United Spirits: FY15-16 earnings downgraded

Diageo seeks to use reserves to retire intra-company debt; cleaning of books may take longer than expected

Investors of United Spirits (USL) will have to wait longer before margins expand and earnings accelerate. The stock has declined six per cent over the past three months as the market’s view on the company is no longer upbeat. The firm’s earnings outlook in FY15 does not look as strong as anticipated earlier. For one, USL has not managed to increase prices in 2014. Typically, state governments refuse higher prices during election years and that is why USL could not push through a price hike this year. Higher prices of ethanol will also impact the company’s earnings. Deutsche Bank Markets Research has cut the company’s FY15 and FY16 earnings by 27 per cent and 25 per cent, respectively, as it is factoring in lower operating margins for the company.

Another reason for the market’s jitters is the delay in Diageo getting control over the company. With promoter holding coming down by 3.4 per cent owing to the liquidation of pledged shares, public shareholding increased. Following this, Kotak Institutional Equities reduced its estimated acceptance ratio to 60-65 per cent from the earlier 70 per cent. “A significant pick-up in hedging activity during the tendering period indicates the market expects a lower acceptance ratio,” the brokerage notes.

In addition to this, USL has sought approval from the Reserve Bank of India to reduce its reserves by Rs 3,690 crore to provide for residual intra-company debt. Also, the sale proceeds of Whyte & Mackay are not sufficient to retire the loan the management took to fund the acquisition. USL said in a release that the proceeds of the sale will not be sufficient to repay the intra-USL group loan, the balance of which stood at Rs 4,790 crore at end-March. Analysts believe the intra-company loans are given mostly for non-core business advances and it might take Diageo three to five years to recover.

While the market has been bullish on the company’s premiumisation strategy, there are fears that Diageo India might use USL only as a distillery in India, which would lower margins further. According to Deutsche Bank Markets Research, the possibility of selling higher margin brands of Diageo through the parent’s 100 per cent subsidiary Diageo India, and USL being used only as a distillery is a key risk. In such a case, the margin expansion expectation might not materialise entirely.