Varun Beverages: Frothy valuations belie weak fundamentals

Market for carbonated drinks, which make up 80% of its revenue, is giving way to healthier beverages

The Varun Beverages (Varun) scrip has fallen 17 per cent since its listing on the bourses on November 8 as against a 3.5 per cent fall in the S&P BSE Sensex during this period. Varun produces and distributes Pepsico's carbonated soft drinks and non-carbonated beverages in north and east India. The sharp fall in its stock price can be attributed to multiple factors such as rich IPO valuations, weak fundamentals and overall weak market sentiment post demonetisation. The stock's current valuations appear stretched and has few legs to stand on. "Varun Beverages does not seem a value buy as it trades at 60 times December 2017 estimated earnings or a 70 per cent premium to the FMCG sector," says Anuj Bansal, analyst at Ambit Capital.

Though Varun cannot be categorised as an FMCG company and the company does not have a comparable listed peer, given its franchisee business model, its valuations are steep.

There are a few fundamental concerns in Varun's business model which could limit its growth avenues. One, it has limited say in decisions related to pricing, new launches and acquisition of new territories and regions to distribute PepsiCo products and the same rests with the global giant. Second, carbonated soft drinks, which form 80 per cent of the company's revenues, are witnessing slowdown amid rising consumer preference for healthier drinks and juices. Third, unlike other franchisees such as Jubilant, Page Industries and the like, Varun cannot own franchisees of different companies as most of them compete with Pepsico either in the packaged foods or beverages market. And lastly, there is high volatility in Varun's earnings profile.

With 45 per cent of its business coming in the June quarter alone (due to summer), the seasonal element in its business is rather high. Sample this. After registering strong earnings in the first half of CY15 worth Rs 167 crore, this metric halved to Rs 87 crore in CY15, implying that the company registered net loss to the tune of Rs 80 crore in the second half of CY15. It will be important to see if this trend continues this year as well given note ban is an additional overhang on consumption demand.

Amid weak revenue growth outlook, there is a silver lining. The company plans to utilise some of the issue proceeds towards debt repayment and pare down its debt from Rs 1,600 currently to about Rs 1,000 crore. This will reduce its interest outgo and rub off favourably on its earnings. However, it appears unlikely that this will be able to offset the impact of weak revenue growth going forward.