On April 10 2017, Madhya Pradesh (MP) became the fourth Indian state in the past two years to announce a ban on liquor. We note that the prohibition is only partial in Tamil Nadu and likely to be repealed in Kerala; liquor prohibition has not lasted for more than two years in any Indian state other than Gujarat and MP makes up a small proportion of national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 could lead to significant near-term damage for the alcoholic beverage companies. Other near-term headwinds include lingering impact of demonetisation, Supreme Court ban on liquor outlets located within 500 metres of state/national highways, uncertainties over inclusion of alcoholic beverages in GST and 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-demonetisation 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 `2,025 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 `930 (`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 premiumisation and operating leverage.
The event and our take on it
Madhya Pradesh has announced closure of all liquor outlets in the state in a phased manner. The first phase would include closing of all liquor shops within a radius of five kilometres 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.
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: 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.
Lingering impact of demonetisation: Discretionary demand was impacted post demonetisation. Some recovery has been observed in consumption, but there is still some time to go to reach pre-demonetisation levels. Highway alcohol sale ban by SC: In December 2016, the SC ruled that stores selling alcoholic beverages within 500 metres from highways will be closed from April 1, 2017. There was some relief granted in response to the review petition on March 31, 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. In response, many states have started de-notifying highways as local roads. Despite this, companies are expected to witness some near-term earnings impact.
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-demonetisation levels. In case of UNSP, we also lower our FY23 Ebitda margin estimate to 16.9% from 18.8% earlier. 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. On incorporating the changes in estimates, our revised DCF valuation indicates a target price of `2,025 for UNSP. For UBBL, apart from cutting PAT forecasts, we have reduced the earnings multiple on FY19e cash EPS from 35x to 33x. This leads to a revised target price of `930 (`1,030 earlier).