Mispriced Opportunity Note

VARUN BEVERAGES LIMITED

Independent Equity Research

28th July, 2020

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 VARUN BEVERAGES LIMITED (VBL)
Synopsis table
Recommendation BUY
Current price (24th July, 2020) Rs. 688
Buying Range Rs. 650 - Rs. 700
6-12-month fair price range Rs. 875 – Rs. 928
Upside from CMP (%) 27% - 35%

Event translating in ‘Mispriced Opportunity’

1-year Price movement

Price Movement wrt
Period Date Price (Rs.) 1-yr Forward P/E
to current price
Recent high 19-Jun-20 732 27.7 -5%
52 Week high 27-Jan-20 870 33.0 -20%
2yr high 27-Jan-20 870 33.0 -20%
Current market price 24-Jul-20 697 26.4 NA

Chart: Share price performance of Varun Beverages (VBL), Britannia Industries (Britannia), Hindustan Unilever (HUL) and Nestle
India (Nestle) over past 1 year

Outpaced most other

Under-performance due to loss of
peers owing to network
sales in lockdown & avoiding “cold”
and territory expansion
beverages during COVID period

Source: Yahoo Finance, Equentis Research

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Explanation of phases over the past five years
 Over the past 12 months, VBL saw a strong stock price rally between July, 2019 and January, 2020 as the company
acquired franchisee rights for Southern and Western India for bottling, sales and distribution. The company already
had bottling rights for North and East India. Post-acquisition, VBL became a franchisee of PepsiCo’s beverages
business across 27 states and seven Union Territories of India.
 At the start of CY2020, the stock price became range bound as the company entered a seasonally weak period (winter).
 Post imposition of lockdown in India, VBL’s stock price took a beating as soft drink consumption took a backseat with
consumers stocking up essentials as a knee-jerk reaction and avoided cold beverages as “hot” was advocated more by
health experts for treatment of COVID’19 conditions and symptoms.
 Having said this, consumption of certain discretionary items such as biscuits, instant noodles, namkeens, etc. picked
up despite lockdown, showing that consumers were not entirely averse to spending on discretionary food items.
 The current period (monsoon) and coming few months (winter) will be seasonally weak for soft drink consumption.
 Going ahead, we expect pick up in soft drink consumption as restaurants, multiplexes, sporting events and social
gatherings make a gradual come back over the next couple of quarters.
 Over the longer term, VBL will benefit from growth in distribution network, greater scale, productivity improvement
and consequently improving margins

Our view
In our opinion, VBL is best poised to stage a recovery over the next 12 months.

Phase - I Phase - II
Stock 1yr return
26Jul19 - 27Jan20 28Jan20 - 24Jul20
VBL 6% 30% -17%
HUL 28% 19% 7%
Nestle 49% 35% 12%
Britannia 43% 19% 20%
Source: BSE Website, Equentis Research

Following are the key reasons that will lead to resurgence in VBL’s stock price in the near to medium term:

 Staples segment is best placed in current uncertain scenario as it is the only sector where the demand is strong.
 Demand for VBL’s product to be better as people are not left with much munching options for in home consumption
due to almost shut down of Restaurants and street foods.
 Addition of new Geographies to increase the scale of business
 International business to provide some cushion to lost domestic business in peak period.

Given the weak economic scenario in India and globally caused led by COVID, near-term performance is likely to be under
pressure, however, the long term growth prospects of the company remains intact. We are optimistic on VBL staging a strong
recovery over the next 3-4 quarters, driven by gradual unlock in the country, start of restaurants, multiplexes, sporting events
& social gatherings leading to revival in on the go consumption and increase in share of in-home consumption. Hence, we
advise investors to BUY this stock.

Risks to our recommendation

1) Discretionary nature of products getting affected by low consumer spending
2) Delay in opening up / starting of multiplexes, social gatherings, sporting events, tourism, etc. affecting soft drink
consumption
3) Any issues in contract with Pepsico
4) Volatility in prices of raw materials (mainly sugar) and packing material (PET)

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 Fundamental Business Strengths

Varun Beverages Ltd. (VBL) is engaged in production and distribution of wide range of carbonated soft drinks, a large section
of non-carbonated beverages, and packaged drinking water. It is the second-largest franchisee in the world (outside the United
States) of carbonated soft drinks and noncarbonated beverages sold under trademarks owned by PepsiCo. It is owned by Jaipuria
family, which has 66% stake, with 26.42% owned by institutions. FIIs own 20.53% stake in VBL with DIIs owning the rest
(5.89%).

We highlight some of VBL’s business strengths below:

1) Contribution of non-carbonated drinks to increase over the long run –

a. Currently VBL derives ~70% of its volumes from carbonated drinks like Pepsi, Mountain Dew, Mirinda, 7up etc.
Rest 30% comes from drinking water and fruits & Dairy based juices.
b. Company has the license to manufacture and distribute PepsiCo brands Tropicana, Tropicana slice, 7UP Nimbooz,
Gatorade, Lipton Ice Tea and Aquafina under Juices and packaged drinking water segment
c. It has recently launched three new variants in value-added dairy beverages under CreamBell brand – Belgian Choco
Shake, Cold Coffee and Mango Shake which has received strong market response
d. In the long run contribution of non-aerated drinks as well as packaged water is expected to increase in VBL’s total
portfolio which will help in improving the overall realization for the company.
Segment (Mix) CY2017 CY2019 CY2023E
Carbonated Drinks 78.2% 70.7% 62.0%
Fruit and Dairy based drinks 5.8% 6.7% 9.0%
Packaged Water 16.0% 22.6% 29.0%
Total 100.0% 100.0% 100.0%
e. VBL is strongly focusing on increasing distribution network for non-aerated drinks as its penetration vs the
carbonated drinks is very low (~5% of its total distribution)
f. At Industry level, the packaged water business is expected to grow at CAGR of 12-13% over next few years due to
rising health concerns, growth in tourism and increase in income levels. VBL is well placed to benefit from this
opportunity through its Aquafina and Aquavess brands which contributes ~23% to the volumes.

Products under non-aerated drinks

Source – VBL CY19 Annual Report

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2) Beverage Industry has strong potential –

a. India continues to be one of the biggest market of consumers owing to its huge population. However per capita
consumption of beverages in India is very low (44 bottles per capita) as compared to other countries (1,489 bottles
in Mexico 1,221 in Germany and 537 in Brazil) as per 2016 data.
b. Rising population, migration in urban areas, increase in income levels, rise in social events, increase in tourism are
some of the factors which will help in increasing per capita consumption of the beverages.
c. The range of products offered by beverage players is seeing huge expansion as the non-aerated fruit based juices,
dairy based milk shakes, sports drinks or energy drinks, zero sugar cold drinks are gaining traction.
d. VBL which derives ~70% of its business from urban areas and has strong product portfolio under non-aerated drinks
and hence is likely benefit the most with this increase in demand.
e. Electricity availability is increasing significantly in rural India especially in UP which is likely to benefit the demand
of cold beverages.
f. VBL is a Quasi FMCG company due to its direct play (mid to high single digit) on Carbonated beverages market
through Pepsico, low double digit on packaged Juice market and high double digit on bottled Water market in listed
space and hence likely to benefit the most

3) Inorganic growth through expansion in new geographies –

a. VBL acquired franchise rights in South and West regions from PepsiCo for national bottling, sales and distribution
footprint in 7 States and 5 Union Territories of India in 2019.
b. With this, acquisition VBL now accounts for over 80% of PepsiCo’s beverage sales volumes vs ~50% earlier
(CY18). With this the risk of losing PepsiCo franchise has come down significantly.
c. VBL has done these acquisitions at more than 50% discount to its own valuation
d. This inorganic expansion is likely to provide new opportunities in terms of increasing market share and reducing
the seasonal nature of the business.
e. In 2019, VBL has raised fresh capital of Rs. 9,000mn through QIP and the entire amount was utilized for repayment
of debt which has helped company to reduce its leverage. Effectively its Net D/E has come down from 1.4xs in
CY18 to 1xs in CY19

Source – VBL CY19 Annual Report

4) International business to provide some cushion to COVID impact –

a. Summer is a peak season for VBL as the consumption of cold drinks is high. Company derives majority of its
business (~80%) from on the go consumption. Hence owing to COVID led lockdown, VBL has lost a good amount
of business in current year’s peak season.
b. However based on Management’s commentary in Q1CY20 call, they are hopeful of pickup in consumption with
easing of lockdown as people are not shying away from having cold beverages despite lockdown and their products
being small ticket size won’t see consumption cut down led by consumption due to economic slowdown.
c. Company owns ~2500 trucks, hence is well placed to deal with supply chain issues led by lack of availability of
transport in lockdown.

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 d. International business which contributes ~25% ( Zambia 2.5%, Zimbabwe 8%, Nepal 7%, Srilanka 2.5% and
Morocco 5%) of total sales is likely to provide some respite as Zambia was not under full lockdown, the intensity
of pandemic outbreak was lower in operational territories except Morocco and Mar-May is not a peak season for
these international geographies.

5) Low capex spends will help in improving return ratios and cash flow –

a. Company has done sufficient Capex over last few years, hence there won’t be any immediate requirement of
increasing capacities.
b. Even if required, company might go for brownfield expansion which won’t need significant capital.
c. Lower spends on capex will help company to deliver better return ratios
d. Management of VBL is cognizant of the fact that historically the return ratios have remained low and the cash flows
have been negative. Now that the company has passed its capex cycle, management is strongly focusing on
improving its return ratios as well as cash flow. From CY12 - CY14 ROCE was less than 10%. The range has
increased to 12-15% in CY15-18. Going ahead we expect ROCE to improve in the range of 15-20% and free cash
flow to turn significantly positive ~Rs1,000cr in CY21 as against 4xs negative in last 5 yrs (CY15-19). This would
be largely achieved through increase in scale of business led by acquisitions, Balance Sheet deleverage and increase
in share of non-carbonated business

Capex and ROCE chart

25,000 25.0%

20.5%
20,000 17.8% 20.0%
17.6%
15.4%
14.2%
15,000 13.1% 15.0%
12.1%
11.3%

10,000 10.0%
7.2%

5,000 5.0%
10,750

23,500
2,000

6,000

7,500

8,500

4,000

5,000

5,000
0 0.0%
CY14 CY15 CY16 CY17 CY18 CY19 CY20E CY21E CY22E

Capex (Rs. Mn.) ROCE (%)

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 6 to 12-month Upside Potential

Fair price range – 6M to 12M

 Trading below long-term valuation average- Currently, the stock is trading at 26xs CY21E EPS, compared to the 3-year
average of 40xs, discount of 35%.

 High margin-of-safety - At these levels, margin-of-safety is considerably high and makes a strong case for price appreciation.

 6-12-month potential upside 27-35% - By valuing the stock at P/E multiple of 33-35xs on CY22E EPS of Rs. 26.5, we arrive
at the target price range of Rs. 875 – 928, offering an upside potential of 27% - 35% from CMP- Rs. 688 (28 th July, 2020)
over the next 6 to 12-month period.

 Price and Earnings performance comparison with other peers – As seen below, VBL’s earnings growth has been better
than peers due to low base and scale, however stock price growth is broadly in line over these periods. We expect strong
comeback in the stock and the gap in stock price performance vs earnings performance will be filled in over medium term.

Earnings Growth (CAGR) Stock Price (CAGR)

Name of the Companies
3Yrs 5Yrs 3Yrs 5Yrs
VBL 114.6% 91.4% 27.7% NA
HUL 17.0% 13.3% 24.4% 19.5%
Britannia 17.0% 20.3% 25.7% 21.5%
Nestle 25.0% 10.7% 36.3% 23.4%
Average 43.4% 33.9% 28.5% 21.5%

3yr price and P/E band - VBL

1600

1400
PE Band - Varun Beverages Ltd.
1200

1000
Price
800
26x

600 35x
45x
400 55x

200

0
Jan-18

Jan-19

Jan-20
Jul-17

Jul-18

Jul-19

Jul-20

Source: BSE Website, ACE Equity

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Financial snapshot
Consolidated
CY12 CY13 CY14 CY15 CY16 CY17 CY18 CY19 CY20E CY21E
(Rs. Mn.)
Revenue 18,000 21,151 25,024 33,941 38,612 40,035 51,053 71,296 66,882 88,358
EBITDA 2,285 2,926 3,865 6,307 7,982 8,383 10,168 14,623 13,161 18,447
EBITDA Margins (%) 13% 14% 15% 19% 21% 21% 20% 21% 20% 21%
Reported PAT 251 -395 -202 1,130 424 2,102 2,928 4,690 3,675 7,608
PAT Margins (%) 1.4% -1.9% -0.8% 3.3% 1.1% 5.2% 5.7% 6.6% 5.5% 8.6%
Reported EPS (Rs.) 0.9 -1.4 -0.7 3.9 1.5 7.3 10.1 16.2 12.7 26.5
ROCE (%) 6.5% 5.4% 7.2% 13.1% 15.4% 12.1% 14.2% 17.6% 11.3% 17.8%
ROE (%) 14.6% -23.3% -13.2% 60.8% 4.8% 12.3% 15.8% 17.6% 10.4% 18.9%
Net D/E 9.7 9.2 6.1 2.6 0.9 1.1 1.1 0.8 0.7 0.5
PE (xs) 42.5 54.3 25.9
Source: Company Data, Equentis Research

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