Downgrade Tata Global to underweight on Starbucks JV

Updated: Nov 20 2012, 06:10am hrs
We downgrade Tata Global Beverages (TGBL) to underweight (from equalweight) with a price target of R140, driven by poor earnings visibility and mediocre return ratios at current valuations. Our price target is based on probability-weighted residual income model (versus our prior method of a base-case residual income model) with an 80% weighting on our base case, 15% on our bull case and 5% on our bear-case value. In addition, we roll forward our estimates to FY14.

Even as TGBL stands to benefit from a cyclical uptrend in its international business, we fail to see any sustainable structural improvements in the tea business and see limited upside in the US coffee business. The stock has doubled year-to-date and outperformed the Sensex by nearly 80% over the same period. It now trades at 21.8x our revised FY14e (versus 17x last five-year average one-year forward multiple). In our view, TGBLs relative outperformance to the Sensex was driven largely by TGBLs JVs with Starbucks and Pepsi, the change in management, and earnings rebound from trough levels in FY12.

Although we view the management change and the JVs as incrementally positive, the contribution from these JVs to earnings will be limited, in our view. In addition, there is lack of visibility in the international business for TGBL, and the international business remains vulnerable to input cost pressures. To that extent, the stock move seems exaggerated to us, and we will use this opportunity to book profits in TGBL.

TGBL reported strong Q2FY13 results, delivering adjusted net profit growth of 30% even though its international business saw a decline in same currency revenue and a ~250 basis points drop in global tea business margins. Earnings were cushioned by foreign exchange (~11%+) and input cost tailwinds (over 30% y-o-y decline in Arabica coffee prices).

However, these tailwinds are waning as we expect revenue growth to moderate from here with low to mid-single-digit foreign exchange gains. We also expect tea business margins to remain under pressure, given rising tea prices and see the ~45% fall in Arabica coffee prices from recent peak to affect the plantations business. We believe the international coffee business will witness better margins, which, based on trailing stock performance, appears priced in.

Morgan Stanley