Anubhav Sahu
Moneycontrol Research
Highlights:
- Varun Beverages may acquire PepsiCo’s bottling plants in West and South India
- Globally, PepsiCo is in favour of an asset light model to improve bottomline
- WIth inorganic growth, Varun Beverages also benefits from an increase in reach
- Capital investment may require calibration: cola drinks or non-carbonated beverages?
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Newsflow suggest that Varun Beverages is in talks for extending its PepsiCo business from north and east regions to pan India. It’s noteworthy that the company already contributes over 50 percent of Pepsi’s carbonated drink sales, while undergoing bottling, sales and distribution operations for the multinational beverage company in the north and east regions.
What it means for Pepsi? How does it fit in its overall strategy?
Worldwide PepsiCo has been implementing an asset light strategy for manufacturing. In India, as well, it did a similar rejig in CY14, when it sold its bottling operations for north and east India to Varun Beverages.
Pepsi has curtailed its sales and distribution cost by reducing the number of distributors and keeping it limited to larger ones. Inventory and warehousing burden has increasingly been shared by channel partners. Higher dependence on the bottling partner for both manufacturing, sales and distribution has helped PepsiCo to turn profitable in FY18.
Ongoing talks between PepsiCo and Varun Beverages for extending partnership is a step towards PepsiCo’s strategy of being asset light and reducing its operating cost.
What’s in for Varun Beverages?
Varun Beverages manufactures and distributes carbonated drinks along with packaged water (Aquafina). It currently distributes most of the fruit juice-based drinks (Tropicana) and sports drink (Gatorade). It is noteworthy that post its earlier stint (CY14) of acquiring bottling plants of PepsiCo along with distribution rights, the company’s operating margin rose to 19-21 percent from the 13-15 percent range. We expect a similar arrangement (manufacturing and distribution) to be agreed upon for new regions and operating margin to sustain at existing levels.
If the deal gets through, Varun Beverages would get access to PepsiCo's pan India supply chain, which could aid sale of other allied products like fruit juices from the latter's portfolio.
Increasing focus on non-carbonated space
Globally, carbonated drink majors are shifting towards healthier drink options after having experienced stagnancy in carbonated drinks segment. This is reflected in their India strategy as well. For instance, PepsiCo has introduced more than 80 products during FY15-18 and aims to increase India sales of its flagship juice brand, Tropicana, by two times by 2020. Such initiatives have partially been able to reduce the impact of lower sales from the carbonated drinks for the cola majors.
Varun Beverage: Participation in the non-carbonated space
Varun Beverages is also witnessing a spurt in volume growth from the non-carbonated space. In the last two quarters (Q2 and Q3 CY18), the company posted double-digit volume growth aided by distribution rights for Tropicana. Looking at the data for last four quarters, non-carbonated segment (water and juices) now contributes about 23 percent of total volumes versus a sub-20 percent share in CY16. In 9MCY18 sales volume for Tropicana juices grew 30 percent year-on-year (YoY) and contributes about six percent to total sales volumes.
The company’s capex plan is underway (Rs 450 crore) for the production of both Tropicana and Gatorade. This in turn would be supportive of margins. Its manufacturing plant is expected to turn operational by March.
EBITDA margin expected to improve beyond 20 percent
It’s noteworthy that company’s Q3 CY18 result witnessed a decline in EBITDA margin by 110 bps YoY to about 18 percent on account of weak contribution from Tropicana (due to the current distribution only arrangement) and lower utilisation in the PepsiCo territories acquired in early CY18. However, as volume growth picks up in new territories and company participates in the manufacturing segment of Tropicana value chain, EBITDA margin is expected to head north of 20 percent.
OutlookOver the last few years, the company benefited from inorganic opportunities and higher participation in the supply chain leading to expansion in both topline and margin. Talks of venturing into remaining regions of PepsiCo would extend this growth at similar margins. However, how long this strategy can continue is questionable, particularly when the cola carbonated drink category has stagnated.
PepiCo is, apparently, making right changes by utilising proceeds from its cash cow (cola carbonated drinks) to stars (Non-carbonated beverages) and restructuring the cola carbonated drinks business (franchisee model) to sustain it.
Challenges for Varun Beverages would also be similar to PepsiCo as it tries to mimic the latter both in terms of reach and portfolio in India. If it increases its share in the cola space, it would have to face challenges of category growth in carbonated drinks. If it makes more emphasis in non-carbonated beverages, then one should be mindful that category’s revenue share is still in single digits and competition is elevated (Dabur, ITC, Hector Beverages).
Taking this into account, we feel the Varun Beverages' stock is currently trading at an expensive multiple (42 times CY19 estimated earnings) compared to other avenues in consumption where the risk-reward are more favourable.
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