Financial analysts are fretting over the premium valuations that British liquor-maker Diageo will be paying for a stake in Vijay Mallyas United Spirits much like they frowned upon Tata Motors when it bought the marquee Jaguar and Land Rover brands back in 2008. Tata Motors borrowed heavily to foot the $2.3 billion bill for the loss-making JLR; Diageo will be much less indebted after it knocks back a 53.4% stake in USL for about $2 billion even though the deal doesnt come cheap at 20 times March 2012 ebitda. As Breakingviews columnist Quentin Webb points out, it would take Diageo a good six years to earn a return higher than its 12% cost of capital. But the worlds biggest maker of spirits, which has waited a long time to set foot in the Indian market, must surely know that. And it would have figured by now that teaming up with the market leader would be the easier way into the Indian market; negotiating high entry manufacturing and distribution barriers in a country where every state has its own sets of liquor laws and politicians can be tricky. Given the scarcity of prospective partners, its been a long wait, but given Mallyas track record with other partners, the alliance should pay off.
India, for Diageo, would be a play on consumers getting a lot more up-market, a trend that promises to get bigger as the catchment grows and per capita consumption goes up. The firm, which sells eight of the worlds top 30 retail brands by value, indicated as much in a call with analysts after the USL transaction was announced, saying it would stay focussed on the top end of portfolio. That makes sense since its hard to make meaningful money on mid-tier brands, given how prices of raw materials and taxes can shoot up and how high the payoffs can be in an over-regulated market; USLs ebitda margins slipped nearly 300 basis points, y-o-y to 11.4% in the three months to September although the top line jumped 24%. Diageo will know how to fix that; by successfully catering to high-end customers and simultaneously pulling in the emerging middle classes into entry-level brands, Diageo has scaled up its Latin American and Caribbean businesses which contributed 12% of sales and profits in FY12. In the next five years it hopes to double sales in some of these countries like Mexico and treble them in others like Argentina and Chile. In India, USLs distribution network would give the 10.76 billion firm an edge in a market thats growing at an estimated 15% on a base of R35,000 crore. So its not really surprising Diageo chose to snap up the USL stake this time, helped by Mallyas need to do the deal. The Tatas turned around JLR in less than three years despite dire predictions the firm would go bankrupt. It should be a lot easier for Diageo to prove the analysts wrong.