Rising tea prices, inorganic growth to boost McLeod Russel's prospects

Falling global tea production and increased consumption will benefit McLeod Russel (McLeod) significantly. The McLeod management expects that tea production in India will be lower by 3-4 per cent in India in 2012, consequent to which tea prices are expected to shoot up by about 15 per cent to Rs 25 a kg. Globally too, as against flattish production growth of 0.5-0.6 per cent, tea consumption is expected to rise by 2 per cent annually.All these factors will boost tea price and hence realisations and profitability of McLeod. These favourable macro dynamics puts McLeod - the world's largest producer of black tea in a sweet spot. Add to this undemanding valuations of 7.7 times FY14 estimated earnings makes most brokerages bullish on the stock. Notably, the McLeod scrip has traded at a five year average one-year forward Price/Earnings multiple of 9 times.

"The McLeod Russel stock currently trades at 5.7 times FY14 estimated earnings excluding treasury shares, which we believe is very compelling in the context of FY13-15 estimated earnings growth of 24 per cent, FY14-15 estimated average adjusted Return on Equity of 28 per cent and Free cashflow Rs 31 a share in FY14", believes Ankur Agarwal of Nomura Equity Research.

McLeod's move to acquire tea gardens in Africa and Vietnam will boost its production significantly. Analysts expect McLeod's realisations to improve by 8 per cent in FY13 and 7 per cent in FY14. Thanks to rising realisations as well as production, McLeod's EBITDA margins are expected to expand by 290 basis points in FY14. Adverse weather conditions in Assam have hit the company's domestic tea production and will reflect in lower earnings growth this fiscal.

"We believe there is potential upside to the return ratios if McLeod decides to re-leverage its balance sheet by acquiring limited land/tea gardens, especially in Africa" believes Agarwal.

Given its strong market position, McLeod stands to gain significantly from adverse weather in Kenya and Sri Lanka in the form of higher exports at higher tea prices. Continued bad weather in Assam could impact tea production for McLeod and remains a key operational risk. Also, given that it exports 30 per cent of its production, any unforeseen volatility in exchange rates will affect its profitability.

"We are positive on the stock with domestic tea consumption growth outstripping production growth in next 4-5 years. This will have a positive impact on tea pricing. McLeod is the largest company in tea production with a clean balance sheet and huge operating leverage. We believe, the downside in the stock is very limited", write analysts at Motilal Oswal Securities in a recent report.