By Geetanjali Kedia

Varun Beverages is entering the primary market on Wednesday 26^th October 2016 with a fresh issue of upto 1.5 crore equity shares of Rs. 10 each and an offer for sale (OFS) of upto 1 crore equity shares by the promoter, both in the price band of Rs. 440 to Rs. 445 per share. At the upper end, issue will raise Rs. 1,113 crore, of which, OFS portion is Rs. 445 crore. Representing 13.74% of the post issue paid-up share capital, issue closes on Friday 28^th October.

Varun Beverages is a franchisee company for Pepsico Inc. across 17 North and East Indian states and 2 union territories, accounting for 46% of Pepsico’s India volumes. It has 16 production facilities in India and 5 abroad (Nepal, Sri Lanka, Morocco, Mozambique, Zambia), aggregating to 4,430 million litres (780 million unit cases) of carbonated soft drinks Pepsi, Diet Pepsi, Seven-Up, Mirinda Orange, Mirinda Lemon, Mountain Dew and non-carbonated beverages Tropicana Slice, Tropicana Frutz and packaged drinking water Aquafina. It is setting up a greenfield facility in Zimbabwe, in anticipation of franchise rights being granted by PepsiCo for this territory. Distribution is undertaken through 80 depots and 1,956 delivery vehicles in India and abroad.

Noted cardiac surgeon Dr. Naresh Trehan is an independent director on the company’s board. While it is strange to see a cardiologist on the board of a company selling colas, which are proved to cause obesity and health disorders, what is even more surprising is page 42 of the RHP mentioning Dr. Trehan’s companies (Dr Naresh Trehan and Associates Health Services Private Limited, Medanta Holdings Private Limited, Naresh Trehan Holdings Private Limited) as ‘group companies’ of Varun Beverages. Clearly, this is not being independent, both in letter and spirit!

Company follows calendar year end for financial reporting purposes. Having sold 1,361 million litres in CY15, its consolidated revenue stood at Rs. 3,394 crore, of which, 84% came from India. In CY15, EBITDA of Rs. 648 crore (EBITDA margin 19.1%) was earned and PAT of Rs. 87 crore, leading to diluted EPS (after effecting for conversion of CCDs and CCPSs into equity in Oct 2016) of Rs. 5.27.

For H1CY16, consolidated revenue stood at Rs. 2,530 crore, up 13% YoY, while EBITDA of Rs. 614 crore was earned (EBITDA margin 24.3%) vis-à-vis H1CY15 EBITDA of Rs. 486 crore. Addition of new marketing territories coupled with harsh summer seen in 2016, as against a cooler summer in 2015 helped company post PAT of Rs. 210 crore for first half of CY16 as compared to Rs. 167 crore in the corresponding period last year. However, this is not a good enough reason to celebrate, as company’s business is highly seasonal in nature.

As seen from the above extract of the consolidated financial statements, H2 i.e. Jul to Dec period is loss making at the operational level (EBIT), as North India, where bulk of company’s operations are concentrated, faces severe cold weather during the Oct-Dec winter season, when sales are extremely poor. Thus, H1CY15 EBIT of Rs. 341 crore was reduced to Rs. 331 crore for full year CY15, due to operational losses of Rs. 10 crore in the lean season of H2CY15. Moreover, H1CY15 PAT of Rs. 167 crore was nearly halved to Rs. 87 crore for full year CY15 i.e. H2 wiped away almost 52% of H1CY15 profits. One may think, in such a scenario, it is better to shut shop in H2, but being a franchisee, this is not an option for the company! Such an extreme, unpredictable nature and seasonality in earnings, wherein June quarter accounts for nearly half the sales volume, is indeed startling!  

Historically, the company’s business has not been too profitable – CY14 posted net loss of Rs. 20 crore and CY13 net loss of Rs. 40 crore. CY12 had net consolidated profit of Rs. 25 crore, which is barely 1.4% net margin. CY15 bottomline is in the black solely due to declining cost of materials consumed, from levels of 55-57% of revenue for 3 years during CY12 to CY14, to 51% of revenue in CY15, and further down to 47% of revenue in H1CY16. Thus, no real efficiencies have kicked into the operations to lead to profit growth in CY15 and H1CY16. Another point noteworthy here is that company is required to purchase the most important input, beverage concentrates, from Pepsi or its authorized suppliers alone, restricting much control over input cost. Moreover, the second most important raw material after beverage concentrate is sugar, accounting for ~27% of cost of material consumed. Sugar prices have risen by 15-20% in 2016, which will push up input costs thereby putting pressure on margins for H2CY16 and CY17. Very limited control over key inputs, with negligible hedging options, add to the business risk.

Company’s current consolidated networth is Rs. 1,326 crore while total debt (30-6-16) is Rs. 2,461 crore. Excluding cash and equivalents of Rs. 116 crore, net debt to equity ratio is 1.8:1, which is quite high. However, this will contract to 1:1, post IPO, as fresh issue proceeds worth Rs. 540 crore will go towards debt repayment. Promoter RJ Corp Group’s holding of 86.34% will contract to 73.72% post IPO. 2 PE investors, Standard Chartered PE and AION (JV between Apollo Global and ICICI Venture), own 7.69% and 4.90% respectively, holding of which will come down to 7.06% and 4.50% respectively, although they are not participating in the OFS.  

At the upper end of the price band of Rs. 445, its market cap will be Rs. 8,097 crore and EV Rs. 9,902 crore, which translates into EV/EBITDA multiple of 15.5x and PE multiple of 83x on historic basis (CY15), which are quite expensive. Estimating CY16 EPS of about Rs. 8.75, issue price of Rs. 445 is being discounted by a PE multiple of 50x, which is steep.

On a broader basis, an analysis could be made with Tata Global Beverages, having beverage basket of tea, coffee and water, an annual topline of Rs. 8,000 crore, consistent net margins and currently trading at PE multiple of 23x and EV/EBITDA multiple of 10x based on FY17 expected earnings. Relatively better predictability in quarterly earnings, negligible debt level, Tata Group pedigree, and the most important ownership of portfolio of brands go in favour of Tata Global Beverages, besides its valuation.  

For the past 4-5 quarters, retail food business has been facing declining same store sales growth, classic case being Dominos-franchisee Jubilant Foodworks, which was once a market darling, has now corrected by nearly 50% from its peak valuation of July 2015. Also, fear of competition being seen from Patanjali and lower consumption of cola drinks by youth, due to health awareness are also seen negatives. Thus, investor fancy for niche consumer brand plays is fading off.  

In short, Varun Beverages’ business is risky given severe seasonality, limited operational bandwidth, poor profitability, and high share of carbonated soft drinks (82% by volume) in overall revenue, growth of which lags non-carbonated beverages and packaged water.

Due to lack of comfort on the business model, this IPO can be given a miss!

Disclosure: No Interest.