It has been three years since Diageo took operational control of USL and we acknowledge that we may have underestimated the management bandwidth required to unravel a complex balance sheet. While our theory of rapid margin expansion has not materialised, driving 28% stock underperformance YTD, investors may have overlooked the sharp improvement in capital efficiencies.
Through F14-F16, even as EBIT increased by only 16%, total assets halved for USL driving the RoE to 20% in F16. We forecast an underlying RoE of 28% in F19 driven by incremental EBIT to incremental assets of 10x for F16-F19. This compares to an average of 3x for consumer stocks.
The next leg will be driven by rapid operating margin expansion.We note that with 3x the volumes and a superior product portfolio, USL operates with 3.7% EBITDA margins in the ‘Regular and below’ segment vs 6.4% for its nearest competitor. Contrary to market views, we see an under-appreciated opportunity for USL to rationalise costs.
We forecast F16-F19 EBITDA CAGR of 18% and 1,000bps expansion in RoCE. Our EPS cuts incorporate the impact of currency demonetisation. GST is key risk but markets may be factoring extreme scenarios: In a worst case scenario, we see 15-30% impact on USL’s earnings, if tax on input costs rise to 12-18% (proposed GST slabs) from 7% currently.