DSP Merrill Lynch United Spirits Ltd

Cutting EPS and PO again on higher molasses prices We have cut our FY09 EPS estimates by 7% owing to continuing price rise in the key input, molasses. As a result, we now expect UNSP’s current year domestic EBITDA margins to contract 80bp versus flat earlier and EPS to grow only 11%. This is a sharp slowdown versus the 30% plus growth rate of last two years. We note our estimates are 18% below consensus. Reiterate Underperform.

Lower PO to factor in slower earnings growth We have cut our PO to Rs1350 from Rs1482. We value the base business at
Rs1150 and treasury stock at Rs200. While we are confident of UNSP long term secular growth potential, we believe FY09 will be a tough year. Key issues are higher input costs and lack of pricing power given government led price controls in approximately two thirds of its domestic volumes.

Valuation – still expensive despite the sharp correction UNSP has corrected 31% from its peak in January. Excluding treasury stock of US$470m, It is now trading at P/E of 27xFY09E EPS and ~70% premium to the Sensex. We believe the risk reward still remains unfavourable owing to rich valuations, high consensus expectations and downside risk to earnings.

Molasses pain likely to intensify Industry sources indicate continuing molasses price run up led by lower sugar production and growing demand for ethanol. We estimate molasses to be in sharp deficit versus surplus over the last two years and FY09 price to rise ~36% vs 25% earlier. We acknowledge that UNSP is well placed versus competitors in terms of its ability to negotiate better prices. Nonetheless, we expect UNSP’s ENA cost (molasses derivative) to rise at least 15% in FY09. We note every 1% change in ENA prices leads to 1.5% change in EPS for UNSP.

Investment Thesis

We believe UNSP’s re-rating is behind us and downside risks are rising. Margins are beginning to peak out with rising molasses prices. Excise duty hikes, albeit marginal, in the recent State Budget reiterates regulatory risks. Visibility on W&M business is low and the possibility of further increases in scotch prices look rather bleak. Growth through higher brand sales by W&M will likely involve a long gestation period. Lastly, it is difficult to forecast the timing of treasury stock sales.

Earnings cut again on rising molasses prices; EPS cut 8% Following our recent cut in April 2008, we have further cut our earnings estimate for UNSP by 8% to Rs3.9bn in FY09E and Rs4.9bn in FY10E. This implies an EPS of Rs43.6 with a 11% growth in FY09E and of Rs55.7 with a 28% growth in FY10E. We are maintaining our topline growth estimates at 15-16% over next two years with ~11% volume growth and 3-4% price and mix benefits.

Molasses prices running ahead of expectations The key reason for this earnings cut is our upward revision of molasses price expectations based on current higher than expected run up. We now expect molasses prices to rise 15% in FY09 and 5% in FY10 for UNSP. We believe UNSP’s margins will reverse their impressive expansion of past three years and decline by 80bps in FY09. Synergy benefits from SWC integration have likely maxed out and UNSP does not have pricing power in 2/3 rd of its Govt. controlled markets to counter rising molasses prices. With this assumption, UNSP has a 1.5x earnings sensitivity to molasses prices as with every 1% rise in price of molasses its EBITDA margin contracts by 17bps and EPS falls by 1.5%.

Consensus is bullish Our earning estimates are ~18% below consensus and we believe consensus is overly bullish on UNSP. It is perhaps underestimating the impact of rise in raw materials or is not factoring in constraints on UNSP to pass on raw material price hikes due to limited pricing power.

Valuation – risk reward still unfavourable Recently de-rated but not yet time to buy UNSP has re-rated from P/E of less than 15x two years back to now 31x FY09E. Excluding the market value of treasury stock of US$470m, it is trading at P/E of 27xFY09E EPS and premium to the Sensex of 70%.

We also note that the stock appears to be over-owned with FII stake at 34% and a consensus Buy. Despite the recent stock correction we believe the outlook is challenging. Rising input costs pose increasing downside risk to domestic
earnings growth (60% of Group EBITDA). Also, visibility on W&M (40% of Group EBITDA) remains poor and our dependence on management guidance is very high. Overall we believe positive surprises are unlikely.

Molasses – price run up continues We are revising upwards our expectations for rise in prices of molasses to 36% from earlier 24% for FY09. This is on the back of continuing sugar production fall – down 10% in the last crushing season ended May 2008 and expectation of

another 15% fall in the next crushing season. In addition, growing demand for ethanol (biofuels) is driving up demand for molasses. As a result, molasses prices are running up higher than our earlier expectations.

Table 2 gives the demand scenario for molasses based alcohol. Data for the years 2006-07 and 2007-08 is provided by USDA Gain report of June 2007. The forecasts for the year 2008-09 is based on our expectations after incorporating sugar

production fall of 14%. We also build in the additional demand for ethanol based on India ‘s bio-fuel policy. We estimate that there is a molasses short fall in excess of 600m litres in FY09 after significant surpluses in the last two years. We conclude this will lead to sharply higher prices and hence margin pressure for UNSP.

Alternative uses of molasses increase demand pressure India has adopted a bio-fuel policy according to which 5% blending of molasses produced ethanol with fuel is permitted. This limit for mixing of ethanol in fuel is going to be raised from 5% to 10% from 1 st Oct’08 . This would generate a significant demand on molasses which is used to manufacture ethanol. Leading sugar manufacturers are already in the process of hiking their capacity for manufacture of ethanol which would increase their in-house consumption of molasses and reduce availability for distilleries. We expect a significant demand supply gap for molasses and ENA with new blending policy. Going forward, this gap should be a key driver for molasses prices.

Price objective basis & riskUnited Spirits (UDSRF)We value UNSP at Rs1,350/share. This is a combination of the base business at Rs1,150 and treasury stock at Rs200. For the base business, we use PEG since UNSP is a growth stock. We take a target PEG of 0.9x for FY10 using EPS CAGR of two years over FY08-10. We forecast EPS to grow at an average of 19pct over the next two years and our target PEG of 0.9x is lower than the sector average of 1x to capture the higher regulatory risks associated with alcohol business in India . Based on this methodology, we arrive at the base business value of Rs1,150. At Rs1,150, the base business would trade at FY10E P/E of 21x. Treasury stock accounts for 13pct of shares outstanding and we assume that these will be sold at market value of Rs1,300/share which implies per share price of Rs200. Upside risks: Stronger-than-expected demand and higher-than- expected value of treasury stock. Downside risks: Sharp input cost increases.