UNSP and 23% for UBBL from pre-demonetization levels.
- We downgrade UNSP to Neutral from Buy due to severe near-term sectoral headwinds and disappointing margin performance versus expectations over past two years. Our revised DCF-based target price of INR2,025 (INR 2,520 earlier) implies only 8% upside.
- Despite cutting forecasts and reducing targeted cash EPS multiple from 35x to 33x for UBBL, we are still able to derive a target price of INR930 (INR 1,030 earlier), implying 24% upside. We thus maintain our Buy rating on the stock. Also, despite near-term headwinds, the longer-term earnings growth prospects remain promising, with volumes likely to grow in double-digits on recovery and margins to improve led by premiumization and operating leverage.
- Madhya Pradesh has announced to close all liquor outlets in the state in a phased manner.
- According to MP Chief Minister Shivraj Singh Chouhan, the first phase would include closing of all liquor shops within a radius of five kilometers from the banks of river Narmada on either side.
- In the next phase, liquor shops will not be allowed to operate in residential areas, near educational institutes or religious places.
- Subsequently, all other outlets will be closed.
Our take on the event
- MP government has not indicated the timeframe for alcoholic store closures.
- The state likely accounts for only 2-3% of sales for UNSP and UBBL.
- Tamil Nadu (a far more important market for both these companies) had also announced prohibition last year, but only ~10% of outlets have been closed.
- Kerala is in the process of repealing the liquor ban.
- Liquor prohibition has not lasted for more than two years in any Indian state other than Gujarat. This may be primarily because alcohol contributes more than 25-40% of revenues for most states.
Dark shadows loom
- Contagion effect: After Bihar (total prohibition for the time being), Kerala and Tamil Nadu, Madhya Pradesh is the fourth state to announce liquor prohibition in last two years. In our view, it is highly unlikely that any of the largest liquor consuming states like Maharashtra, Karnataka, Andhra Pradesh, Telangana and Punjab will announce such prohibition. However, the possibility of some smaller states announcing such a measure cannot be ruled out.
◦April 2015: Kerala implements ban on alcohol, barring beer and wine.
◦April 2016: Bihar implements prohibition on all alcoholic beverages (after initially speaking of excluding beer).
◦April 2016: Tamil Nadu announces prohibition; starts closing down the first batch of outlets.
◦April 2017: Madhya Pradesh announces prohibition; starts closing down the first batch of outlets.
- Lingering impact of demonetization: Discretionary demand was adversely impacted post demonetization. Some recovery has been observed in consumption, but there is still some time to go to reach pre-demonization levels.
- Highway alcohol sale ban by SC: In December 2016, the SC ruled that stores selling alcoholic beverages within 500 meters from highways will be closed from 1 April 2017. There was some relief granted in response to the review petition on 31 March 2017, which benefited outlets in Karnataka, AP and Telangana (ban implementation extended up to June 2017) and Tamil Nadu (extended up to September). In many others states, the ban is already in place as directed by the SC. In response, many state governments have started de-notifying highways as local roads. Despite this, companies are expected to witness some near-term earnings impact.
- Uncertainties over inclusion in GST: Last year, the central government announced that alcoholic beverages will be kept out of GST ambit, denying input cost credit to spirit/beer companies.
◦GST rates applicable on inputs: While our interaction with most companies suggests that applicable GST rates on inputs should be much lower than feared initially, the actual rates have still not been revealed.
◦Availability of set-offs: Over past few quarters, companies in the sector have been negotiating with the state governments for set-offs on input tax credit foregone. Until rates are finalized (most likely in May), there would not be any clarity on the quantum of set-offs granted, if any.
◦Price increases if set-offs are not granted: While complete set-offs to offset the impact of absence of input cost credit would be ideal, some states may not agree to the same – there would then be negotiations over the extent/timing of price increases (e.g. in states like Karnataka, where the government controls pricing). Even if price increases are granted to the extent desired, we believe there would be near-term impact on volumes as price hikes would be passed on to consumers.
◦Availability of freight cost abatement, and GST rate applicable for used bottles: There is no clarity yet on both these factors, risking earnings prospects of companies like UNSP and UBBL.
- Discretionary consumption revival: Big spurt in demand and premiumization for discretionary products like alcoholic beverages needs incomes to rise and employment to be generated. As of now, this does not seem to be happening if one looks at employment in the organized sector. Since both UNSP and UBBL are capital-intensive businesses (unlike other FMCG peers), sensitivity of earnings to revival is high.
- Valuation and view: Factoring in the near-term headwinds for the alcoholic beverages sector in India, we cut FY18E EPS by as much as 26% for UNSP and 23% for UBBL from pre-demonetization levels. In case of UNSP, we also lower our FY23 EBITDA margin estimate to 16.9% from 18.8% earlier, given the continued disappointment on the margins front over past few years. We believe UNSP is far from getting anywhere close to ~25% EBITDA margin levels that Pernod Ricard India enjoys. Moreover, UNSP is even at risk of missing its medium-term guidance of mid-teen margins (a level that it had guided for two years ago). On incorporating the changes in estimates, our revised DCF valuation indicates a target price of INR2,025 (INR2,520 earlier) for UNSP, leading us to downgrade our rating from Buy to Neutral. For UBBL, apart from cutting PAT forecasts, we have also reduced the earnings multiple on FY19E cash EPS from 35x to 33x. This leads to a revised TP of INR930 (INR 1,030 earlier). However, despite near-term headwinds, we believe that UBBL’s beer business in India could return to double-digit volume growth on revival (note that the industry’s volumes grew at ~14% CAGR for eight years before slowing down from FY14). Moreover, we note that UBBL enjoys strong barriers to entry in the form of distribution, brewery presence across states and brand. The longer-term margin outlook too is attractive. We thus maintain our Buy rating on UBBL.
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