Nath Balakrishnan

A few months ago, when SAB Miller snapped up the Foster's beer business in India, a Dow Jones story began with a quote from American acting legend Humphrey Bogart, who once remarked that the problem with the world was that everyone was a few drinks behind. Having been in the wilderness for quite a while, liquor companies have proved Bogart wrong, catching up with their counterparts in more-fancied industries with a scorching run.

The fizz in the sector was conspicuous by its absence even three years ago. Then, such majors as United Breweries and McDowell's (now called United Spirits) the principal players were trading at around Rs 10 (adjusted for the stock split) and Rs 80 respectively. Now, the stocks trade at Rs 180 and Rs 820 respectively, and the price move has been accompanied by a significant expansion in the earnings multiples accorded them.

In the past, if the bitterly competitive environment and several legal battles in the sector were not bad news enough, the significant bargaining power of suppliers and a hardening of input costs compounded the industry's woes and made margins anaemic. It was not without reason that the stocks languished. The story is quite different now. The way the stocks have moved is clearly an index of Dalal Street's optimism about the sector. Here's a look at what drove the sector's re-rating and what factors can keep the story sparkling.

Consolidation

: If there's one word that captures the essence of the sector's improving outlook, it is consolidation. In pre-consolidation times, even as McDowell's, Shaw Wallace, Herbertsons and Radico Khaitan slugged it out in the marketplace, it was their fragmentation that turned out to be the industry's undoing. Moreover, the legal tussles involving the first three did not exactly make for bonhomie on the ground.

The complexion of the business changed with the UB Group finally acquiring the spirits businesses of both Shaw Wallace and Herbertsons. These two outfits, along with a few more, have been folded into McDowell's to form United Spirits, which will control about 50 per cent of the total spirits market. Apart from giving the business scale, the acquisition also provides the UB Group combine with enough headway to change it cost structure, be it in rationalising facilities, phasing out tail-end brands or optimising advertising expenses.

Second, and more important, is the clout that the leading player will command with both suppliers and governments, who are large beneficiaries, courtesy the industry's multiple tax payouts. Packaging constitutes a key component of costs; it is estimated that the entire UB Group's demand for glass bottles (the primary packaging material) accounts for 40 per cent of the total demand for this product. From a situation where the supplier of bottles was calling the shots, the tables have been now turned. The industry is also experimenting with other variants, such as plastic bottles, laminated paper packs and cans, which should reduce dependency on glass. Bargaining power with governments should also improve, at least in terms of the industry being able to push through cost-based price increases. These moves should lead to the industry being able to cushion the impact on margins in the event of the cost of key raw materials heading north.

Demographic composition

: India's demographics will be the key driver of liquor consumption in the medium term. Close to half of India's population is under the age of 25, and represents a growing target segment for alcoholic beverage companies. Juxtapose that with an economy that is in healthy shape and the proliferation of jobs in the services sector that leaves a sizeable disposable income in the hands of a young target audience, and it is clear why liquor manufacturers have good reason to smile.

The attractiveness of the market is also the key reason why we believe it is only a matter of time before foreign majors make an aggressive pitch to capture a slice of the action. In the beer business, leading names such as Anheuser-Busch and InBev, to name just two, could be potential entrants, what with several breweries under construction in the northern States. On the spirits side, Diageo, the largest drinks company in the world, has already inked a joint venture with Radico Khaitan for a new line of products. In time, choice, it seems, will be the buzzword for the Indian consumer.

Improvements in distribution

: Changes on this front have been slow-paced, but whatever little has happened in recent times has been for the better. The principal change has been the move from an auction-controlled mode of distribution to a government-controlled one in the key States of Punjab and Haryana.

The former mode is characterised by cartelisation and is the least-preferred mode from a manufacturer's standpoint. With distribution in more than two-thirds of the market under government control, regulatory imposition would continue to be stringent.

However, with governments also exhibiting signs of taking a favourable view on price increases on account of input cost pressures this should provide a leg-up to the industry's profitability.

Sector outlook

We tend to view the industry's prospects as attractive, given the inherent strengths of the incumbents, the high barriers to entry for new players in terms of procuring licences and tying up nation-wide bottling arrangements and the long gestation period involved in building brands, especially as there is a ban on direct advertising.

Within the sector, we are more inclined towards stocks of spirits companies, as opposed to beer businesses. It is strong versions of beer that are registering good growth and, given the extant tax structure and the resultant pricing, it could be argued that consumers will migrate to the spirits category. Though patterns are changing, beer consumption continues to display seasonal trends; further, the competitive intensity in this business is higher, as the market is a two-way fight between UB and SAB Miller, and the latter's deep pockets cannot be discounted.

Stock view

In the listed space, we believe that United Spirits is a good play on the Indian consumption theme, more so after the consolidation has bestowed on it significant size and scale. But the stock's sharp run-up in the homestretch to the completion of the restructuring exercise makes us adopt a cautious stance. We recommend an entry into the stock on dips from the current level; investors who have entered the stock at lower prices can retain their holdings. We also suggest that investors of United Breweries retain their holdings.

Investors can consider buying into Radico Khaitan in small lots. The company has made significant strides over the past few years and has a 12 per cent market share.

Its recent tie-up with Diageo for a new line of products can be viewed as a positive and opens up opportunities for Radico to capitalise on the former's equity and take these new brands abroad. Also, its setting up of a grain-based distillery gives it a platform to export into European markets and also acts as a hedge domestically, if price movements of molasses turn adverse. Domestic prospects also look encouraging. Buy in small quantities, to give your portfolio a kick!

(This article was published in the Business Line print edition dated November 19, 2006)
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