United Spirits: Paradigm shift - Beginning of a new era

22 September 2014

Update | Sector: Consumer

United Spirits

BSE Sensex

27,207

S&P CNX

8,146

CMP: INR2,362

TP: INR3,000

Upgrade to Buy

Paradigm shift: Beginning of a new era

Multi year growth story provides a good compounding play

Stock Info

Bloomberg

Equity Shares (m)

52-Week Range (INR)

1, 6, 12 Rel. Per (%)

M.Cap. (INR b)

M.Cap. (USD b)

UNSP IN

145.3

2,941/2,226

-5/-34/-41

347.6

5.7



Financial Snapshot (INR b)

Y/E Mar

2015E 2016E 2017E

Net Sales

91.8 103.9 119.2

EBITDA

Adj PAT

EPS (INR)

Gr. (%)

BV/Sh (INR)

RoE (%)

RoCE (%)

P/E (x)

P/BV (x)

9.9

4.5

31.1

12.9

14.9

77.0

9.9

13.3

7.6

52.5

68.6

17.9

18.8

45.7

8.2

16.2

10.2

70.4

34.2

361.6

19.5

21.5

34.0

6.6



Diageo now control 55% of UNSP. We expect UNSP to embark on new journey

with improved and strengthened balance sheet, focus on premiumization and

cleaner governance practices.

Our optimism is backed by the solid long-term prospects for IMFL and UNSP’s

dominant positioning in the same. With new management and better controls in

place, we believe UNSP offers a unique multi-year play on IMFL growth story.

UNSP provides an interesting and liquid vehicle to ride the favorable

demographics driven long term consumption story of India.

The 20% price correction after the conclusion of the open offer provides a good

entry point. Our DCF-based target price of INR3,000 indicates an upside of 27%,

prompting us to upgrade our stock rating from Neutral to Buy.

Regulation and taxation policy related risks, spike in RM cost, and potential

corporate governance issues emanating from operating two different entities in

similar business are key risk factors.

Diageo in driver’s seat; course correction to gather pace

Post the completion of open offer, Diageo controls 55% of UNSP. We now

expect the course correction in UNSP to gather pace. With bulk of the balance

sheet clean up done, we expect Diageo to focus on driving operational

improvement – sharper focus on in-market execution and investments behind

premium power brands. In the medium term we expect the triumvirate of

attractive long term prospects of IMFL industry, UNSP’s dominant market

positioning within the same and strong management with better controls and

governance practices to drive shareholder returns.

241.1 293.6

Shareholding pattern % (Mar-14)

Jun-14 Mar-14 Jun-13

Promoter

DII

FII

Others

33.0

0.1

11.5

55.4

38.6

4.0

40.7

16.7

21.1

6.0

42.4

30.5

Premiumization to gain steam, aiding profitability

We expect the Diageo management to continue driving premiumization and

focus on (a) brand investments, (b) leverage reduction, (c) working capital

improvement, and (d) prudent capex. EBITDA margin should expand from 8.3%

in FY14 to 12.8% in FY17. Diageo has indicated the possibility of achieving 20%

EBITDA margin (last seen in FY08) in the long term. We expect margin

expansion efforts to gather pace post FY16. Our 10-year forecast builds in 20%

EBITDA margin by 2023.

Notes: FII includes depository receipts

Stock Performance (1-year)

United Spirits

Sensex - Rebased

3,600

3,200

2,800

2,400

2,000

W&M divestment to deleverage balance sheet

Divestment of W&M should free management bandwidth to focus on the

lucrative domestic opportunity and drive deleveraging of UNSP’s balance sheet.

We factor in INR37b debt reduction in FY15 from the proceeds of the W&M

stake sale, driving interest cost savings of ~INR4b (UNSP’s FY14 standalone PAT

was INR2.4b). UNSP also holds 3.6% stake in United Breweries (UBL) and owns

an IPL team. While Diageo intends to use the IPL asset as a marketing tool, we

believe it would be open to divesting its stake in UBL.

22 September 2014

United Spirits

IMFL opportunity big and growing; UNSP best placed

Favorable demographics (50% population <25 years of age), low per capita

consumption (0.9 litre per annum), rising middle class, growing disposable

income, increasing social acceptance of drinking, and rising consumption of

IMFL among women are the key long-term IMFL growth drivers. With a deep

and wide portfolio across price points and ~41% volume market share in a

segment characterized by a plethora of entry barriers (controlled distribution,

manufacturing, retailing and pricing, ban on advertisement), UNSP is well

placed to capitalize on this opportunity.

DCF-based target price implies 27% upside

We expect bulk of the financial improvement to happen post FY16. Given this,

we believe DCF is the best metric to capture the expected long-term value

enhancement. We use a two-stage DCF model to arrive at our fair value of

INR3,000. We revise our stock recommendation from

Neutral to Buy.

We have

been conservative in our estimates vs. consensus and believe UNSP, in the

ensuing 3-5 years, can offer many earnings upgrade opportunities. Near-term

stock price weakness due to disappointing quarterly earnings and write offs

should present a good buying opportunity, in our view. Regulation and taxation

policy related risks, spike in raw material cost, and potential corporate

governance issues emanating from operating two different entities in similar

business are key risk factors.

DCF valuation summary – fair value of INR3,000/share

INR m

EBITDA

Other income

Tax

WC change

Capex

FCF

PV of each FCF

Sum of PV of FCF

Terminal value

PV of terminal value

Net debt

Equity value

No of shares

Per share value

2015E

9,981

2,750

-2,762

10,774

-6,000

14,742

104,822

890,046

372,331

477,153

40,063

437,090

145

3,008

Source: Company, MOSL

78%

2016E

13,306

3,025

-2,228

669

-4,000

10,772

8,876

2017E

16,165

3,328

-3,756

-2,005

-4,000

9,731

7,277

2018E

19,854

3,660

-5,039

-720

-4,500

13,255

8,998

2019E

24,591

4,026

-6,416

-1,386

-5,000

15,815

9,746

2020E

31,235

4,429

-8,310

-1,195

-5,000

21,159

11,835

2021E

40,581

4,872

-10,848

-4,059

-5,000

25,545

12,970

2022E

52,147

5,359

-14,258

-7,757

-5,000

30,491

14,052

2023E

65,526

5,895

-18,383

-9,013

-5,000

39,025

16,325

22 September 2014

United Spirits

IMFL opportunity big and growing

United Spirits is best placed to capitalize on IMFL opportunity



The Indian Made Foreign Liquor (IMFL) industry, a 300m case industry as at the end of

FY14, is likely to grow at a CAGR of 13% over FY14-17.

Favorable demographics, low per capita consumption, rising middle class, growing

disposable income, increasing social acceptance of drinking, and rising consumption of

IMFL among women are the key long-term growth drivers.



With a deep and wide portfolio across price points and ~41% volume market share in a

segment characterized by a plethora of entry barriers (controlled distribution,

manufacturing, retailing and pricing; ban on advertisement), UNSP is well placed to

capitalize on this opportunity.

IMFL industry set to grow at a CAGR of 13% over FY14-17

The Indian Made Foreign Liquor (IMFL) is a 300m case industry as on FY14 and is

likely to grow at a CAGR of 13% over FY14-17. Whisky constitutes the largest pie of

IMFL, with 59% of volumes followed by Brandy, Rum, Gin, and Vodka, with 22%,

15%, 3%, and 1%, respectively. UNSP enjoys ~41% volume market share in IMFL.

Exhibit 1: Whisky forms bulk of the IMFL market…

IMFL Market (in volume terms)

Rum

15%

White

Spirits

Exhibit 2: …with nearly 2/3rd value contribution

IMFL Market (in value terms)

White

Rum

Spirits

15%

Brandy

22%

Whisky

59%

Brandy

16%

Whisky

66%

Source: Company, Industry, MOSL

Source: Company, Industry MOSL

Exhibit 3: IMFL industry expected to post healthy double digit value CAGR

INR m

Spirits

Brandy and Cognac

Rum

Whiskies

Gin

Vodka

2013

994.7

164.2

115.1

666.9

6.9

41.5

2014

1,110.3

185.8

125.0

745.1

6.8

47.5

2015E

1,227.2

207.8

134.6

824.2

6.7

53.8

2016E

1,345.8

229.7

144.4

904.6

6.7

60.4

2017E

1,463.7

250.5

154.8

984.7

6.6

67.1

CAGR

12.5

13.7

9.7

13.3

3.3

25.0

Source: Industry Sources, Company, MOSL

Multiple growth drivers

1. Favorable demographics:

The age profile of the Indian population is most conducive for sustained growth

in liquor consumption. People in the age group 20-59 years are considered as

primary consumers of liquor and more than half of India's population is below

22 September 2014

United Spirits

30 years. Over next 10 years, 150m potential new consumers are expected to

come of drinking age.

There is today a sea change in social values and attitudes towards drinking. This

is aided by the growing proportion of nuclear families, urbanization, and

changing social ethos with greater acceptance of drinking alcohol (increasingly

becoming a lifestyle drink in big metros). All these factors indicate sustained

demand growth for the liquor industry in the coming years. Also, the middle

class population is expected to grow from 120m to 600m (45% of total) by 2025,

which augurs well for premium spirits, in our view.

Exhibit 4: More than half of India’s population is below 30 years

0-19

4.0%

9.1%

9.5%

13.2%

18.0%

46.3%

20-29

30-39

40-49

50-64

65 & over

5.7%

11.6%

12.3%

15.1%

17.1%

38.3%

2013

Source: United Nations, MOSL

4.7%

9.9%

10.6%

14.6%

17.8%

42.4%

2003

1993

2. Rising income levels:

India is one of the fastest growing economies in the world, with average GDP

growth of 6.2% for the past four years. Per capita income has increased 3.6x in

the last 12 years to INR66k. With robust economic growth, an increasing

proportion of the population is coming into the consuming class. Both the

affluent and the middle class income groups are expected to form 80% of

national consumption by 2025. Moreover, we expect discretionary income to

grow at a much faster pace than GDP growth, boosting demand for lifestyle

products, including liquor.

Exhibit 5: Rising disposable income has aided IMFL growth

Personal disposable income (INR'000)

Source: Company, Industry, MOSL

22 September 2014

United Spirits

3. Low per capita consumption:

Despite the per capita consumption growing at 22% in the past five years, India

per capita consumption of liquor (0.9 litre p.a) is relatively low as compared to

global standards (4.6 liters p.a). Even a small increase in per capita consumption

can significantly alter the growth rates and aggregate consumption levels of

liquor in India. As factors like age composition, income levels, and social

attitudes are positively inclined, we expect the liquor industry to post steady

double-digit growth in the coming years.

Exhibit 6: Per capita consumption remains low

9.5

Per Capita consumption (litres per annum)

8.5

Exhibit 7: Urban markets constitute two third of IMFL

industry (consumption in mn litres)

Urban (%)

1,444

1,618

0.9

Rural (%)

1,920

1,990

1,798

4.7

4.5

4.6

Russia

Brazil Thailand

USA

World

India

2009

2010

2011

2012

2013

Source: Company, MOSL

22 September 2014

United Spirits

Diageo in driver’s seat; course correction to gather

pace

Deep Economic Moat + MNC => multi-year compounding story!!



Post the completion of open offer, Diageo controls 55% of UNSP. We now expect the

course correction in UNSP to gather pace.

We expect gradual recovery in the balance sheet, cash flows, and return ratio. Bulk of

the ‘kitchen sinking’ of UNSP’s financials is behind, in our view.

Favorable long term industry prospects plus dominant market positioning now gets an

additional catalyst of a strong MNC management.

UNSP’s operational performance belie benefits of scale

Despite enjoying mark

et leadership in IMFL, with 41% volume share and ~50% value

share, UNSP’s operational performance has been sluggish vis-à-vis peers.

Disproportionate focus on volumes (even at the expense of profitability), imprudent

capital allocation, expansion in working capital with concomitant increase in

leverage, and group issues pertaining to Kingfisher have resulted in sub-par margins

and return ratios. UNSP has been unable to leverage scale benefits (volumes 4x of

next competitor). Even smaller domestic peers like Radico Khaitan (RDCK) and

Tilaknagar Industries (TLNGR) have outp

erformed UNSP on the EBITDA/case metric.

Exhibit 8: EBITDA margin (S/L) has deteriorated sharply

EBIDTA Margin (%)

18.8

15.7

10.2

5.2 5.6 5.5

15.3 15.7 15.1

12.6 12.5

9.1

49.9

47.3

41.1

35.4

54.4

Exhibit 9: Consol. working capital expanded significantly

NWC/Sales (%)

51.6

43.8

FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14

Source: Company, MOSL

FY08

FY09

FY10

FY11

FY12

FY13

FY14

Source: Company, MOSL

Exhibit 10: UNSP EBITDA per case (INR terms) lower than smaller domestic peers

United Spirits

Tilaknagar Industries

Radico Khaitan

FY08

FY09

FY10

FY11

FY12

FY13

FY14

Source: Company, MOSL

22 September 2014

United Spirits

Majority shareholding an incentive for Diageo to expedite operational

improvement

Post the Diageo-UNSP deal in November 2012, UNSP was re-rated, with

expectations of better management of core business. Diageo now owns 54.8% of

UNSP, having successfully completed its second open offer. With majority

shareholding and Diageo’s plans to consolidate UNSP financials with it w.e.f. 1

July

2014, we believe Diageo now has greater incentive to expedite operational

improvement. We see strong opportunity for Diageo to take UNSP’s margins back to

glory days. However, we expect this to happen gradually. Given the potential that

IMFL holds and Diageo’s focus on profitable volume growth, there could be further

stock re-rating.

Exhibit 11: Diageo now owns 54.8% of United Spirits

Entity

UBHL

KFIL

SWEW

UB Sports Mgmt

Palmer

Open offer

Preferential allotment

(10%)

Open market

Shares acquired in open

offer

Diageo's total shares

Total shares outstanding

Shares sold

to Diageo

10,141,437

6,575,550

125,531

548,460

4,376,771

58,668

14,532,775

1967940

3500000

37785214

79,612,346

145,327,750

% of expanded

capital

6.98

4.52

0.09

0.38

3.01

0.04

10.00

1.35

2.41

26.00

54.78

100.00

Source: Company, MOSL

Consideration

(INR m)

14,604

9,469

181

790

6,303

20,927

4,736

8,661

114,489

180,243

Is it a UBHL

Subsidiary

Yes

Has money flown

into company

What has Diageo done so far?

Diageo has implemented several corrective measures post acquiring control of

UNSP. Broadly these can be bracketed as a) Balance sheet clean up b) Management

and board level changes and c) Operational changes. We discuss them in details

below.

Kitchen sinking largely done; bulk of the write-offs over

While there should be gradual recovery in the balance sheet, cash flows, and return

ratios, this would be interspersed with some ‘kitchen sinking’ of UNSP’s financials.

In the recently announced FY14 results, UNSP has written off/made provisions for

certain intra group debt and outstanding debtors. We list them below:

Write offs/provisions: Balance sheet clean up



UNSP has provided for INR 36.2b as provision for loans given to intra- group

entity (net proceeds of W&M divestment being insufficient to pay off group

loans).



Explanation:

This write off is necessitated as the proceeds from the

divestment of W&M are not sufficient to pay off intra-group loans. W&M

22 September 2014

United Spirits

was sold for GBP430m. Net proceeds of GBP408m after paying transaction

charges would not be sufficient to repay intra-group loans, which stood at

INR47.9b as at 31

March 2014. After adjusting foreign currency

translation reserves of INR 9.4b, the net worth would be reduced by

INR36.2b.



It has also completely written off and provided for the entire investment made

in the subsidiary – Palmer (INR6.9b) and Montrose International (INR133.9m) –

cumulative provisions of INR7.1b.

Provision for debtors: INR6.5b has been provided as provision for account

receivables under debtors/third party manufacturers/project related parties,

advanced in earlier years.



Explanation:

These parties had accepted the due amount to UNSP earlier

but have subsequently reneged on the commitment and are proposing to

repay the dues only after receiving their own payments from other UB

group entities. These entities have claimed that they have advanced this

sum to certain “alleged UB group entities” and thus, the dues owed by

them to UNSP will be repaid only after receipt of their dues form such

entities. (Possibility of erstwhile UNSP management rerouting the sum to

other group entities via debtors). Management has proposed to conduct

detailed inquiry in these claims.

As regards the intra group loan of INR14.2b given to wholly owned sub UBHL,

UNSP has provided INR3.3b towards outstanding principal as on 31

March 2014

and has not recognized the interest income of INR 963.1m. Balance amount for

which no provision is created stand at INR9.95b.



Explanation:

UNSP has advanced loans of INR13.4b to UB Holdings at

9.5% per annum, effective 31

July 2013. Creditors of UB Holdings have

filed a winding up petition and the matter is subjudice. We believe the

probability of recovering these loans is low, as UB Holdings has defaulted

on its loan commitments to other banks. In our view, these loans would

be completely written off going forward. In the next few quarters, we

expect the remaining INR10b loans to be written off as well.

22 September 2014

United Spirits

Management and operational changes

Exhibit 12: Operational changes instituted by the new management

Senior management and board-level changes



Appointed Mr Anand Kripalu as CEO with effect from 1 April 2014. Mr Kripalu

has recently been roped in to be part of Diageo’s global executive committee.



The company appointed Mr Paul Walsh (ex-CEO, Diageo) and Mr Ravi Rajagopal

(Head, Global Business Development, Diageo) on the board.



Inducted Mr Sudhakar Rao (former Chief Secretary, Karnataka), Mr D

Sivanandhan (former IPS Officer), and Ms Indu Shahani as independent directors

on the board.



Appointed Mr Sam Fischer (currently Managing Director, Diageo Greater China)

as President, Diageo Greater China and Asia.



Created a new role and appointed Mr Ashoke Roy as Head, Compliance (in

various media interactions, the senior management of Diageo has highlighted

compliance, culture and performance as the key focus areas during integration).

Changes aimed at operational improvement / cost rationalization



Transferred some employees, including senior ones, off the payrolls of United

Spirits



Entered into distribution arrangement with Diageo India to leverage UNSP’s

wide distribution network. UNSP has booked INR 164m as income from

distribution services for FY14.



Appointed Accenture to suggest cost rationalization measures to drive stricter

financial discipline



Sold distillery unit: United Spirits has sold its distillery in Poonamallee, Tamil

Nadu to Enrica Enterprises Private Limited by way of a slump sale for INR1.25b.

Tamil Nadu is a state-controlled market (both wholesale and retail). TASMAC

had imposed an upper limit on the volumes that United Spirits could sell in the

state and had curtailed the production capacity at its Pooonamallee unit. Due to

excessive political interference in IMFL operations, United Spirits has hived off

its distillery unit and will now be working with Enrica on royalty basis.



Written off intra group loans and outstanding debtors totaling INR 53b.



As per media reports, UNSP will focus on select 14 power brands - Johnnie

Walker, VAT 69, Black & White, and Smirnoff from Diageo India stable while

Royal Challenge, Signature, Antiquity, Bagpiper, Director's Special Whisky,

McDowell No.1 Whisky, White Mischief Vodka, Romanov Vodka , No. 1

Celebration Rum and Black Dog scotch whisky

22 September 2014

United Spirits

Diageo – A backgrounder

Diageo is a global leader in alcoholic beverages with a collection of brands across

spirits, beer and wine categories. Its brands have broad consumer appeal across

geographies and are sold in more than 180 countries across the world.

Exhibit 13:Diageo PLC: 2/3 of net sales concentrated across few key brands

Brands

Johnie Walker

Crown Royal

J&B

Buchanan's

Windsor

Bushmills

Captain Morgan

Smirnoff

Ciroc

Ketel One Vodka

Baileys

Don Julio

Tanqueray

Guinness

Category

Scotch Whisky

Canadian Whisky

Scotch Whisky

Premium Scotch Whisky

Super Premium Scotch Whisky

Irish Whisky

Rum

Premium Vodka

Ultra Premium Vodka

Super Premium Vodka

Liqueur

Ultra Premium Tequila

Imported Gin

Stout

mn cases (9 liter)

18.9

5.3

3.7

1.6

0.7

0.8

10.9

25.9

2.2

2.4

6.4

0.3

2.3

10.2

Source: Company, MOSL

Exhibit 14: Diageo –Financial Details

GBP m

Turnover

Cost of sales

Gross Profit

Other Operating Revenue

Operating Expenses

Operating profit

Other Operating Revenue

Interest Expense

Foreign Exchange Losses

Net Non-Operating Losses

Pretax Income

Income Tax Expense

Income Before XO Items

Extraordinary Loss Net of Tax

Minority Interests

Net profit

FY08

8,090

3,245

4,845

2,570

2,275

494

(385)

2,093

522

1,571

(26)

1,521

FY09

9,311

3,893

5,418

3,034

2,384

768

(340)

1,990

286

1,704

(2)

101

1,605

FY10

9,780

4,099

5,681

3,152

2,529

844

(509)

2,239

477

1,762

114

1,629

FY11

9,936

4,010

5,926

3,059

2,867

540

(16)

2,360

343

2,017

117

1,900

FY 12

10,762

4,259

6,503

3,336

3,167

493

(416)

3,121

1,038

2,083

130

1,942

FY13

11,303

4,416

6,887

3,520

3,367

502

(1)

(178)

3,057

507

2,550

2,452

FY14

10,258

4,029

6,229

3,118

3,111

455

(57)

2,711

447

2,264

(67)

2,248

Source: Bloomberg, Company, MOSL

22 September 2014

United Spirits

Exhibit 15:Diageo performance across five regions

Financials by Region

Volume

Net Sales

Operating Profit

% Share by Region

Volume (%)

Net Sales (%)

Operating Profit (%)

% Share of Net Sales

by 21 Markets

>20%

3-6%

North America

US Spirits & Wines

Diageo-Guinness UDA

(DGUSA)

Western Europe

Afrca, Eastern

Europe and Turkey

Latin America and

Turkey

Asia Pacific

North America

49.3

3444

1460

Western Europe

2169

639

Afrca, Eastern

Europe and Turkey

2075

554

Latin America and

Turkey

1144

328

Asia Pacific

14.8

1347

283

Western Europe

Nigeria, East

Africa, Turkey, WestLACm Paraguay,

Africa, Regional

Uruguay & Brazil

Markets

Russia & Eastern

Europe, South Africa

Mexico, Venezuela,

Columbia

Global Travel Asia &

Middle East

South East Asia,

Australia, North Asia,

Greater China

India

Source: Company, MOSL

2-3%

<2%

Canada

Bytes from Diageo India – Recent media interview of MD, Diageo India

Source: Business Standard and Hindu Business Line



It has been an year since Diageo acquired strategic control of United Spirits and

put in a sales agent contract for Diageo brands in India. What have been the key

learnings so far?



It's been an exciting ride, particularly in the wake of the completion of

Diageo's transaction with United Spirits. Suddenly, Diageo's commitment to

the market has multiplied and we are learning and adapting fast to the new

scenario. United Spirits' strong route-to-market war machine has given a

fillip to our brands in India, which have seen a 22% growth in volumes

while parallely delivering 40% growth to our top line.



The premiumisation effort which United Spirits has been driving over the

past few years fits exactly into our strategy of upgrading consumers. We

are sharing various best practices of adapting to Diageo's global systems

and processes and the United Spirits network is extremely receptive to it.

How difficult it has been to tune the United Spirits sales network to the more

premium brands of Diageo?



Diageo India has been activating intense marketing measures along with

United Spirits, and despite the weak economic scenario during the last

year, we have been able to withstand and grow our business. United

Spirits' brands are in a sweet spot and provide the best platform for the

consumer to premiumise as every segment is uptrading. We are working

closely with United Spirits brands such as Signature and Antiquity and will

further sharpen the team's finesse to sell premium brands.

22 September 2014

United Spirits



After the sales network integration, isn't it a matter of time before Diageo India

is integrated with United Spirits as well?



As of now besides the sales agreement, which is being fine-tuned, there is

not much of an update. We are happy with the sales agency operating

model. However, the United Spirits board may be studying various options

of how operations can be done more synergistically. We will continue along

the growth trajectory which we have been on for the past four years, and

going forward it will be more evolutionary and not revolutionary.



The United Spirits network sure has given us a good leg-up and it will

continue. The influence on United Spirits is more through leadership as

well as changes on the board. I am involved only to the extent of how we

can leverage the United Spirits network for Diageo brands. There is a three-

year road map which is being fine-tuned and which may be concertized

shortly as to how the brand portfolio should look like, both from United

Spirits' as well as from Diageo's lens.

What have been the pain points of integrating the sales network?



I would not term them as pain points, but it is more to do with

organizational learning. When you have a new partner you need to make

sure that as a sales agent one really understands how to sell and what

motivates consumers. We have worked collaboratively to share knowledge.

Transferring the knowledge of our brands is the key, while understanding

United Spirits' deep network and how to position our brands is another

learning. Are we completely there? May be not, but I feel that 80-90 per

cent of that process is done.

The Kerala government's move to roll out prohibition came as a shock. How is

Diageo addressing it?



We acknowledge that there is misuse of alcohol and we have been

supporting various programmes for road safety. We have partnered with

the Institute of Road Traffic Education, the Ministry of Road Transport and

Highways and the IRF to roll out a national campaign, Road to Safety,

aimed at enhancing road safety and reducing road fatalities due to driving

under the influence of alcohol. The programme will be implemented in 30

cities in India and includes training and capacity building of enforcement

agencies like the traffic police; distribution of high-quality breath alcohol

analysers; training drivers of commercial vehicles such as school bus, truck

and auto rickshaw drivers; and educating university students on the

dangers of underage drinking. We believe that efforts to reduce the misuse

of alcohol are most effective when government, civil society, individuals

and families, as well as the industry, work together.

The last two years have been busy for Diageo in India while it went about

acquiring United Spirits. Can you run us through how Diageo’s Indian operations

fared during this period?



It has been an exciting ride. With Diageo plc’s acquisition of a 54.8%

shareholding in United Spirits, its investment and commitment to India has

multiplied manifold, and we are learning and adapting fast to the

opportunities the new scenario presents.



22 September 2014

United Spirits



In October last year, Diageo appointed United Spirits (USL) as its sales

promotion agent. USL’s strong route-to-market, combined with Diageo’s

investments in its brands, have given a fillip to our brands in India which

have seen a 22% growth in volumes while parallelly delivering over 40%

growth to our top line. Strong performance by Johnnie Walker Black Label,

VAT 69 and Black & White drove most of the growth in Scotch, and our

share in Scotch increased 1.9 percentage points. Smirnoff too returned to

high single digit growth. The two organisations have been exploring

synergies, sharing best practices and combining our respective strengths.

As the results show, it’s been working well for us.

One of your competitors in India has become the leading liquor maker in the

country in value terms. What plans does Diageo have to create a bigger share

for itself in the next few years?



First, our partnership with USL has clearly transformed Diageo’s position in

India. Our ambition now is to deliver scale and sustainable growth for the

long-term. There are three areas we will clearly invest in — our talent, our

brands and our facilities. We are lucky to have iconic brands such as

Johnnie Walker, VAT 69 and Smirnoff — we will further build brand equity

and loyalty through our global marketing expertise and give consumers

opportunities to trade up and premiumize by offering them more choices.

Have you identified any brands as part of power brands. How do you plan to

drive their growth?



Among the many international brands in our portfolio, we are focused on a

set of core brands; so our marketing strategy is geared towards these

power brands. These include our Scotch whisky brands such as Johnnie

Walker, VAT 69 and our single malt The Singleton. In the vodka category,

we are focused on growing share for Smirnoff in the premium vodka

segment and CIROC in the luxury vodka segment. Our super deluxe Johnnie

Walker Blue Label is another big growth driver for Diageo. Investments

have been deployed in each of these brands by way of offering new leading

edge experiences, relevant brand associations, as well as the launch of new

variants all aimed at driving growth and recruiting consumers into our

brand fold.

What are the new brands that you plan to bring into India?



We have just launched Smirnoff Black, an unconventional product that

signifies a shift from the existing offerings in the portfolio. With clutter

breaking packaging and a unique bold flavour, our aim is to redefine the

vodka category in India with Smirnoff Black. We recently introduced

Smirnoff Black in Maharashtra and in a couple of days it will be available in

Karnataka. Over the next few months, we will launch Smirnoff Black in

other States as well.

Do you believe that inclusion of alcohol in the Goods and Services Tax will help

the industry?



GST is aimed at removing cascading of taxes and creating a common

national market for goods and services. Ideally, a landmark legislation like

GST should be comprehensive and all-encompassing. Exclusion of any

sector or service would be a dilution of the objectives of GST and lead to

revenue leakage and stranded input costs. Second, the denial of GST-input

tax credits will have cascading effects of tax on tax. Third, excluding alcohol



22 September 2014

United Spirits



will also greatly complicate administration and compliance (because of the

need to allocate input GST between exempt and taxable transactions).

These issues will have an adverse impact on volumes, prices and the

growth of the sector, leading to a reduction in overall tax revenue. For an

enlightened government, including alcohol in the GST regime would

represent a bold step towards aligning the Indian tax system to

international best practices with manifold benefits to both government and

industry and a potential reduction in overall GST rate.

How do you think inclusion of the liquor industry in GST will help the State

governments, who are otherwise opposing its inclusion?



According to the estimates of Satya Poddar of consultancy firm Ernst &

Young, an international expert on GST, the States would stand to gain

around INR10,000 crore by applying GST at 10% to alcoholic beverages.

There would be an additional gain in State revenues through better control

of undeclared movement of alcohol. Even though this will translate to an

additional INR10,000-crore tax burden to the alcoholic beverage industry, a

GST audit trail will provide greater exposure of unreported activities, which

could otherwise pose significant public health concerns.

Will exclusion of the liquor industry from GST impact any other sector or

services?



Most certainly. Besides potential compliance breaches by input service

providers to unrecorded alcohol, the exclusion of alcohol from the GST

regime will also have far reaching impact on trade partners, government

agencies and other industries. States which are currently under a VAT

regime will be forced to change their taxation systems resulting in an

increase in consumer prices. Multiple tax regimes will be created where an

assessee would have to file special tax returns for excluded products. In

contrast to GST products, the documentary trail will be lost after goods

leave the manufacturer, creating a loophole for possible tax evasion.

Valuation issues will arise, leading to increased litigation by all assessees

including consumption points such as hotels and restaurants.

What according to you is the biggest challenge foreign companies like yours face

in India today?



The most critical issue is the current deadlock on account of the Food

Safety and Standards Regulations (FSSAI). Since February, imported alcohol

stocks (like many other consumer goods) are being rejected at ports across

India on the basis that the manufacturer’s address and ingredients are not

listed on the label according to the “mandatory labelling requirements” of

the FSSAI. The health and well being of our consumers is a primary concern

for us — and we are absolutely prepared to abide by the labelling

requirements of the government. However, since the alcohol beverage

industry is governed by State Governments, any labelling changes

demanded must be synchronised with the annual state excise label

registration cycle, or they will be logistically impossible. We need a

minimum of six months in order to introduce the changes during the next

label registration cycle.

22 September 2014

United Spirits

Premiumization to gain steam, aiding profitability

EBITDA margin to move up gradually



We expect the Diageo management to continue driving premiumization and focus on

(a) brand investments, (b) leverage reduction, (c) working capital improvement, and

(d) prudent capex.



Consol. EBITDA margin should expand from 8.3% in FY14 to 12.8% in FY17. Diageo has

indicated the possibility of achieving 20% EBITDA margin (last seen in FY08) in the long

term.



We expect margin expansion efforts to gather pace post FY16. Our 10-year forecast

builds in 20% EBITDA margin by FY23

Margins have contracted significantly

Consistent increase in excise duties by various state governments has resulted in a

sharp 16pp increase in excise duty as a percentage of sales. Excise duties constituted

60.8% of UNSP’s gross sales in FY14 as compared with 44.4% in FY07.

Viewed differently, the state governments’ share of liquor revenues has gone up

consistently. For example, the Kerala government’s share of KSBC’s (Kerala State

Beverages Corporation) liquor sales has increased from 77% in FY07 to 82% in FY13.

IMFL volumes in Kerala have grown at a CAGR of 10.5% over FY08-13 while KSBC’s

gross sales have grown at a CAGR of 18.7%. Interestingly, the contribution to the

state exchequer has grown at a CAGR of 20%.

Exhibit 16: KSBC’s liquor revenues have grown at a CAGR of

19% over FY08-13

Gross sales (INR b)

78.6

67.3

36.7

46.3

55.4

24.2

29.1

36.2

42.6

88.2

Exhibit 17: Contribution of liquor revenues to state exchequer

rising

Contribution to state exchequer (INR b)

62.9

52.3

72.4

31.5

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY07

FY08

FY09

FY10

FY11

FY12

FY13

Exhibit 18: Over 80% of IMFL sales go to state treasury

Contribution to state exchequeras % of grosss sales

82.1%

79.4%

78.2%

77.1%

76.9%

77.7%

80.0%

Exhibit 19: While IMFL volumes were flattish in FY13, the five-

year CAGR is healthy

CAGR (FY08-13)

19.2%

20.0%

10.5%

11.6%

IMFL volumes

FY07

FY08

FY09

FY10

FY11

FY12

FY13

Beer volumes

Gross sales

Contribution to

state exchequer

Source: Company, MOSL

22 September 2014

Source: Company, MOSL

United Spirits

Increase in alcohol taxation coupled with lack of adequate price increases in

government controlled markets (Tamil Nadu last granted price increase in 2007) and

UNSP’s focus on volumes have impacted its gross margins. UNSP’s gross margins

have contracted from 47.6% in FY07 to 40.2% in FY14.

Exhibit 20: Excise duty as percentage of sales up 12pp

Excise (% of Gross Sales)

46.2 44.4 45.1 47.3 48.5

37.1 36.5

34.5

52.3 54.6

57.3

60.8

Exhibit 21: Gross margin down 360bp in last four years

Gross Margin (%)

48.7 47.6 50.1

38.2

43.5 44.3 43.8

36.5 36.2

40.3 40.0 40.2

Source: Company, MOSL

Expect trend towards premiumization to accelerate

With the new management taking control and Diageo’s increased stake in UNSP, we

expect greater focus on profitable growth. Given that gross margins in the Prestige

segment are 4x the Regular segment, we expect UNSP to drive profitability through

mix improvement and pricing management.

Volume decline of 0.2% in FY13 and 6% in 9MFY14 in the Regular and Below

segment underscores the strategy of defocusing on the Regular portfolio, given the

context of rising raw material costs, higher excise duties, and lack of price increases

in big markets like Tamil Nadu. We do not expect the new management to overhaul

UNSP’s low-end portfolio immediately. We believe it will try to realign prices for

brands making sub-par contribution to the P&L.

Exhibit 22: Volume growth (%) in Prestige+ segments higher

than in Regular segment

Prestige & above

29.4

13.8

0.9 2.0

-5.4

1.1

19.5

13.2

1.1

-5.2

4.9

12.4

Regular & below

Exhibit 23: Steady rise in ENA prices

ENA/Case (INR)

-3.6

-8.8

1QFY13 2QFY13 3QFY13 4QFY13 1QFY14 2QFY14 3QFY14

Source: Company, MOSL

22 September 2014

United Spirits

Exhibit 24:Premium sub-segments of IMFL are growing at faster clip

Prestige +

17.3%

Below Prestige

9.5%

2.4%

1.7%

FY14

Source: Industry, MOSL

FY13

Exhibit 25:Across IMFL sub-segments growth of premium folio >> regular

Growth (%)

Whisky

Scotches

Super-premium

Premium-whisky

Prestige-whisky

Regular- whisky

Economy-Whisky

Total-Whisky

Rum

Premium- rum

Regular-rum

White rum

Economy-Rum

Total-Rum

Brandy

Premium- brandy

Semi-premium- brandy

Regular-brandy

Economy-Brandy

Total-Brandy

Gin

Regular-gin

Economy-Gin

Total-Gin

Vodka

Premium- vodka

Semi premium- vodka

Regular- vodka

Total- Vodka

Total IMFL

-0.3

2.5

-8.4

-5.3

3.9

9.1

17.0

-8.2

2.7

2.5

Source: Industry, MOSL

-14.1

-24.9

-5.6

0.9

-12.5

-8.3

64.2

61.7

13.9

14.5

11.1

-31.8

30.8

26.5

-25.2

2.0

63.9

-5.3

-10.5

-6.3

-5.3

33.3

5.5

-4.8

-14.8

1.0

8.1

19.1

12.9

13.1

-2.8

-6.2

4.1

17.1

11.3

12.5

4.4

-4.8

-2.1

3.3

FY13

FY14

22 September 2014

United Spirits

While it has tactically curtailed some low-end brands in select markets (Old

Cask

Rum

in Kerala), Diageo does not intend to disrupt UNSP’s existing brand

architecture, as this could result in loss of customers and market share. In a

conference call that we hosted in January 2014, the senior management indicated

gradual mix enhancement. Nevertheless, we note that the proportion of Prestige+

brands has gone up from 20.7% in FY11 to 27.4% in 9MFY14. The premiumization

trend is already underway for UNSP as well as the industry; we expect this to

accelerate, going forward.

Exhibit 26: Salience of Prestige+ segment up 6pp in three

years

Prestige & above as % of total volumes

26.0

22.2 22.6

20.1

21.7 22.3 22.0

24.3 23.7 23.9

26.2

27.7 28.3

Exhibit 27: So is the case with Radico Khaitan

Premium Brands as % of total volumes

19.3

18.4

18.3

17.9

17.3

17.1

16.216.1

16.2

15.3

15.2

14.5 14.5

14.114.6

Source: Company, MOSL

Please refer to our

Corner Office

report on

ABD dated 22 May 2014

Model for relatively sedate near-term volume growth

We model for a relatively sedate 5% volume growth in FY15 facilitated by a low base

of FY14. Over FY16-23, we expect volume growth to average at 6.5-8%. This is in line

with the CAGR delivered over FY09-14 (including the impact of Tamil Nadu issues

over FY12-14) but much lower than the 20% volume CAGR over FY05-14. Given the

expected focus on expanding profit margins, we see the company striking a balance

between volume and realization metrics. Over the next 10 years, we expect UNSP to

deliver 7.4% volume and 15.6% revenue CAGR in standalone P&L. Over the next

three years, we build in 6.2% volume and 12.5% value CAGR in standalone P&L, as

Diageo stabilizes operations.

Exhibit 28: We build in modest volume CAGR over FY14-17

Volume Growth (%)

32.1

20.5

12.5

6.2

Sales Growth (%)

2005-2014

2014-2017

Source: Company, MOSL

22 September 2014

United Spirits

Mix improvement + cost savings = operating margin recovery

UNSP’s EBITDA margin has shrunk from 21% in FY08 to 9.6% in FY13 and 8.3% in

FY14. This is a reflection of prioritizing volume growth over profitability in an

environment of rising input costs and inadequate price increases in government-

controlled markets. Domestic peers, Radico Khaitan (RDCK) and Tilaknagar

Industries (TLNGR) have not seen as much margin deterioration despite lower scale

of operations (RDCK sold 20m cases and TLNGR sold 16m cases as against UNSP’s

122m cases in FY14).

Apart from the inflationary raw material environment, we believe cost inefficiencies

specific to UNSP have also resulted in weaker margin output despite its gigantic

scale of operations. We expect Diageo to drive cost savings in every line item of the

P&L except investments on branding. It has appointed Accenture to suggest cost

rationalization measures.

We draw comfort from our earlier interaction with Diageo, wherein it had pointed

towards the possibility of recouping lost margins and reverting to UNSP’s historical

EBITDA margin of 20%. Nonetheless, we model for incremental margin gain of

450bp over FY14-17, with 190bp expansion in FY15, 180bp expansion in FY16, and

80bp expansion in FY17.

We expect Diageo to focus initially on putting in place its systems, global practices,

and people, while simultaneously driving investments in the premium portfolio. This

would mean lower flow-through of gross margin benefits to the EBITDA level, but

would build the foundation for medium to long-term growth and margin expansion.

We expect margins to stabilize in 3-5 years, as brand investments and

premiumization start yielding results.

Exhibit 29: We build in 450bp margin expansion in three years Exhibit 30: Peer’s margins (%) have not suffered as much

21.0

EBIDTA Margin (%)

18.0 17.5

14.4

Radico

Tilaknagar Industries

29.6

11.5

9.6

8.3

10.2

12.0 12.8

22.1

13.3

13.2

22.8

19.2 18.1

17.2

15.6

17.1

29.2

26.3

23.6

15.9

FY08

Source: Company, MOSL

FY09

FY10

FY11

FY12

FY13

FY14

Source: Company, MOSL

Diageo leveraging UNSP’s distribution network to market its premium

brands

Additional income stream for UNSP; little threat of brand cannibalization

Since 1

October 2013, Diageo has been using UNSP’s distribution network to

market its premium brands. It has entered into a sales agency agreement, under

which UNSP is a sales agent for all Diageo brands in India and receives fees for

distribution. UNSP provides sales promotion services to Diageo India for all Diageo

brands manufactured by and/or imported by Diageo India and sold in India.

22 September 2014

United Spirits

From Diageo’s viewpoint, this arrangement leverages UNSP’s superior distribution

network and strong trade relationships to push its brands. UNSP, on the other

hand, is able to monetize its supply chain infrastructure and generate an

additional revenue stream.

According to Diageo’s 1HFY14 results, it is already deriving significant benefits

from the sales promotion arrangement with UNSP. Diageo’s India sales grew 35%

YoY against low single-digit growth in other emerging markets. UNSP has booked

INR 164m of distribution income for FY14.

Some investors have raised concerns over possible cannibalization of UNSP brands

by Diageo India’s (unlisted) premium portfolio. We believe the price differential

between UNSP’s and Diageo India’s brands is too steep to warrant such concern.

Though the Indian market is firmly on the premiumization path, it remains a price-

conscious and value-seeking market, precluding any drastic shift in brand

preferences in the medium term. Besides, Diageo India has a limited portfolio in

India, with less than 1% market share in India, and as such does not pose a

meaningful threat for UNSP.

Exhibit 31: United Spirits versus Diageo India – product pricing comparison

Price for 750ml (INR)

Diageo

United Spirits

1,700

4,100

1,300

1,400

6,050

4,950

280

Bagpiper

280

Director's

Special

720

Signature

725

Royal

Challenge

920

Antiquity

Blue

VAT 69

Black &

White

Johnnie

Walker Red Walker Black

Label

Talisker

Johnnie

Walker Gold

Label

Source: Company, MOSL

Focus on select 14 power brands to drive growth

22 September 2014

United Spirits

An MNC touch should benefit United Spirits

Heineken’s entry resulted in operational benefits for United Breweries



Carlsberg and Heineken jointly acquired S&N's global operations for USD15.4b in

January 2008. Consequently, Heineken got hold of S&N's 37.5% stake in United

Breweries (UBL). Dr Vijay Mallya opposed this on the ground that Heineken

already owned ~44% in Asia Pacific Breweries (APB). APB used to sell the beer

brand,

Tiger

in India. Heineken would, therefore, have dual interest in India –

one with APB and one with UBL. The UB Group even moved the Bombay High

Court to restrain Heineken from exercising management rights that were

accorded to S&N, citing that Heineken was part of a rival firm, APB. This issue

was resolved in December 2009.

Heineken bought APB's assets in India and transferred them to UBL. Besides, it

transferred the rights to brew, bottle and distribute Heineken brands in India to

UBL, and paid a one-time fee of INR3b. The “peace deal” ensured that Heineken

got the same rights that S&N had enjoyed – power to nominate the Chief

Financial Officer and equal board representation.

UBL’s performance improved post the deal. Volumes, gross margins, and profits

increased significantly post the transaction. Market share went up, leverage

came down, and PAT moved up 3x over FY09-12. Even working capital and

return ratios improved. Consequently, UBL got re-rated.

Exhibit 32: UBL performance aided by Heineken entry

United Breweries (INR m)

Volumes (m cases)

Growth

Market share

Net Sales

Growth

EBITDA

Margin

Interest

EBIT

Profit Before Tax

Net Profit

Margin

Net Debt

No of shares

Networth

Book value per share

Net debt/Equity

FY07

FY08

13.9%

15,590

30.3%

2,157

13.8%

576

1,581

850

542

3.5%

6,694

216

6,741

31.2

99.3%

FY09

9.4%

48.0%

19,295

23.8%

2,807

14.5%

1,054

1,752

856

456

2.4%

7,138

240

11,443

47.7

62.4%

FY10

101

22.6%

50%+

22,755

17.9%

3,174

13.9%

665

2,509

1,469

896

3.9%

7,035

240

12,228

50.9

57.5%

FY11

125

24.2%

54.0%

30,598

34.5%

4,353

14.2%

779

3,574

2,266

1,475

4.8%

6,491

255

12,944

50.9

50.1%

FY12

133

6.0%

54.5%

36,252

18.5%

4,659

12.9%

989

3,670

2,182

1,398

3.9%

6,995

264

13,658

51.7

51.2%

FY13

139

4.5%

52.0%

39,031

7.7%

4,764

12.2%

799

3,965

2,655

1,722

4.4%

5,104

264

15,107

57.1

33.8%

FY14

139

0.0%

52.0%

42,355

27.0%

17.0%

8.5%

5,873

27.1%

15.9%

13.9%

798

5,074

15.0%

23.7%

3,341

0.3%

31.3%

2,256

-9.0%

37.7%

5.3%

3,851

264

17,059

64.5

22.6%

Source: Company, MOSL

FY07-09

CAGR

11.7%

FY09-14

CAGR

11.0%

11,968

1,737

14.5%

412

1,325

851

550

4.6%

4,795

216

6,205

28.7

77.3%

22 September 2014

United Spirits

Exhibit 33: Sales growth picked up post Heineken deal

Net Sales growth (%)

34.5%

30.3%

23.8%

17.9%

37.6%

36.8%

38.3%

Exhibit 34: Gross margins improved too

Gross margin (%)

41.3%

FY08

FY09

FY10

FY11

Source: Company, MOSL

FY08

FY09

FY10

FY11

Source: Company, MOSL

Exhibit 35: Net profit margins improved

Net Profit Margin (%)

4.8%

3.5%

2.4%

3.9%

4.4%

5.3%

Exhibit 36: Leverage eased off significantly

99.3%

Net debt/Equity

62.4%

57.5%

50.1%

51.2%

33.8%

22.6%

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY08

FY09

FY10

FY11

FY12

FY13

FY14

Source: Company, MOSL

22 September 2014

United Spirits

W&M divestment to deleverage balance sheet

Monetization of other non-core assets also a possibility



Divestment of W&M should free management bandwidth to focus on the lucrative

domestic opportunity and drive deleveraging of UNSP’s balance sheet.

We factor in INR37b debt reduction in FY15 from the proceeds of the W&M stake sale,

driving interest cost savings of ~INR4b (UNSP’s FY14 standalone PAT was INR2.4b).

UNSP holds 3.2% stake in United Breweries (UBL) and owns an IPL team. While Diageo

intends to use the IPL asset as a marketing tool, we believe it would be open to

divesting UBL.

W&M divestment concluded; see substantial debt reduction in FY15

UNSP has divested W&M to Emperador group for GBP430m. Apart from

deleveraging the balance sheet (UNSP’s net debt stood at INR75.8b, with net debt-

equity of 1x), we believe this frees management bandwidth to focus on the

attractive domestic market.

The divestment of W&M also removes a key drag on the consolidated balance

sheet. W&M’s performance had deteriorated post the conclusion of the bulk

contract deal in FY11. While its revenues have grown from GBP216m in FY09 to

GBP252m in FY14, EBITDA has declined from GBP57m to GBP25m.

Exhibit 37: W&M’s margins had consistently declined

EBITDA margin

32.1%

32.6%

21.4%

3.1%

20.4%

9.9%

-15.3%

FY08

FY09

FY10

FY11

FY12

FY13

FY14

Revenue

EBITDA

Source: Company, MOSL

Exhibit 38: W&M was a drag on consolidated P&L

FY09-14 CAGR

19.2%

Source: Company, MOSL

According to the disclosures given to exchanges and annual report, of the net

proceeds of GBP408m, UNSP would be utilizing GBP370m for debt repayment. We

expect UNSP’s debt to reduce by INR37b in FY15. Net debt to equity should ease to

1.1x in FY15 from 2.6x in FY14.

22 September 2014

United Spirits

Exhibit 39: Post W&M divestment, expect leverage to ease to 1.1x in FY15

Net Debt/Equity (%)

2.9

2.4

1.3

0.7

1.4

1.5

1.4

1.1

0.7

0.5

FY07

FY08

FY09

FY10

FY11

FY12

FY13

FY14

FY15E

FY16E

FY17E

Source: Company, MOSL

Monetization of other non-core assets also a possibility

UNSP holds 3.2% stake in United Breweries (UBL), which could be monetized for

debt reduction, going forward. At the current price, this stake is valued at INR6.1b.

UNSP also owns an IPL team through its 100% subsidiary, Royal Challengers Sports.

In various media interactions, Diageo has indicated that it would continue to retain

this sports franchise. It intends to leverage the vehicle for marketing/branding

activities.

While IPL is a good vehicle to market brands, we believe for a liquor company,

owning a cricket team is a suboptimal capital allocation decision, given the already

stretched working capital needs of the core business. Potential divestment of the IPL

franchise would be positive from a deleveraging perspective.

We note that Sun TV Network had bought the Hyderabad franchise in 2012 for a

sum of INR4.25b, translating into INR85m per annum for the remaining five years of

IPL.

Exhibit 40: Royal Challengers Sports (IPL team) – key financials

INR m

Sales

PBT

PAT

FY10

913.4

-84.7

-53.2

FY11

537.7

-78.4

-54.3

FY12

944.4

-94.9

-70.8

FY13

813.9

-116.3

-78.6

FY14

914.6

-1054.2

-990.5

Source: Company, MOSL

22 September 2014

United Spirits

Expect gradual improvement in financials over

FY14-17

6.2% volume CAGR; 12.5% revenue CAGR



We believe Diageo will take time to put its systems, processes, and people in place.

Hence, we are factoring in modest recovery in volumes and margins in the next three

years.



Over FY14-17, we expect volumes to grow at a CAGR of 6.2% and net standalone

revenue to grow at a CAGR of 12.5%. We factor in 350bp EBITDA margin expansion to

12.6% in the standalone business, largely driven by gross margin expansion.



We expect Diageo to enforce better financial discipline on working capital and build in

working capital improvement from 44% of sales in FY14 to 29% in FY17.

Volumes to grow at a CAGR of 6.2%

We are building in modest volume growth, as we believe Diageo would concentrate

on driving volumes of Prestige+ brands, with bulk of its advertising spend behind

these brands. Overall, we are factoring in 6.2% volume CAGR over FY14-17 on a low

base of FY13 and FY14. For the Regular and Below portfolio, we are building in 2.5%

volume CAGR.

Exhibit 41: We build modest volume CAGR for the next three years

2009-2014

13.3%

26.7%

CAGR

2005-2014

20.5%

32.1%

2014-2017

6.2%

12.5%

Source: Company, MOSL

Volume Growth

Sales Growth

Net standalone revenue to grow at a CAGR of 12.5%

We expect net standalone revenue to grow at a CAGR of 12.5% over FY14-17. Price

hikes in government-controlled markets were difficult to come by in FY14 due to

elections. With the general elections behind, we expect price hikes to materialize in

FY15. Our interactions with IMFL players indicate that discussions on price hikes

have already begun.

EBITDA margin to expand 350bp to 12.6%

We believe the pace of margin expansion would be gradual in the first few years

despite continued premiumization of its portfolio. Over FY14-17, we factor in 350bp

EBITDA margin expansion to 12.6% in the standalone business, largely driven by

gross margin expansion. Cost rationalization measures initiated by Diageo should

provide further margin upside; however, we are not building this in our estimates,

yet.

22 September 2014

United Spirits

Exhibit 42: Gross margin to expand ~400bp over FY14-17…

Gross Margin (%)

50.1

43.5 44.3 43.8

40.3 40.0 40.2

43.5 44.2

Exhibit 43: … driving 350bp expansion in EBITDA margin

18.8

EBIDTA Margin (%)

15.3 15.7 15.1

12.6 12.5

9.1

10.0

11.9 12.6

42.2

FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15E FY16E FY17E

Source: Company, MOSL

Working capital to improve from 44% of sales to 29%

We expect Diageo to enforce better financial discipline on working capital. While

debtor days from government-controlled markets may not change much, we expect

Diageo to employ state-specific strategies as in the case of Tamil Nadu. Rising

working capital needs have crimped UNSP’s free cash generation in the past and

have weighed on return ratios. With improved margin profile and better financial

control, we expect UNSP’s working capital metric to improve, going forward. We

build in working capital improvement from 44% of sales in FY14 to 29% in FY17.

Exhibit 44: Working capital has remained sticky

NWC/Sales (%)

49.9

54.4

47.3

51.6

41.1

43.8

35.4

35.5

30.8 28.5

10.6%

0.4%

2.9%

4.7% 1.5%

1.4%

-6.2%

-7.4%

FY13

FY14

Exhibit 45: Poor FCF generation

Consol FCF/Sales

20.7%

18.9%

Standalone FCF/Sales

17.5%

11.7%

-3.4%

FY08

Source: Company, MOSL

FY09

FY10

-4.7%

FY11

FY12

Source: Company, MOSL

Exhibit 46:United Spirits: Consensus v/s MOSL Forecast

INR m

MOSL

Sales

EBITDA

PAT

Consensus

Sales

EBITDA

PAT

Difference: MOSL v/s Consensus

Sales

EBITDA

PAT

(6.3)

(18.9)

10.4

(5.1)

(15.3)

6.3

2.3

(9.9)

10.3

Source: Bloomberg, MOSL

22 September 2014

104,802

12,303

4,097

116,730

15,718

7,171

123,764

17,936

9,277

98,226

9,981

4,523

110,796

13,306

7,626

126,646

16,165

10,231

2015

2016

2017

United Spirits

DCF-based target price implies 27% upside

Upgrading stock rating to Buy



Given our expectations of gradual improvement in operating/financial metrics and

that equilibrium would be reached only after 3-5 years, we believe DCF is the

appropriate valuation tool.



Our DCF valuation works out to INR3,000/share (46x FY16E EPS and 34x FY17E EPS),

indicating 27% upside. We upgrade our stock rating from Neutral to Buy.

We would view any near-term weakness in stock price owing to quarterly earnings

disappointment and/or business/financial cleanup as a good buying opportunity.

We have made the following assumptions for our two-stage DCF-based valuation:



Weighted average cost of capital of 10.2% with 12.9% cost of equity (RFR-8%,

ERP-7%, beta of 0.75) and 8% cost of debt. We have assumed TVG of 5.5%.



Net sales CAGR of 13.8% over FY15-23.



EBITDA margin expansion from 8.3% in FY14 to 20% by FY23.

Exhibit 47: DCF valuation summary – fair value of INR3,000/share

INR m

EBITDA

Other income

Tax

WC change

Capex

FCF

PV of each FCF

Sum of PV of FCF

Terminal value

PV of terminal value

Net debt

Equity value

No of shares

Per share value

2015E

9,981

2,750

-2,762

10,774

-6,000

14,742

104,822

890,046

372,331

477,153

40,063

437,090

145

3,008

77%

2016E

13,306

3,025

-2,228

669

-4,000

10,772

8,876

2017E

16,165

3,328

-3,756

-2,005

-4,000

9,731

7,277

2018E

19,854

3,660

-5,039

-720

-4,500

13,255

8,998

2019E

24,591

4,026

-6,416

-1,386

-5,000

15,815

9,746

2020E

31,235

4,429

-8,310

-1,195

-5,000

21,159

11,835

2021E

40,581

4,872

-10,848

-4,059

-5,000

25,545

12,970

2022E

52,147

5,359

-14,258

-7,757

-5,000

30,491

14,052

2023E

65,526

5,895

-18,383

-9,013

-5,000

39,025

16,325

Source: Company, MOSL

Risks and concerns



Alcoholic Beverages is a heavily regulated industry in India. In states that

together constitute 70% of the IMFL industry revenues, the state governments

control manufacturing, distribution, retailing, and pricing. Excise and other taxes

from the IMFL industry hold great importance for state governments; any

abnormal increase in taxation on liquor constitutes a downside risk.

Discrimination in favor of local breweries/distilleries at the expense of branded

manufacturers, as currently underway in Tamil Nadu, could prevent UNSP and

other liquor companies from realizing the full benefits of premiumization.

Any spike in prices of raw material (ENA, molasses, glass) would impact margins

adversely, as price hikes in government-controlled markets lag RM inflation.

Operating two entities – Diageo India and United Spirits – could give rise to

corporate governance issues. Current premium valuations also reflect

expectations of high corporate governance standards.

22 September 2014

United Spirits

Deep Economic Moat + credible management = strong returns in

consumer sector

Indian consumer sector’s history is littered with examples of Deep Economic Moat +

Credible management combo delivering outsized returns. We highlight few cases.

We compare three parameters for the period 2004-14.



Earnings growth



Return on Equity



PE rerating

EXHIBIT 48: CONSUMER STORIES WHICH DELIVERED CONSISTENT ROBUST EARNINGS PERFORMANCE OVER 2004-2014

Asian Paints (2004-2014)

19.0

20.2

23.5

19.3

GSK (2004-2014)

24.0

18.3

Sales CAGR (%)

EBITDA CAGR (%)

PAT CAGR (%)

Source: Company, MOSL

Sales CAGR (%)

EBITDA CAGR (%)

PAT CAGR (%)

Source: Company, MOSL

ITC (2004-2014)

17.5

17.1

17.7

15.7

Nestle (2004-2014)

15.8

15.0

Sales CAGR (%)

EBITDA CAGR (%)

PAT CAGR (%)

Source: Company, MOSL

Sales CAGR (%)

EBITDA CAGR (%)

PAT CAGR (%)

Source: Company, MOSL

Pidilite (2004-2014)

22.4

28.5

Titan (2004-2014)

35.8

25.1

19.5

19.4

Sales CAGR (%)

EBITDA CAGR (%)

PAT CAGR (%)

Source: Company, MOSL

Sales CAGR (%)

EBITDA CAGR (%)

PAT CAGR (%)

Source: Company, MOSL

22 September 2014

United Spirits

Exhibit 49: Return ratios of our select consumer universe over the decade

RoE (%)

Asian Paints

GSK

ITC

Nestle

Pidilite

Titan

2003

30.3

17.6

38.0

77.4

21.5

3.4

2004

35.3

16.0

28.7

65.5

19.5

19.4

2005

32.1

13.7

32.2

61.6

20.2

35.5

2006

34.2

22.4

27.5

65.4

21.3

50.1

2007

36.8

23.4

27.4

69.5

25.8

43.4

2008

42.5

25.1

27.7

106.9

30.9

42.4

2009

33.4

24.8

25.3

126.7

21.3

42.5

2010

48.8

25.7

28.9

132.3

33.0

41.0

2011

38.5

31.2

31.3

116.5

27.2

49.2

2012

36.0

31.0

32.8

94.0

25.3

48.9

2013

32.9

32.2

36.1

71.6

27.0

42.5

2014

30.4

41.9

38.8

55.8

23.8

26.8

Source: Company, MOSL

Consistent earnings delivery led to expansion of valuation multiples and premium vs. market P/E.

Exhibit 50: Asian Paints

PE (x)

PE Relative to Sensex PE (%) (RHS)

145.4 175

100

-50

35.6% Stock Return

Exhibit 51: GSK

PE (x)

PE Relative to Sensex PE (%) (RHS)

175

103.0

32.5

100

-50

35.9% Stock Return

39.3

Source: Company, MOSL

Exhibit 52: ITC

58.6

PE (x)

PE Relative to Sensex PE (%) (RHS)

25.4

130

-20

Exhibit 53: Nestle

PE Relative to Sensex PE (%) (RHS)

43.8

28.1% Stock Return

173.4

-10

PE (x)

230

150

25.7% Stock Return

Source: Company, MOSL

Exhibit 54: Pidilite

33.5

PE (x)

PE Relative to Sensex PE (%) (RHS)

109.2

37.7% Stock Return

125

-25

-100

Exhibit 55: Titan

35.5

-50

PE (x)

PE Relative to Sensex PE (%) (RHS)

121.2

100

49.8% Stock Return

175

Source: Company, MOSL

22 September 2014

United Spirits

We see similar potential for UNSP notwithstanding the relatively harsher regulatory

and government restrictions in the IMFL industry. Possibility of multi-year solid

earnings growth partly explains the current premium valuations of UNSP,

notwithstanding the near term volatility in financials.

Five things we will monitor under new regime

As the UNSP story unfolds over the next few years, we enumerate some key

parameters to be closely monitored.



Portfolio strategy:

While premiumisation is a stated goal, execution of this

strategy will largely influence the trajectory UNSP’s EBITDA margins will take in

the medium term. Though we rule out any sweeping changes in portfolio, how

Diageo gradually defocuses on lower end brands will be an interesting case

study.



Geographic strategy:

UNSP has changed its strategy in TN and moved from

direct operations to third party royalty based arrangement. Will similar strategy

be adopted in markets like Kerala, Karnataka, Andhra Pradesh in future? If yes,

how much benefits can accrue from working capital perspective?



Pricing strategy:

Price increases have been difficult to come by for variety of

reasons in government controlled markets. How will Diageo maneuver such

markets? Will it follow in the footsteps of Pernod Ricard?



Management changes:

Diageo has retained most of the senior managers of UB

group. With the fullness of time, will Diageo gradually change the complexion of

senior managers by replacing existing talent from its global pool?



Balance sheet management:

Success in driving working capital and balance

sheet improvement will weigh on return ratios and consequently valuation

premium. Thus it is THE most critical parameter to monitor, in our view.

22 September 2014

United Spirits

Annexure-I

UNSP dominates the market characterized by

significant entry barriers

Market leader with comprehensive product portfolio

United Spirits enjoys 41% market share in the IMFL segment. It has strong portfolio

presence with brand presence across all the sub-segments of IMFL across price

points. This bestows significant competitive advantage on UNSP given the plethora

of entry barriers which characterize IMFL industry which is inherently complex to

operate in.

Exhibit 56: United Spirits enjoys 41% volume market share in IMFL

UB Group

37.1

Pernod Ricard

35.9

ABD

Jagajit

32.4

Radico

33.1

Others

32.4

38.6

6.4

41.6

2007

6.9

42.1

2008

7.5

42.3

2009

8.4

42.6

2010

9.0

41.6

2011

9.7

41.0

2012

Source: Company, Industry, MOSL

Exhibit 57: UNSP’s portfolio straddle across price points

Source: Company, MOSL

22 September 2014

United Spirits

Exhibit 58: UNSP’s product offerings

CY11

Whisky

Black Dog

Antiquity

Mc Dowells No. 1

Signature

Royal Challenge

Director's Special Black

Mc Dowells Platinum

Old Tavern

Bagpiper

Director's Special

Gilbeys Green Label

Gold Riband

Hayward

Mens Club

Total Whisky

Rum

Celebration

Olde Adventurer

Rare Old Cask

Bagpiper

Total Rum

Brandy

Mc Dowells VSOP

Mc Dowells No. 1

Honey Bee

Mens Club

Total Rum

Vodka

White Mischief

Romanov

Romanov Flavours

Total Vodka

Gin

Carew

Blue Riband

Blue Riband Duet & Tango

Total Gin

Total IMFL

1.1

0.5

0.4

2.0

114

1.2

0.4

0.3

1.9

117

1.2

0.4

0.3

1.8

118

1.5

1.0

0.5

3.2

1.7

0.9

0.4

3.2

2.0

0.9

0.4

3.4

1.4

11.7

4.7

0.1

20.2

1.9

10.9

4.9

0.3

20.4

2.2

9.2

3.4

2.9

18.6

15.5

1.0

2.2

1.5

20.2

17.7

0.9

1.3

0.4

20.3

18.9

0.8

0.7

0.1

20.5

0.2

0.6

13.6

1.5

1.3

2.9

2.1

11.1

15.5

4.5

2.9

3.1

6.2

1.1

68.0

0.3

0.6

16.4

1.7

1.5

2.8

1.8

11.6

13.5

4.3

3.3

3.5

7.1

1.2

71.1

0.4

0.7

20.6

1.7

1.9

2.7

1.8

11.5

11.2

4.0

2.7

2.3

9.2

1.3

73.1

CY12

CY13

Source: IWSR, Company, MOSL

22 September 2014

United Spirits

Exhibit 59:Whisky forms 57% of the IMFL Industry

Segment wise Percentage distribution of IMFL

IMFL segment

Whisky

Scotches

Super-premium

Premium-whisky

Prestige-whisky

Delux- whisky

Upper regular- whisky

Regular- whisky

Medium-whisky

Economy-Whisky

Total-Whisky

Rum

Premium- rum

Delux-rum

Regular-rum

White rum

Economy-Rum

Total-Rum

Brandy

Premium- brandy

Semi-premium- brandy

Delux- brandy

Regular-brandy

Economy-Brandy

Total-Brandy

Gin

Regular-gin

Medium-gin

Economy-Gin

Total-Gin

Vodka

Premium- vodka

Semi premium- vodka

Regular- vodka

Economy- Vodka

Total- Vodka

All India

0.3

0.8

1.6

0.0

2.7

100.0

0.3

0.8

1.4

0.0

2.5

100.0

0.3

0.9

1.3

0.0

2.5

100.0

0.1

0.9

0.2

1.2

0.1

0.9

0.2

1.1

0.1

0.8

0.1

1.0

0.3

0.7

6.8

8.6

7.4

23.7

0.5

1.0

6.3

9.4

8.1

25.3

0.3

1.3

6.0

11.6

5.9

25.2

0.2

0.0

10.9

0.4

4.7

16.2

0.3

0.0

10.0

0.3

4.2

14.8

0.3

0.1

10.3

0.3

3.5

14.6

0.4

0.3

2.1

4.5

5.2

5.5

21.8

3.5

13.0

56.2

0.4

0.3

2.2

4.9

5.9

6.0

20.4

4.3

11.7

56.3

0.5

0.3

2.4

5.0

6.9

7.2

19.0

4.1

11.2

56.8

FY12

FY13

FY14

Of IKSource: Industry, MOSL

22 September 2014

United Spirits

Operational complexity characterizes IMFL industry

1. Significant entry barriers

Strong entry barriers characterize the Indian liquor industry. These have resulted in

very few new players having successfully entered and established new brands. The

industry is dominated by few players like United Spirits (UNSP), Pernod Ricard,

Radico Khaitan (RDCK), Jagatjit Industries (JGI), and Mohan Meakin (MOHN).



Media advertising of liquor is banned in India. Manufacturers undertake

surrogate advertising and sponsorships of various sports events to create brand

awareness. Surrogate advertising is generally done for soda, bottled water, and

sports equipment. This makes it difficult for any player to launch a new brand

and make it a success. This has thwarted the attempts of many global majors to

gain a strong foothold in the Indian liquor industry.



Though one can readily expand existing units, it is difficult to obtain a fresh

license to set up a new unit. This acts as an entry barrier for any new global

players.



Taxes and duties constitute more than 50% of the final consumer price. In

addition to excise, there are high taxes on inter-state movement of liquor. These

different types of taxes on liquor in India raise the entry barriers for any new

player.



Liquor is subject to 150% import duty and several state level duties, which raises

the price of imported liquor to very high levels. This results in very high prices

for imported liquor, thus limiting their consumer reach.



High taxes on inter-state movement of liquor results in manufacturers having

small bottling units in various states, thus creating inefficiencies in

manufacturing. Operating in India is akin to operating in 30 countries.

2. More than 60% of market is government controlled

Liquor is a state subject in India. Consequently, the liquor industry is subjected to

very strict distribution controls by the state governments. There is pricing flexibility

in 32% of the market, while 57% of the market is controlled by government

monopolies and 11% by government sponsored cartels. Currently, three types of

distribution systems are prevalent in India – government controlled, auction market,

and free market. Each distribution system has its own characteristics, some of which

have been impeding the growth of the liquor industry in India.

3. Strenuous taxation regime

The taxation structure for alcoholic drinks in India is complex, with legislation

varying from state to state. The central government issues licenses for establishing

manufacturing facilities, and imposes an import tax on imported alcoholic drinks.

Besides, state governments also impose excise and sales taxes in their own states.

They also control the decision with regards to retailing of alcoholic drinks. There are

also restrictions on setting up liquor shops in the vicinity of an educational

institution, as well in residential areas. Different legislation in different states leads

to anomalies in the taxation structure and restricts the growth of domestic

manufacturers. While imported products are subject to customs duty, domestically-

produced alcoholic drinks are subject to different levies in various states, as well as

22 September 2014

United Spirits

other fees. These include license fees, vending fees, assessment fees, and sales and

transport fees.



The individual states have the authority to impose excise duties on domestically

manufactured liquor but their jurisdiction does not extend to imported

products.



Each state imposes: (1) state excise duty on the production of alcohol in the

state, (2) import duty on any alcoholic products from outside the state, and (3)

export duty on all alcoholic products manufactured in the state for consumption

in other states.



The high tax on alcoholic drinks means that these products constitute a major

source of revenue for the central and state governments. States find it difficult

(or, perhaps, counter-productive) to enforce prohibition and even harder to find

alternative revenue sources to replace lost alcohol taxes. Andhra Pradesh, for

example, imposed prohibition in 1994, only to revoke it in 1997 in the wake of

diminishing tax revenues. Gujarat, in West India, enforces total prohibition.

However, the main impact of this is to remove a major income source for the

Gujarat government, while encouraging the bootlegging of spirits. Most

organized crime in the state has its roots in bootlegging, and alcoholic drinks are

widely available.



International trade forums have repeatedly raised the issue of restrictive /

prohibitively high import duties on alcoholic beverages in India. There was a

significant pressure on the central government to reduce tariffs on alcoholic

drinks during the review period, following the entry of India to the World Trade

Organization (WTO).

22 September 2014

United Spirits

Exhibit 60: Manufacturer receives less than one-third of MRP

SEMI-PREMIUM

Uttar Pradesh

bottle per case

Proof litre

Landed cost

Excise duty

EXTRA Excise DUTY

Landed cost

Warehouse margin

WHOLESALE PRICE

Shop margin

Total

MRP Per bottle

750

993

3263

4282

4353

807

5160

430

Bottle per case

Proof litre

Landed cost

Excise duty

Development Cess

Permit Fee

Total

Wholesale margin

Total

VAT 13%

VAT S/C 10%

Total Tax

Duty to be paid by

shop

Total (Landed at shop)

Shop margin

Retail price per case

MRP Per bottle

SEMI-PREMIUM

Punjab

750

731

340

1098

132

1230

160

176

1350

2756

1444

4200

350

Source: Company, MOSL

bottle per case

Proof litre

Landed cost

EXPORT FEES-U.P

IMPORT FEES-Haryana

EXCISE DUTY

Total Landed to

Wholesale.

Wholesalers Margin

Total

Shop margin

Total

MRP Per bottle

SEMI-DELUXE

Haryana

750

812

108

270

1204

1300

2060

3360

280

22 September 2014

United Spirits

Annexure-II

Liquor ban in Kerala – can it be emulated by other

states?

Kerala government has decided to impose ban on liquor and move towards

a path of prohibition in 10 years

Measures



In Kerala, liquor bar licenses are renewed annually. 418 liquor bars whose

licenses had expired on Mar’14 were not renewed. Additionally, licenses of 312

bars won't be renewed after March 31

2015

Kerala State Beverages Corporation outlets will be phased out with a plan to

close 10% outlets per annum.

Sunday and first day of every month will be observed as dry day.

Kerala is one of the largest IMFL market in India with close to 12% of the

industry size. It is a government controlled market with trade, distribution and

pricing under its control.

It contributes close to 8-10% of revenues for UNSP and Radico. However, given

the pricing restrictions it contributes less than 5% of EBITDA.

As the phase out is gradual, it will not have immediate material impact on

revenues.

As the ban comes into effect, there exists a possibility of goods moving from

neighboring states like Karanataka and Tamil Nadu.

Historical data from KSBC suggests (as discussed in earlier section through

exhibits) IMFL was a lucrative revenue resource for the state with nearly 80% of

the sales going into state treasury.

Impact



Bar and hotel owners have appealed against the policy decision in courts. Supreme

Court has subsequently asked the government to maintain status quo till 30

September and directed the government to file a fresh affidavit before the Kerala

High Court before the aforementioned date.

Long term implications



While it is difficult to surmise on future course of policy action by state

governments, IMFL constitutes an important source of revenue for states (excise

duties, plethora of state taxes like import-export duty etc) and given the fiscal

conditions of state governments and the difficulty in finding ready replacement

for IMFL revenues, they will be constrained before replicating Kerala

government’s policy, in our view.

Secondly, in Kerala, politics was a major driver for this decision. Both the key

political parties were posturing for stringent alcohol control for sometime as

excessive liquor consumption (Kerala has highest per capita IMFL consumption

in India) has become a key socio-political issue in Kerala.

Thus, while replication of Kerala’s policy by other states remains a theoretical risk,

we attach little probability to that scenario.

22 September 2014

United Spirits

Annexure-III

India a manageable market even for an MNC

Pernod Ricard’s performance stands testimony



Excessive government control in manufacturing, distribution, pricing, and

retailing of IMFL restricts the degree of freedom and is often touted as a key

challenge for an MNC like Diageo. However, Pernod Ricard’s India performance

amply illustrates the feasibility of running a successful liquor operation in India

despite the plethora of operational challenges typifying the Indian liquor sector.

Despite selling 1/4

of UNSP’s volumes in FY13 (29m cases), Pernod’s PAT at

INR6.9b was more than double UNSP’s standalone PAT. Also, Pernod’s balance

sheet exemplifies the quintessential FMCG DNA – net cash and negative WC.

While Pernod’s product mix is concentrated in the Premium and Prestige

segments (top 3 brands - Royal Stag, Imperial Blue and Blenders Pride account

for 98% of volumes), UNSP’s Prestige+ portfolio is still larger than Pernod’s

portfolio. Similar EBIT for both UNSP and Pernod, despite UNSP’s bigger volume

base and consequent operating leverage, highlights the inefficiencies in UNSP’s

P&L. Alternatively, it also underscores the extent of opportunity available for

Diageo to improve operations.

FY11

43,932.2

5,078.0

3,352.0

11.6%

7.6%

FY12

59,407.8

8,818.6

5,925.7

14.8%

10.0%

FY13

72,164.2

10,068.2

6,851.7

14.0%

9.5%

Source: Company, MOSL

Exhibit 61: Pernod India’s PAT more than doubled in two years

INR m

Gross Revenue

Profit before tax

Profit after tax

PBT Margin

PAT Margin

Exhibit 62: Pernod runs a net cash balance sheet…

Net D/E

Exhibit 63: …with minimal working capital requirements

7.4%

NWC/Sales (%)

6.5%

5.2%

-0.6

-0.9

FY11

FY12

-0.6

-1.0

FY10

FY13

FY11

FY12

FY13

Exhibit 64: Pernod Ricard’s sales/case is ~4x United Spirits’…

United Spirits

Pernod Ricard

Exhibit 65: …while PBT/case is ~9x United Spirits’

United Spirits

Pernod Ricard

FY10

FY11

FY12

FY13

Source: Company, MOSL

FY10

FY11

FY12

FY13

Source: Company, MOSL

22 September 2014

United Spirits

Annexure-IV

Wholesaler

Cumbersome trade dynamics

Auction Market

State auctions distribution rights to

private parties for selected areas and

time

Private vendors

20%+

Very low

Free Market

Manufacturers sell to

wholesalers/retailers

Private parties obtain license for nominal

fee

8-10%

High

Exhibit 66: Distribution systems for alcoholic beverages in India

Government controlled

State through its entity

Retailers

Retailer Margin

Sellers

bargaining

power

Methodology

Key States

State operated or private

12-15%

Low to average

Annual tender from manufacturers

Karnataka, Kerala, Uttaranchal, Tamil

Nadu, Andhra Pradesh, Orissa, Bihar,

Rajasthan, MP

Private parties negotiate with liquor

companies

Punjab, Haryana, Chandigarh, Uttar

Pradesh

Private wholesalers directly procure from

manufacturers

Goa, Maharashtra, Assam, Delhi, West

Bengal, Tripura, Pondicherry, Chandigarh,

Jharkhand

Source: Company, MOSL



Government controlled:

Under the government controlled system, the state

government (either on its own or through an agency) purchases liquor from

various entities through negotiated prices and sells at a mark-up through its own

shops. This system currently exists in southern India. It indirectly imposes limits

on the availability of the product.

Auction market:

Under the auction market system, the state government

auctions the right to sell liquor to various parties for a certain fixed fee annually.

The winners of these contracts then negotiate prices with the liquor companies

and sell to the consumers through their own distribution network. This creates

distribution monopolies in small regions, which results in high consumer prices

and fat margins for the retailers.

Free market:

The open/free market system is most favorable to the trade and

industry. It improves the availability of products and ensures fairness to both

the consumer and retailer. Under this system, interested parties can open liquor

shops by taking licenses from the state for a certain fee. Manufacturers sell the

liquor directly to the retailers at negotiated prices. This ensures fair play for the

manufacturer, as no one retailer can force it to reduce prices.

22 September 2014

United Spirits

Exhibit 67: State-wise distribution system

Type of market and jurisdiction

Government- controlled markets

Andhra Pradesh

Bihar

CSD

Chattisgarh

Karnataka

Kerala

Orissa

Rajasthan

Tamil Nadu

Uttaranchal

Hybrid markets

Delhi

Uttar Pradesh

Oligopolistic markets

Chandigarh

Haryana

Himachal Pradesh

Punjab

Uttar Pradesh

Free markets

Assam

Bihar

Daman

Goa

Jharkhand

Maharashtra

Pondicherry

West Bengal

Free market

Government- controlled

Free markets

Free market

Source: Company, MOSL

Private Oligopoly

Free market

Government- controlled

Free market

Government- controlled

Free market

Government- controlled

Free market

Government- controlled

Free market

Government- controlled

Free market

Wholesale

Retail

22 September 2014

United Spirits

Financials and valuations

Income statement

Y/E Mar

Net Sales

Change (%)

EBITDA

EBITDA Margin (%)

Depreciation

EBIT

Interest

Other Income

PBT

Tax

Tax Rate (%)

Reported PAT

Adjusted PAT

Change (%)

Min. Int. & Assoc. Share

Adj Cons PAT

2012

86,372

25.9

10,603

11.5

1,474

9,129

7,773

2,106

3,461

1,481

42.8

1,872

1,988

-42.6

1,988

2013

98,524

14.1

10,037

9.6

1,784

8,253

8,861

1,446

838

1,781

212.4

-1,050

-904

-145.5

-904

2014

99,116

0.6

8,711

8.3

2,026

6,685

12,771

7,550

1,463

2,762

188.8

-44,888

-1,302

44.1

-3

-1,302

2015E

91,801

-7.4

9,981

10.2

1,472

8,509

4,508

2,750

6,751

2,228

33.0

4,523

-447.4

4,523

(INR Million)

2016E

103,882

13.2

13,306

12.0

1,642

11,664

3,306

3,025

11,383

3,756

33.0

7,626

68.6

7,626

2017E

119,198

14.7

16,165

12.8

1,809

14,356

2,413

3,328

15,271

5,039

33.0

10,231

34.2

10,231

Balance sheet

Y/E Mar

Share Capital

Reserves

Net Worth

Debt

Deferred Tax

Total Capital Employed

Gross Fixed Assets

Less: Acc Depreciation

Net Fixed Assets

Capital WIP

Investments

Current Assets

Inventory

Debtors

Cash & Bank

Loans & Adv, Others

Curr Liabs & Provns

Curr. Liabilities

Provisions

Net Current Assets

Total Assets

2012

1,259

45,359

46,764

75,231

-592

121,403

29,620

-9,432

20,188

1,080

2,358

75,729

27,548

17,737

3,632

26,812

36,570

34,119

2,451

39,159

121,403

2013

1,259

46,614

47,984

72,517

-589

119,911

31,026

-10,721

20,305

1,312

2,179

82,059

25,112

24,170

2,816

29,960

44,330

40,517

3,812

37,729

119,911

2014

1,453

28,869

30,330

81,563

-967

110,927

35,317

-13,413

21,905

1,097

2,380

87,129

29,351

22,652

7,047

28,078

36,683

30,542

6,141

50,447

110,927

2015E

1,453

33,390

35,043

41,563

-855

75,751

31,317

-14,884

16,433

500

2,380

74,382

25,566

20,183

3,713

24,920

38,044

31,486

6,557

36,339

75,751

(INR Million)

2016E

2017E

1,453

41,013

50,902

42,666

52,555

36,063

30,063

-668

-416

78,062

82,203

35,317

39,317

-16,527

-18,335

18,791

20,982

500

2,380

80,223

90,330

27,319

31,228

22,766

27,064

4,335

4,280

25,802

27,758

43,931

52,088

37,640

45,107

6,291

6,981

36,292

38,242

78,062

82,203

E: MOSL Estimates

22 September 2014

United Spirits

Financials and valuations

Ratios

Y/E Mar

Basic (INR)

EPS

Cash EPS

Book Value

DPS

Payout (incl. Div. Tax.)

Valuation(x)

P/E

Cash P/E

Price / Book Value

EV/Sales

EV/EBITDA

Dividend Yield (%)

Profitability Ratios (%)

RoE

RoCE

Turnover Ratios (%)

Asset Turnover (x)

Debtors (No. of Days)

Inventory (No. of Days)

Creditors (No. of Days)

Leverage Ratios (%)

Net Debt/Equity (x)

2012

16.2

28.3

382.0

2.5

15.4

147.6

84.8

6.3

4.2

36.2

0.1

4.3

9.3

0.8

70.5

109.5

75.4

1.6

2013

-7.4

7.2

392.0

2.5

-33.9

-324.6

333.4

6.1

3.7

38.1

0.1

-1.9

8.1

0.9

84.7

88.0

60.7

1.5

2014

-9.0

5.0

208.7

2.5

-27.9

N.A.

481.1

11.5

3.7

45.0

0.1

-4.3

12.8

0.9

78.7

102.0

54.1

2.7

2015E

31.1

41.3

241.1

0.0

77.0

58.1

9.9

3.6

35.2

0.0

12.9

14.9

1.3

75.0

95.0

61.2

1.2

2016E

52.5

63.8

293.6

0.0

45.7

37.6

8.2

3.1

26.0

0.0

17.9

18.8

1.4

75.0

90.0

68.2

0.8

2017E

70.4

82.8

361.6

2.0

2.8

34.0

28.9

6.6

2.7

21.0

0.1

19.5

21.5

1.5

78.0

90.0

74.5

0.6

Cash flow statement

Y/E Mar

OP/(Loss) before Tax

Others

Interest

Direct Taxes Paid

(Inc)/Dec in Wkg Cap

CF from Op. Activity

(Inc)/Dec in FA & CWIP

(Pur)/Sale of Invt

Others

CF from Inv. Activity

Inc/(Dec) in Net Worth

Inc / (Dec) in Debt

Divd Paid (incl Tax)

CF from Fin. Activity

Inc/(Dec) in Cash

Add: Opening Balance

Closing Balance

2012

3,461

-2,106

7,773

-1,481

-156

7,384

-16,736

-814

-448

-17,998

3,303

8,124

-379

7,876

-2,738

6,370

3,632

2013

838

-1,446

8,861

-1,781

614

6,978

-1,406

179

-1,227

2,611

-2,714

-379

-6,568

-816

3,632

2,816

2014

1,463

-7,550

12,771

-2,762

-8,487

-48,153

19,211

-201

-1

19,009

27,278

9,047

-41

33,374

4,231

2,816

7,047

2015E

6,751

-2,750

4,508

-2,228

10,774

17,055

19,597

189

-40,000

-39,987

-3,334

7,047

3,713

(INR Million)

2016E

2017E

11,383

15,271

-3,025

-3,328

3,306

2,413

-3,756

-5,039

669

-2,005

8,576

7,311

-4,000

-3

-5,500

-6,000

-339

-3,954

-3,367

622

-56

3,713

4,335

4,336

4,280

E: MOSL Estimates

22 September 2014

United Spirits

NOTES

22 September 2014

Disclosures

This research report has been prepared by MOSt to provide information about the company(ies) and sector(s), if any, covered in the report and may be distributed by it and/or its affiliated company(ies). This

United Spirits

report is for personal information of the select recipient and does not construe to be any investment, legal or taxation advice to you. This research report does not constitute an offer, invitation or inducement to

invest in securities or other investments and Motilal Oswal Securities Limited (hereinafter referred as MOSt) is not soliciting any action based upon it. This report is not for public distribution and has been

furnished to you solely for your general information and should not be reproduced or redistributed to any other person in any form. This report does not constitute a personal recommendation or take into

account the particular investment objectives, financial situations, or needs of individual clients. Before acting on any advice or recommendation in this material, investors should consider whether it is suitable

for their particular circumstances and, if necessary, seek professional advice. The price and value of the investments referred to in this material and the income from them may go down as well as up, and

investors may realize losses on any investments. Past performance is not a guide for future performance, future returns are not guaranteed and a loss of original capital may occur.

MOSt and its affiliates are a full-service, integrated investment banking, investment management, brokerage and financing group. We and our affiliates have investment banking and other business

relationships with a significant percentage of the companies covered by our Research Department Our research professionals provide important input into our investment banking and other business selection

processes. Investors should assume that MOSt and/or its affiliates are seeking or will seek investment banking or other business from the company or companies that are the subject of this material and that

the research professionals who were involved in preparing this material may participate in the solicitation of such business. The research professionals responsible for the preparation of this document may

interact with trading desk personnel, sales personnel and other parties for the purpose of gathering, applying and interpreting market information. Our research professionals are paid in part based on the

profitability of MOSt which include earnings from investment banking and other business. MOSt generally prohibits its analysts, persons reporting to analysts, and members of their households from

maintaining a financial interest in the securities or derivatives of any companies that the analysts cover. Additionally, MOSt generally prohibits its analysts and persons reporting to analysts from serving as an

officer, director, or advisory board member of any companies that the analysts cover. Our salespeople, traders, and other professionals or affiliates may provide oral or written market commentary or trading

strategies to our clients that reflect opinions that are contrary to the opinions expressed herein, and our proprietary trading and investing businesses may make investment decisions that are inconsistent with

the recommendations expressed herein. In reviewing these materials, you should be aware that any or all o the foregoing, among other things, may give rise to real or potential conflicts of interest . MOSt and

its affiliated company(ies), their directors and employees may; (a) from time to time, have a long or short position in, and buy or sell the securities of the company(ies) mentioned herein or (b) be engaged in

any other transaction involving such securities and earn brokerage or other compensation or act as a market maker in the financial instruments of the company(ies) discussed herein or act as an advisor or

lender/borrower to such company(ies) or may have any other potential conflict of interests with respect to any recommendation and other related information and opinions.

Unauthorized disclosure, use, dissemination or copying (either whole or partial) of this information, is prohibited. The person accessing this information specifically agrees to exempt MOSt or any of its

affiliates or employees from, any and all responsibility/liability arising from such misuse and agrees not to hold MOSt or any of its affiliates or employees responsible for any such misuse and further agrees to

hold MOSt or any of its affiliates or employees free and harmless from all losses, costs, damages, expenses that may be suffered by the person accessing this information due to any errors and delays. The

information contained herein is based on publicly available data or other sources believed to be reliable. Any statements contained in this report attributed to a third party represent MOSt’s interpretation of the

data, information and/or opinions provided by that third party either publicly or through a subscription service, and such use and interpretation have not been reviewed by the third party. This Report is not

intended to be a complete statement or summary of the securities, markets or developments referred to in the document. While we would endeavor to update the information herein on reasonable basis, MOSt

and/or its affiliates are under no obligation to update the information. Also there may be regulatory, compliance, or other reasons that may prevent MOSt and/or its affiliates from doing so. MOSt or any of its

affiliates or employees shall not be in any way responsible and liable for any loss or damage that may arise to any person from any inadvertent error in the information contained in this report. MOSt or any of

its affiliates or employees do not provide, at any time, any express or implied warranty of any kind, regarding any matter pertaining to this report, including without limitation the implied warranties of

merchantability, fitness for a particular purpose, and non-infringement. The recipients of this report should rely on their own investigations.

Recipients who are not institutional investors should seek advice of their independent financial advisor prior to taking any investment decision based on this report or for any necessary explanation of its

contents.

MOSt and/or its affiliates and/or employees may have interests/positions, financial or otherwise in the securities mentioned in this report. To enhance transparency, MOSt has incorporated a Disclosure of

Interest Statement in this document. This should, however, not be treated as endorsement of the views expressed in the report.

Disclosure of Interest Statement



Analyst ownership of the stock

UNITED SPIRITS LTD

Analyst Certification

The views expressed in this research report accurately reflect the personal views of the analyst(s) about the subject securities or issues, and no part of the compensation of the research analyst(s) was, is, or

will be directly or indirectly related to the specific recommendations and views expressed by research analyst(s) in this report. The research analysts, strategists, or research associates principally responsible

for preparation of MOSt research receive compensation based upon various factors, including quality of research, investor client feedback, stock picking, competitive factors and firm revenues.

Regional Disclosures (outside India)

For U.K.

This report is not directed or intended for distribution to or use by any person or entity resident in a state, country or any jurisdiction, where such distribution, publication, availability or use would be contrary to

law, regulation or which would subject MOSt & its group companies to registration or licensing requirements within such jurisdictions.

This report is intended for distribution only to persons having professional experience in matters relating to investments as described in Article 19 of the Financial Services and Markets Act 2000 (Financial

Promotion) Order 2005 (referred to as "investment professionals"). This document must not be acted on or relied on by persons who are not investment professionals. Any investment or investment activity to

which this document relates is only available to investment professionals and will be engaged in only with such persons.

Motilal Oswal Securities Limited (MOSL) is not a registered broker - dealer under the U.S. Securities Exchange Act of 1934, as amended (the"1934 act") and under applicable state laws in the United States.

In addition MOSL is not a registered investment adviser under the U.S. Investment Advisers Act of 1940, as amended (the "Advisers Act" and together with the 1934 Act, the "Acts), and under applicable state

laws in the United States. Accordingly, in the absence of specific exemption under the Acts, any brokerage and investment services provided by MOSL, including the products and services described herein

are not available to or intended for U.S. persons.

This report is intended for distribution only to "Major Institutional Investors" as defined by Rule 15a-6(b)(4) of the Exchange Act and interpretations thereof by SEC (henceforth referred to as "major institutional

investors"). This document must not be acted on or relied on by persons who are not major institutional investors. Any investment or investment activity to which this document relates is only available to major

institutional investors and will be engaged in only with major institutional investors. In reliance on the exemption from registration provided by Rule 15a-6 of the U.S. Securities Exchange Act of 1934, as

amended (the "Exchange Act") and interpretations thereof by the U.S. Securities and Exchange Commission ("SEC") in order to conduct business with Institutional Investors based in the U.S., MOSL has

entered into a chaperoning agreement with a U.S. registered broker-dealer, Motilal Oswal Securities International Private Limited. ("MOSIPL"). Any business interaction pursuant to this report will have to be

executed within the provisions of this chaperoning agreement.

The Research Analysts contributing to the report may not be registered /qualified as research analyst with FINRA. Such research analyst may not be associated persons of the U.S. registered broker-dealer,

MOSIPL, and therefore, may not be subject to NASD rule 2711 and NYSE Rule 472 restrictions on communication with a subject company, public appearances and trading securities held by a research

analyst account.

Motilal Oswal Capital Markets Singapore Pte Limited is acting as an exempt financial advisor under section 23(1)(f) of the Financial Advisers Act(FAA) read with regulation 17(1)(d) of the Financial Advisors

Regulations and is a subsidiary of Motilal Oswal Securities Limited in India. This research is distributed in Singapore by Motilal Oswal Capital Markets Singapore Pte Limited and it is only directed in Singapore

to accredited investors, as defined in the Financial Advisers Regulations and the Securities and Futures Act (Chapter 289), as amended from time to time.

In respect of any matter arising from or in connection with the research you could contact the following representatives of Motilal Oswal Capital Markets Singapore Pte Limited:

Anosh Koppikar

Kadambari Balachandran

Email:anosh.Koppikar@motilaloswal.com

Email : kadambari.balachandran@motilaloswal.com

Contact(+65)68189232

Contact: (+65) 68189233 / 65249115

Office Address:21 (Suite 31),16 Collyer Quay,Singapore 04931

For U.S.

For Singapore

Motilal Oswal Securities Ltd

22 September 2014

Motilal Oswal Tower, Level 9, Sayani Road, Prabhadevi, Mumbai 400 025

Phone: +91 22 3982 5500 E-mail: reports@motilaloswal.com