Earnings to be on a high from lower molasses prices

We believe earnings cycle for Indian liquor industry is set to turnaround as prices of key raw material?molasses are expected to fall sharply. This earnings surge should lead to significant re-rating of the sector. To play this development we upgrade United Spirits (USL) and also reinitiate on Radico Khaitan (second largest listed Indian liquor player) with a Buy. Our price objective (PO) for USL is Rs 2,000, implying 43% potential upside while our PO of Rs 250 for Radico implies a 63% potential upside.

The extent of decline in molasses prices has surprised us. Sugarcane production is expected to be up 15-20% this year, which has led to spot prices of molasses to fall 30% year-on-year. We see further declines from October onwards as molasses supply increases with the beginning of the sugar crushing season. We are building in 20%/10% input cost decline in FY11/12E for both USL and Radico. Molasses forms about 70% of the raw material cost, with 2-3% earnings per share (EPS) rise for every 1% fall in molasses prices.

We also expect strong volume growth of 14-15% for the sector to sustain. Consumer demand continues to remain strong. The September quarter should especially be strong as it makes up for the one-off weak June quarter with trade re-stocking beginning in Andhra Pradesh (20% of market). We expect Radico to grow ahead of USL led by relaunch of flagship brand 8PM and a wider rollout of new brand ?Morpheus?.

The domestic liquor sector had witnessed massive de-rating during global financial crisis as the companies looked vulnerable due to their stretched balance sheets. However, both USL and Radico have made fresh equity issuances and used the proceeds to deleverage. As a result net gearing for both USL and Radico are now at a comfortable level of 0.7x. Also, this has led to sharp decline of 24-46% in interest, cost providing support to earnings growth and offsetting hit to EPS from dilution.

We expect a strong recovery in earnings for the liquor sector with a 63% EPS CAGR (compound annual growth rate) estimate for USL and 4.5x earnings growth for Radico over FY10-12E.

We expect a massive 800-900 basis points gross margin expansion for both USL and Radico. This would be led by a 20%/10% decline in molasses prices for FY11/12E. With spot prices of molasses prices running 30% down year-on-year and expectations of further weakness in prices as sugar crushing season begins from October onwards, we believe our estimates are reasonable.

With deleveraging looking complete for both USL and Radico, we are witnessing a sharp reduction in interest costs for both. While interest cost for USL is set to fall about 30% over FY10-12E, for Radico we estimate a decline of 40-50%.

We had been concerned about deterioration of working capital cycle for the industry in FY10. This was led by higher inventory costs due to costlier raw materials and longer receivable days as industry compromised on trade cycle to push price hikes with state governments. With input costs set to fall, we expect a reversal of both these factors. This should lead to a significant improvement in the working capital cycle for the industry. We estimate a 4-6% improvement for both USL and Radico in terms of the working capital-to-sales ratio.

We believe the transformation is structural to a large extent and not just cyclical in nature. This is because both USL and Radico have taken several steps over last two-three years, which have helped them de-risk their businesses. With this, we are now more confident of earnings stability and any hit from unforeseen factors should be minimal.

Molasses availability/price is dependent on the sugarcane cycle and since liquor companies do not have pricing power in two-third of the markets, their margins are cyclical. Since grain prices are fairly stable, the cost of production, using grains, is fairly predictable. However, it is costlier to use grains and, unless molasses prices are running quite high, it is not economical to use grains. Though Radico has been more proactive in putting up dual substrate facilities, USL has also now followed suit. This gives them the flexibility to use molasses during the downcycle (like the one expected over the next two years) and a shift to grains when the cycle turns.

Our favored methodology for valuing the liquor sector is target price-to-earning (P/E) multiple. We peg USL at 22xFY12E and Radico at 18xFY12E. For comparison with historical performance we use EV/ebitda (enterprise value/earnings before interest, taxes,depreciation and amortisation) as a proxy for P/E as losses made by both USL and Radico in FY09 make P/E comparison difficult. At our price objective,implied EV/ebitda for USL is 13xFY12E and for Radico it is 12xFY12E. This is at 10%/25% discount to last five-year average for USL/Radico.

We believe this discount is warranted as additional trigger of acquisitions / JVs would be missing, going forward.

Higher multiple is justified for USL as it enjoys a formidable market share, has more established brands, covers a larger product portfolio and has got a better distribution network. As per our price objective, Radico provides a 63% potential upside vs 43% potential upside for USL. Higher return for Radico is possible given the higher re-rating potential.