Good time for short-term investors to exit USL

Diageo's open offer is at an attractive valuation & factors in most of the near-term earnings upsides; however, those in for the long term have reason to stay the course

 

United Spirit’s (USL) share price, languishing for three-odd months, surged almost 12 per cent on Tuesday following the open offer by Diageo to acquire a 26 per cent stake in the company. The open offer at Rs 3,030 a share is a 18.5 per cent premium to Friday’s closing price.

 In the past, positive news flow about restructuring of operations, entry of new management and stake sale of USL’s subsidiary, Whyte and Mackay (W&M), to cut debt have done the rounds. However, as most of the news flow is already now factored into the current share price, market participants believe short-term investors would be better off in tendering shares in the open offer, as current valuations have become expensive.

“At the offer price, I do not see why one should not tender the shares. There is definitely a long-term story but at the offer price, investors have more to gain because of the valuations. Also, most of the recent surge in the share price is accounted by the news flows and once that subsides, you will need earnings to support it, which I do not think is going to happen anytime soon,” said Daljeet Singh Kohli, head of research at IndiaNivesh Securities.

The Street is expecting a net profit of about Rs 700 crore in financial year 2016. Even if one includes a gain of about Rs 300 crore (due to the planned reduction in debt), net profit in FY16 is unlikely to exceed Rs 1,000 crore. “We see further potential upside in earnings (33 per cent from current estimates) from the W&M stake sale and re-structuring of debt at a lower cost,” said Harit Kapoor , tracking the company at IDFC Securities.

In this case, supposed to be the best case scenario, on the said offer price the price to earnings ratio is almost 44 — high, given the company’s growth rates and return ratios.

Though the valuations suggest investors can tender shares, for those who do not wish to time the market (long-term investors) and are willing to wait to reap the potential in the long term, tendering shares now might not be a good strategy. After the open offer, it is possible the shares might continue to trade at higher valuations, as there will be very low liquidity in the counter. Most of the shares are held by the institutions (almost 40 per cent of the equity capital of USL). Also, the company is considered one of the best consumer plays in the Indian market, which might also keep the stock in demand.

More important, with Diageo taking control, analysts see the change in management in a positive light, and believe it should rub-off well on earnings in the coming years. “USL is a pioneer in the Indian alcohol industry, with 40 per cent market share in the IMFL (India-made foreign liquor) segment. USL is perfectly poised to benefit from a change in management control and the resultant shift in focus from volume to value growth,” said Bharat Chhoda, who is tracking the company at ICICI Direct.com.

The financial year 2015 (FY15), will be the first full year of Diageo in charge. It is expected to not only bring global expertise to USL but to help improve the profitability by focusing on value-added products and de-leveraging. While gains from a focus on value-added products will accrue in the long run, de-leveraging could be the biggest near-term trigger for earnings’ re-rating. The company is already looking to sell W&M, acquired at an enterprise value of Rs 9,480 crore. If this business is sold, it will be enough to significantly bring down USL’s debt, which in FY2013 was Rs 8,246 crore. In FY13, the company paid Rs 985 crore as interest costs on an operating profit of Rs 1,236 crore.

“We believe Diageo’s sale of the W&M business (sans two distilleries, Dalmore & Tamnavulin) will be positive for USL, as it will significantly reduce the debt burden to the extent of Rs 3,267 crore and, consequently, reduce interest cost in the range of Rs 130-150 crore annually,” said Chhoda. Additionally, the sale will bring down inventory levels, improving its working capital cycle, he says. While such a move will positively impact the earnings, most of it is likely to be visible only in FY16 and after.