Margin contraction and competitive pressure may keep spirits low at USL

Investors in United Spirits (USL) did not make any money in 2019. The stock, which has underperformed the broader indices, ended marginally lower than the year-ago levels. From its September levels when it had peaked, the stock has shed about 11 per cent.

Pegged back by a consumption slowdown and high base, the company recorded muted volume in the September quarter. What hampered sales further were the liquidity challenges for trade in certain states and a temporary supply-chain disruption. The company faces some headwinds on account of margin contraction and competitive pressures.

The hike in key raw material prices is putting pressure on gross margins. Half the raw material cost is contributed by extra neutral alcohol (ENA) and glass. A spike in their costs had led to a 410-basis point (bp) dip in the September quarter to 45 per cent. The company offset the impact somewhat at the operating profit level by curtailing its marketing, employee, and other expenses. Advertising expenses, as a proportion of sales at 7.6 per cent, was the lowest in eight quarters.  

The government’s ethanol blending policy and higher cost of the ethanol blending component in ENA, coupled with the rise of 15-18 per cent in glass prices over the past few years, have been putting pressure on gross margins. While the company has been taking steps to offset the impact and has maintained its operating profit margins over the past couple of years, cost surge could keep margins under stress.

Analysts at Elara Capital expect the cost of goods sold as a proportion of sales to rise from 49.6 per cent in 2018-19 to 54.3 per cent in 2019-20. This is expected to move up further by another 300 bps to cross the 57-per cent mark in 2021-22. In the December quarter, gross margins are expected to fall 200 bps year-on-year to 46.6 per cent, while operating profit margins are weaker by 10 bps.  

Regulatory changes are another headwind which could impact the revenues of USL. In November last year, the Andhra Pradesh government had introduced a new bar policy, which included the cancellation of existing bar licences, issuance of new ones from January 2020, and reduction in the number of bars.

Source: Company, Brokerage Reports and BS Research

The government has also imposed additional retail excise tax on Indian Made Foreign Liquor sold to bars, which led to sharp price increases. The state contributes 4 per cent to USL’s sales. Analysts at Emkay Global expect third-quarter volumes to be impacted by 2-3 per cent, but expect a recovery from the March quarter as trade stabilises.

In addition, any excise duty hike by the states will be an added headwind, at a time when volume growth has been impacted by the ongoing slowdown. In addition to price increases, which have to be approved by the state governments, higher revenues will be a function of higher sales in states, with increased realisations and better product mix.

Finally, analysts at Elara Capital believe the company (shed 500-bp market share since 2013-14) will continue to struggle to regain lost share because of underperformance in the high margin category and an inability to do course reversal due to poor planning.

While the near-term stock performance will depend on the December quarter results, investors should await signs of margin improvement and volume uptick, especially in the Prestige-and-above segment before considering investment in USL.