Institutional Equities - Nirmal Bang Consumer Healthcare... · EPS growth expectations for GSKCH...

Please refer to the disclaimer towards the end of the document.

Institutional Equities

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Reuters: GLSM.BO; Bloomberg: SKB IN

GlaxoSmithKline Consumer Healthcare

The Pulls & Pressures Of Competition We believe the earnings growth of GlaxoSmithKline Consumer Healthcare (GSKCH) is likely to decline substantially from ~23.5% CAGR over the past five years to 10% CAGR over FY14-FY16E because of tapering sales growth, steep rise in raw material costs and escalation of competitive intensity leading to advertising and promotion (A&P) spending being higher than the long-term average. Earnings growth will also be much weaker than peers and lead to deterioration of RoE and RoCE. Despite this, the stock trades at an undeserved premium to peers as well as its historical average. With the market not as enamoured with defensive bets as it once was, such a weak performance will not be viewed kindly. Our earnings estimates for FY15/FY16 are 6.2%/10.1% below Bloomberg consensus estimates, respectively, mainly because we expect a 63bps EBITDA margin decline over FY14-FY16E. We have assigned Sell rating to the stock with a target price of Rs3,896, which is 13% below the CMP.

Slowing sales growth: Sales growth and volume growth have been declining because of economic slowdown and persistently high inflation. Over the next couple of years, the outlook is sanguine on both these economic variables. Historically, price hikes have played a significant role in sales growth. In such a scenario and at a time when raw material costs are rising sharply, the company will find it difficult to go for steep price hikes, unlike the case earlier where biennial price hikes were not an issue. With 80% of the sales coming from the southern and eastern regions which have lower irrigation levels, the demand could also get affected by a poor monsoon, which is now looking more likely.

Likely escalation in competition: Unfortunately for GSKCH, the slowdown is occurring at a time when competition is likely to escalate substantially. Heinz (Complan brand), the third-largest player in the health food drinks or HFD category (94% of GSKCH’s sales, 65% market share) is targeting doubling the market share in the next two years from ~12% currently. After the global takeover of Heinz by Warren Buffett and 3G Capital, we believe the aggression in emerging markets will increase. Emerging markets account for only 20% of sales of Heinz and India accounts for less than 2%. Complan is its largest brand in India and the most scalable and Heinz has already increased advertising spending sharply using celebrities. In its quest for doubling market share in the next two years, pricing actions are likely to ensue as well. Even if GSKCH is able to maintain market share, its advertising spending is bound to escalate and stay at elevated level for the next two years.

Other factors affecting margins: Despite a 3.5% price hike in January 2014, gross margin dipped 82bps YoY and 202bps sequentially as material costs, mainly milk, are increasing. In view of slowing demand, price hikes may not be easy. The pace of other operating income growth is slowing too.

Valuation: At the CMP of Rs 4,484, GSKCHL stock trades at 28.8x FY16E EPS, at a steep premium not only to the average sector multiple of 24x, but also to its 5-year and 10-year forward multiples of 26.5x and 20.6x, respectively. We believe that given the weak earnings CAGR of 10% (slowest in the past 20 years, barring the CY02-CY04 period) over FY14-FY16E as well weak earnings growth as compared to peers, valuation is bound to correct downwards. Assigning a target multiple of 25x, we have arrived at a target price of Rs3,896, down 13% from the current market price.

SELL

Sector: FMCG

CMP: Rs4,484

Target price: Rs3,896

Downside: 13%

Krishnan Sambamoorthy [email protected] +91-22-3926 8033

Saiprasad Prabhu [email protected] +91-22-3926 8172

Key Data

Current Shares O/S (mn) 42.1

Mkt Cap (Rsbn/US$bn) 188.6/3.1

52 Wk H / L (Rs) 5,886/3,801

Daily Vol. (3M NSE Avg.) 13,333

Shareholding (%) 3QFY14 4QFY14 5QFY14

Promoter 72.5 72.5 72.5

FII 11.8 11.9 11.9

DII 0.6 0.6 0.8

Corporate 2.0 2.0 1.9

General Public 13.1 13.0 13.0

One-Year Indexed Stock Performance

Price Performance (%)

1 M 6 M 1 Yr

GSKCH 1.3 0.4 (21.3)

Nifty Index 4.7 22.5 29.8

Source: Bloomberg

Y/E March (Rsmn) CY12 FY14* FY15E FY16E FY17E

Revenue 31,875 48,686 44,304 50,950 58,083 YoY (%) 15.3 52.7 (9.0) 15.0 14.0 EBITDA 5,734 8,728 7,576 8,814 9,990 EBITDA (%) 18.0 17.9 17.1 17.3 17.2 Adj. PAT 4,368 6,748 5,891 6,556 7,228 FDEPS (Rs) 103.9 128.4 140.1 155.9 171.9 YoY (%) 23.0 23.6 9.1 11.3 10.3 RoE (%) 34.9 34.2 29.9 28.1 26.5 RoCE (%) 32.4 31.5 27.2 26.0 24.7 EV/EBITDA 30.3 24.3 22.5 19.3 17.0 P/E (x) 43.2 34.9 32.0 28.8 26.1

Note: FY14 is a 15 month period , hence FY15E sales show a decline. Normalized sales growth in FY15E at 13.8%> Valuation metrics and ratios are normalized. Source: Company, Nirmal Bang Institutional Equities Research

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GlaxoSmithKline NSE CNX NIFTY INDEX

16 June 2014


GlaxoSmithKline Consumer Healthcare Palmolive (India)

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Outlook and valuation

EPS growth expectations for GSKCH between FY14 (annualised) and FY16E are:

1) The weakest among peers (excluding HUL), as indicated in the table below.

2) Far below its own EPS growth trend in the preceding years.

3) Below EPS growth expectations for the indices during this period.

Exhibit 1: Comparative EPS growth

Company (Rs) FY14 FY15E FY16E Growth (%)

Colgate-Palmolive (India) or CPIL 36.1 43.1 55.3 53%

P&G Hygiene and Healthcare or PGHH 81.9 97.6 116.3 42%

Hindustan Unilever or HUL 17.1 18.4 20.4 19%

ITC 11.2 12.9 15.1 35%

Nestle India 114.4 119.2 140.7 23%

Britannia Industries (BIL) 33.0 33.0 40.0 21%

GSK Consumer Healthcare 128.4 140.1 155.9 21%

United Breweries (UB) 8.6 10.1 12.8 49%

Marico 7.5 8.6 10.1 34%

Godrej Consumer 22.3 27.2 33.1 49%

Nifty 50 420.3 482.7 560.2 33%

Source: Company, Bloomberg, Nirmal Bang Institutional Equities Research

Exhibit 2: Lower EPS leads to decline in return ratios

Source: Company, Nirmal Bang Institutional Equities Research

Our PAT forecasts are 6.2% below Bloomberg consensus estimate for FY15 and 10.1% below consensus estimate for FY16 because of slowdown in sales and our expectation of a 63bps decline in EBITDA margin over FY14 and FY16E because of:

1) Unsustainably high gross margin in FY14 and the steep rise in raw material costs.

2) Rise in the advertising spending to sales ratio because of increased competitive intensity.

Exhibit 3: Our estimates versus Bloomberg consensus estimates

FY15E FY16E

(Rsmn) NBIE estimates BBG consensus est. Diff. (%) NBIE estimates BBG consensus est. Diff. (%)

PAT 5,891 6,280 (6.2) 6,556 7,295 (10.1)

Source: Bloomberg, Nirmal Bang Institutional Equities Research

Despite the expected growth in EPS between FY14 and FY16E being (a) weaker than peers; (b) weaker than GSKCH’s own historical track record as well (c) as weaker-than-expected EPS growth of the index in this period, the valuation at 28.8x FY16E EPS is among the most expensive in the sector.

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Exhibit 4: P/E comparison with peers

Companies (x) FY14 FY15E FY16E

CPIL 42.1 35.3 27.5

P&GHH 51.5 43.2 36.2

HUL 37.0 34.5 31.1

ITC 29.8 25.8 22.0

Nestle India 43.4 41.7 35.3

Britannia Industries 28.1 28.1 23.2

GSK Consumer 34.9 32.0 28.8

United Breweries 84.2 71.5 56.3

Marico 32.4 28.5 24.1

Godrej Consumer 38.5 31.6 25.9

Nifty 17.9 15.6 13.5

Source: Company, Bloomberg, Nirmal Bang Institutional Equities Research

Average one-year forward multiples are 26.5x for the past 5 years and 20.6x for the past 10 years. Current one-year forward multiple of 28.8x is at a significant premium to these averages.

Exhibit 5: One-year forward P/E

Source: Bloomberg, Nirmal Bang Institutional Equities Research

While we are positive about the prospects of GSKCH’s business in the long run, tepid earnings growth likely in the medium-term is unlikely to be viewed positively by the market. The appetite in the market for defensive bets is on the wane and only stocks with continued healthy earnings prospects, best-in-class return ratios or structural growth stories with low competitive intensity will continue to command high P/E multiples that defensive stocks enjoyed in the past five years.

We, therefore, assigned a target multiple of 25x FY16E EPS to GSKCH, a discount to average 3-year and 5-year multiples. This signifies a 13% downside from the current market price and leads to a target price of Rs 3,896 on GSKCH, resulting in a Sell rating on it from a medium-term perspective. As we expect eventual recovery in margins and earnings growth, we have valued the stock well above the 10-year average multiple of 20.6x.

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Exhibit 6: A look at financials for the past 17 years

Financial snapshot (%) CY96 CY98 CY99 CY00 CY01 CY02 CY03 CY04 CY05 CY06 CY07 CY08 CY09 CY10 CY11 CY12 FY14 FY15E FY16E

Sales growth 12.8 15.1 9.9 23.5 14.1 (12.5) 5.8 8.6 12.1 16.6 15.8 20.6 24.6 19.9 16.9 15.3 52.7 (9.0) 15.0

RM costs/ sales 45.7 43.5 41.9 38.8 36.5 34.0 34.8 36.0 32.5 33.9 34.1 37.0 36.2 36.6 36.9 36.1 35.7 36.0 36.0

Employee costs/ sales 7.4 8.5 8.6 7.8 8.2 10.7 11.5 11.6 11.8 11.9 11.8 10.9 10.2 9.7 9.3 9.4 9.7 9.6 9.6

Advertising costs/ sales 6.6 6.4 7.0 9.2 9.0 11.4 12.3 11.7 13.0 12.6 12.5 12.3 15.3 15.7 15.8 15.6 16.7 17.1 17.0

Royalty costs/ sales 4.1 4.0 4.2 3.8 3.9 3.8 3.8 3.8 3.9 4.1 4.1 3.6 3.6 3.5 3.4 3.3 3.3 3.4 3.4

Other expenses/ sales 17.9 17.9 18.7 18.7 17.9 18.6 22.0 20.4 19.3 18.9 17.7 18.7 16.4 16.2 16.3 17.5 16.8 16.7 16.7

EBITDA margin 18.3 19.6 19.6 21.7 24.5 21.5 15.7 16.5 19.6 18.6 19.7 17.6 18.4 18.4 18.2 18.0 17.9 17.1 17.3

Net interest costs/ sales (1.2) (1.8) (0.6) 0.6 0.8 0.3 (0.1) (0.4) (0.5) (0.8) (1.5) (2.1) (1.0) (1.7) (2.4) (3.0) (3.2) (3.7) (2.9)

Depreciation/ sales 1.6 1.6 1.8 2.1 2.1 4.7 5.7 4.8 4.3 3.8 3.3 2.6 2.1 1.7 1.7 1.1 1.3 1.6 1.7

PBT margin 19.6 20.9 22.6 20.1 22.5 18.0 12.5 13.3 16.7 16.8 18.7 18.0 17.9 19.1 19.5 20.4 20.9 19.8 19.2

Net margin 12.8 14.6 15.9 14.8 14.7 12.1 9.6 8.4 11.0 11.2 12.4 11.9 11.8 12.7 12.8 13.7 13.9 13.3 12.9

FATR (x) 10.7 8.1 4.5 2.2 2.1 1.9 2.4 2.8 3.4 4.4 5.4 7.0 8.5 7.6 7.9 8.2 8.0 6.6 6.1

NWC (days) 20.3 32.6 33.3 23.1 9.8 1.6 (2.7) (6.1) 4.8 14.9 17.7 26.1 14.8 1.4 7.6 6.5 1.5 4.0 4.0

RoE 40.9 40.6 37.1 33.3 31.1 19.7 15.7 14.3 21.3 24.9 27.4 26.8 27.9 32.2 33.8 34.9 34.2 29.9 28.1

RoCE 38.6 39.1 35.4 30.3 26.5 16.1 14.7 13.3 19.8 23.1 25.3 24.7 27.0 30.7 31.6 32.4 31.5 27.2 26.0

RoIC 63.2 58.7 52.5 39.3 32.0 21.3 20.6 22.6 33.3 38.1 49.8 54.6 NM NM NM NM NM NM NM

OCF/CE - - - - 36.0 30.4 28.0 23.9 18.5 25.9 30.6 18.8 47.8 35.0 37.1 44.3 24.9 21.3 24.6


Note: FY14 is a 15 month period as due to change in accounting year, hence FY15E sales show a decline because preceding year is a 15 month period. Normalized sales growth in FY15E is expected at 13.8%

GSKCH reported double-digit sales growth for nine consecutive years up to FY14. In fact, sales growth was at double digits or close to double digits for all but three years (CY02-CY04) in the past 17 years. The company has strong brands with high pricing power. Which is why, despite competitors who have far superior distribution reach or sourcing of the key component milk i.e. Nestle India (Milo), Cadbury India (Bournvita), and Amul (which had Nutramul earlier), GSKCH has been able to report consistently strong growth, leading to a rise in market share as well. Pace of growth, however, is slowing down.

Despite a consistent rise in costs because of food inflation, gross margin stayed above 60% since CY00, an indication of the pricing power that the company has. Improvement in gross margin had been quite sharp in the preceding period, CY95-CY00. Reduction in excise duty (from 15.6% in CY95 to 5.5% in CY12) and increase in other operating income (from less than 1.0% of sales earlier to 3.4% of sales in CY12) also helped gross margin. Gross margin at 64.3% of sales and operating income in FY14 was superior when compared to most FMCG peers. But, sharp rise in raw material costs means that sustaining high gross margin will be very difficult especially as sales growth is slowing. Gross margins were also inflated because of other operating income growth, which is now slowing.

Employee costs and other expenses compared to sales are back to the mid-90s level after witnessing a spurt at the beginning of the millennium, when sales had slowed down. Royalty payment to the parent has also been steady during this period.

Improvement in gross margin over the past 18 years has been ploughed back into the business in the form of advertising and promotion (A&P) spending, which steadily increased from less than 7% of sales in the mid-90s to close to 17% of sales in FY14. The A&P spending fueled the growth that the company witnessed in the past 17 years, particularly the consistent double-digit sales growth in the past nine years. However, given the sharp increase in competitive intensity, we expect the A&P spending to sales ratio to increase further, thereby affecting margins and earnings growth

EBITDA margin has been fairly stable as savings on material costs to sales have been successfully invested in growing the business through A&P spending. This is likely to be under pressure for the next few years as competitive intensity increases.

Fixed Asset Turnover Ratio (FATR) has improved phenomenally since the beginning of the millennium and is now at a similar level compared to the mid-90s. Net working capital days also reduced, mainly because of lower inventory days and higher creditor days. Net working capital could increase, given the competitive intensity likely to be witnessed.

RoCE and RoE remained strong and would have improved further, if not for the cash balance which is now more than half of the company’s total assets. Payout has been stingy in recent years, as the company assiduously built up cash balance citing potential for acquisitions and the need for Greenfield capex with capacity utilisation now reaching close to 100% level. Stripping out cash as well as cash earnings, RoIC improvement in the past 18 years has been remarkable. With slowdown in earnings, RoCE and RoEs are likely to deteriorate.



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Key Arguments

1) Sales slowdown

Exhibit 7: Sales breakdown

Source: Company

Price hikes have played a significant part in historical sales growth

Biennial price hikes were a regular feature. They were usually taken every year in January and July. This was understandable given the category dominance, low velocity of consumption and healthy volume growth, but volume growth has slowed down recently and steep price hikes could reduce volume growth further.

Moreover, even the company is cautious on volume growth versus earlier - volume growth in the core HFD segment slowed down from double-digit over CY07-CY10 to single-digit in recent years. Volume growth was ~9% in FY14, but slipped to 7% by the end of March 2014 quarter, and the management has guided for 6%-9% volume growth and 12%-15% sales growth. Volume growth, going forward, will thus be the lowest since CY06 and sales growth the lowest since 2005. While this outlook is still better than other FMCG peers, it is also true that persistently high inflation levels is leading to a sharp slowdown in sales compared to historical track record. Likely poor monsoon may affect GSKCH more than other FMCG peers because of the fact that nearly 80% of its sales come from the southern and eastern regions, areas with lower irrigation levels, compared to the northern and western regions. The last big deceleration in earnings growth for GSKCH also coincided with poor monsoon between CY02-CY04.

2) Likely margin pressure as well

Two other factors viz. rise in raw material costs and likely uptick in competitive intensity could also result in sharp slowdown in EBITDA and PAT growth as well, along with tepid sales growth.

Exhibit 8: Rise in raw material costs Exhibit 9: Gross margin comparison with peers

Source: Nestle analyst presentation Source: Company

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Raw material costs like milk and sugar continue their uptrend. Pressure on gross margin has already started. Despite a price hike of ~3.5% in January 2014, gross margin dipped 82bps YoY (202bps QoQ) in the March 2014 quarter. While the company had success in passing on the rise in raw material costs with biennial price hikes earlier (usually in January and July), slowdown in volume and increase in competitive intensity inhibits sharp price hike currently. The base effect also does not help, going forward, as gross margin in FY14, at 64.3%, is the highest since CY07. In fact, gross margin is the highest among FMCG peers barring ITC, as indicated in the chart above.

An increasingly high base leads to higher vulnerability on earnings when sales are slowing down and material costs are rising steeply.

Further steep price hikes could lead to sharp slowdown in volume, but if adequate price hikes are not taken, there could be pressure on gross margin and EBITDA margin.

3) Increase in competitive intensity and consequent increase in advertisement spending

Slowdown in sales and its consequent increase in competitive intensity meant that advertisement spending intensity has increased in the FMCG sector over the past few quarters. For the 15-month ended FY14 (the company changed its financial year-end from December to March), advertisement spending has already increased by 110bps to sales at 16.7% compared to CY12. We expect the advertisement spending to sales ratio to be not only high because of low sales growth, but actually increase going forward because of uptick in advertising spending intensity by Complan (Heinz).

Complan threat

Complan (Heinz) is the third largest player in the HFD category with ~12% market share. It always had high brand equity and has been present in India for over 50 years, but was under-investing on advertising, did not use celebrity advertising and its product was always at a significant premium to other key brands in the category, Boost and Horlicks (GSKCH) and Bournvita (earlier Cadbury India and now owned by Mondelez, the global food business of Kraft).

What has changed at Heinz

There has been a takeover of Heinz in February 2013 by Warren Buffett and the Brazilian private equity player, 3G Capital. Heinz had 20% of sales coming from emerging markets at the time of the deal, among the lowest proportion compared to global peers like Unilever, Colgate-Palmolive (over half of sales of both these companies comes from emerging markets), P&G (over 40%) and Nestle (over 30%). In the quest for growth, Heinz is likely to be highly aggressive in emerging markets including India, which is less than 2% of its global sales. As the takeover was through a leveraged buyout, the quest for growth will be intense in next few years.

In recent months, there are increasing signs that Heinz is aiming to be highly aggressive in India, especially through Complan. Its other brands in India include the eponymous tomato ketchup brand, Nycil, Glucon-D and Sampriti Ghee, but Complan formed more than half of its Rs13,660mn sales in India in FY13. It has two plants in India, at Aligarh in Uttar Pradesh and Sitarganj in Uttarakhand. Interestingly, Heinz acquired Complan, Nycil and Glucon-D from Glaxo in the mid-1990s.

Sales were up by only 7.9% in FY13, leading to high aggression since then. Apart from being Heinz’s largest brand in India, we believe that Complan is also its more scalable brand. The ketchup business, a mainstay of the parent globally, has not made much impact (less than a 10% market share) in a segment dominated by HUL and Nestle India and the category itself has not grown as expected. Other Heinz brands in India like Nycil, Sampriti and Glucon D are unlikely to be huge growth drivers. On the other hand, with low penetration level of ~30%, favourable demographics, strong brand equity of Complan and considerable pricing power that players in the category enjoy, the growth opportunity does look promising in the HFD category.

Heinz’s management has been quoted saying that they want to double Complan’s market share in the next two years. As the market is not growing at a rapid pace of late, to even get anywhere close to that target, Heinz is likely to follow a strategy of disruptively high advertisement spending and possibly even price cuts.

Advertisement spending intensity has been pumped up for Complan and the company has begun telecasting advertisements since March 2014 using celebrity advertisers for the first time in India, including Hindi film super star Amitabh Bachchan, chess champion Vishwanathan Anand and southern film star Suriya. This is a judicious campaign using a mix of national celebrities as well as icons that are popular in South India, the largest market for HFD drinks and GSKCH’s stronghold.



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Also, using these celebrity advertisers, Complan is moving away from focusing solely on the image of the HFD category being a kids’ drink. According to news reports, 35%-40% of consumption of Complan is by adults. We do not have the adspend growth number for Heinz but our observation is anecdotal.

If the stated target of doubling market share is to be met, we believe there will be price actions on Complan as well, given the significant prevalent premium of the brand to HFD peers.

Exhibit 10: Prices of HFD products

Type Weight range (gms) Price range (Rs) Price per 500gms

Plain

Cadbury India

Bournvita Refill/box 200-1,000 98-370 185-240

GSK Consumer Healthcare

Horlicks Refill/box 200-1,000 92-360 177-230

Boost Refill/box 450-750 186-283 189-207

Heinz

Complan Refill 500 195 195

Flavoured

Cadbury India

Bournvita 5 STAR Refill/box 500-1,000 193-205 178-205


Horlicks -Chocolate/kesar Refill/box 200-1,000 92-354 177-240

Boost - Éclair Refill 500 210 210

Heinz

Complan - choc/mango/strawberry/kesar pista Refill/box 200-500 130-225 225-325

Special

Cadbury India

Bournvita - Lil CHAMPS Box 200-500 130-240 240-325


Horlicks – Women/Lite - Plain/Chocolate Box 500 240 240

Heinz

Complan - Memory chargers Refill/Box 200-500 140-240 235-350

Source: Nirmal Bang Institutional Equities Research

Unfortunately for GSKCH, aggression from Complan arrives at a time when sales and volume growth in the category is slowing down and raw material costs are high. At the moment, despite GSKCH’s 65% market share in volume terms in the HFD category and slowing sales in the category, we are not assuming any significant loss of market share as yet, but we certainly believe that steep price hikes are a thing of the past and the advertising spending to sales ratio will increase further in FY15 and remain at elevated level for the next 2-3 years. While volume growth could still be healthy compared to peers, overall sales growth will certainly be lower compared to historical level as steep price hikes are restricted.

Exhibit 11: Sales growth Exhibit 12: Lower EPS growth leading to declining return ratios

Source: Company, Nirmal Bang Institutional Equities Research Source: Company, Nirmal Bang Institutional Equities Research

Note: FY14 is a 15 month period as due to change in accounting year. Data in the above exhibits are normalised for 12 months.

The low EPS growth will exert pressure on RoE and RoCEs as well.

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Despite our pessimism on earnings, we are not currently assuming a worst-case scenario. Things that can possibly go wrong are:

a) Steep loss of market share.

b) Steep slowdown in volume growth.

c) Possible increase in net working capital (NWC) arising from increased competitive intensity. NWC days improved sharply in recent years.

Exhibit 13: NWC days


Note: FY14 is a 15 month period as due to change in accounting year. Data in the above exhibit is normalised for 12 months.

d) Sharp decline in gross margin in our forecast. We are only assuming a 30bps decline over the high base

of FY14.

If any of these factors come through because of a sustained rise in material costs and higher-than-expected advertisement spending intensity or steep discounting by Heinz, the earnings growth for GSKCH will be even lower than 9.1% and 11.3% that we have estimated for FY15 and FY16.

4) Other worries

a) Dependence on southern and eastern regions is also a worry, given the likely El Nino occurrence and monsoon worries.

Nearly 80% of sales for GSKCH come from the southern and eastern regions, areas in which irrigation levels are not as good as the northern and western regions of the country. Consequently, the impact of a weak monsoon as a result of likely El Nino could be worse for GSKCH compared to other FMCG players.

Exhibit 14: Regional sales mix

Source: Company

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46 45 4645 44 46 43 34

4 4 45

5 4 54

8 9 9 5 8 8 7 11

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

4QFY12 1QFY12 2QFY13 3QFY13 1QFY13 2QFY14 3QFY14 4QFY14

North South East West Exports



9

b) Lack of utilisation of the cash balance is a worry- while GSKCH’s RoIC has been excellent over the past five years at ~100% or higher, its RoE and RoCE, while healthy in the late 20% level, are much lower than RoIC because of the cash balance, which increased from Rs 4.71bn (44% of total assets) in CY08 to Rs18.8bn (55% of total assets) in FY14.

Exhibit 15: Declining return ratios



Exhibit 16: Cash & Cash Equivalents

(Rsmn) CY01 CY02 CY03 CY04 CY05 CY06 CY07 CY08 CY09 CY10 CY11 CY12 FY14 FY15E FY16E

Cash & equivalents 859 998 2,038 2,632 1,858 2,676 3,915 4,710 8,198 9,761 10,797 14,642 18,842 18,009 18,579

% of total assets 11.8 14.3 29.2 35.6 27.1 34.5 42.9 43.6 57.9 55.4 51.8 57.3 54.6 50.5 45.8


Cash balance has been accumulated over the years not only through strong earnings growth but also because of low dividend payout, which has been between 33% and 43% since CY06 for all years barring CY10. Despite FY14 being a 15-month period, dividend per share was maintained only at Rs45, same as CY12 level, as payout declined from 43% in CY12 to 35% in FY14. Payout level at GSKCH, barring a spike because of special dividend in CY10, has been consistently among the lowest compared to MNC peers.

Exhibit 17: Dividend payout versus MNC peers

Source: Company

The management indicated in a conference call recently that the company is looking at Greenfield expansion as it is close to full capacity utilisation at existing facilities, which put together, have a capacity of 130kt. We have not yet increased our capex estimate substantially, as the management has not yet disclosed the quantum and timing of investment. Even a 18kt capacity costs around Rs7bn-Rs9bn, far lower than the existing cash balance of Rs18.4bn to which the company is expected to add over Rs 4bn each year in operating cash flow.

10

15

20

25

30

35

40

45

CY

96

CY

98

CY

99

CY

00

CY

01

CY

02

CY

03

CY

04

CY

05

CY

06

CY

07

CY

08

CY

09

CY

10

CY

11

CY

12

FY

14

FY

15

E

FY

16

E

RoE RoCE

(%)

0

20

40

60

80

100

120

FY08 FY09 FY10 FY11 FY12 FY13 FY14

Colgate PGHHL HUL Nestle GSKCH

(%)



10

c) Slowdown in pace of growth of other operating income

GSKCH earns substantial auxiliary commission of ~16% on sales of GSK Asia’s products which include Sensodyne, Eno, Crocin, Iodex and Paradontax. As there aren’t any additional costs incurred, the income contributes directly to EBITDA. The proportion of other operating income to sales (which mainly consists of auxiliary commission stated above) has been increasing as a percentage of sales, and contributed 21.2% to EBITDA in FY14.

Exhibit 18: Other operating income to sales

Source: Company

Exhibit 19: Break-up of other operating income

(Rsmn) CY06 CY07 CY08 CY09 CY10 CY11 CY12

Business auxiliary service commission 221.6 310.2 366 467.2 544.2 725.4 972.2

% of other operating income 84.0 90.0 88.5 90.5 91.2 91.2 89.9

Source: Company

Auxiliary commission is thus a key contributor to overall profitability. However, the pace of growth in other operating income has eased over the past few quarters because of a high base and slowdown in the pace of consumption. Another factor that has affected growth partly in the March 2014 quarter and will affect growth for three or four quarters more is the price cut imposed on Crocin (around 13-14% of sales for GSK Asia) by the Food and Drug Administration, which resulted in halving of its price from Rs20 per strip to Rs10 per strip.

Exhibit 20: Other operating income to sales-quarterly

Source: Company

Slowdown in the growth of a key component will impact profitability going forward. If, in the long run, distribution commission gets renegotiated downwards, the impact on margins could be sharp.

0

5

10

15

20

25

0

2,000

4,000

6,000

8,000

10,000

12,000

CY01 CY02 CY03 CY04 CY05 CY06 CY07 CY08 CY09 CY10 CY11 CY12 FY14Other oprerating income EBITDA %

(Rsmn) (%)

-

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

(20)

(10)

0

10

20

30

40

50

60

1Q

CY

10

2Q

CY

10

3Q

CY

10

4Q

CY

10

1Q

CY

11

2Q

CY

11

3Q

CY

11

4Q

CY

11

1Q

CY

12

2Q

CY

12

3Q

CY

12

4Q

CY

12

1Q

CY

14

2Q

CY

14

3Q

CY

14

4Q

CY

14

5Q

CY

14

Quarterly Other Op. Inc. YoY % of sales

(%) (%)



11

d) Royalty payment to parent is lower than peers and could increase

Royalty payment to parent is lower than peers and has not been renegotiated for a few years. As there is no upper limit on royalty payment, there is always a possibility of a rise in royalty payment, as a percentage of sales, which could have a detrimental effect on future profitability. The other two players with low royalty rates, HUL and Nestle India, have already announced steep royalty payment hike of 20bps and 30bps annually for the next few years.

We do acknowledge that the new Companies Act states that any increase in royalty payment requires the approval from two-thirds of minority shareholders, which could happen if the company is able to justify by bringing any innovative product from its parent stable. Looking at the parent product portfolio currently, we do not see any breakthrough innovative products being launched in India.

In case the minority shareholders do not allow an increase in royalty payment, the company could reduce business auxiliary income by reducing the commission for products sold on behalf of GSK Asia, which we have highlighted above. Currently, GSK Asia pays about 16% as distribution commission, which the company has the liberty to lower it to compensate for the royalty payment. This would have a direct impact on EBITDA, as it contributes to ~21% of consolidated EBITDA.

In both cases, either increase in royalty payment or reduction in distribution commission, we feel there is a risk of long-term impact on margins.

Exhibit 21: Royalty payment to parent versus peers

(%) FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13

HUL 0.5 0.5 0.5 0.6 0.9 1.3 1.3 1.4

Colgate-Palmolive (India) 2.1 2.4 3.1 4.1 4.3 4.9 5.2 5.2

Nestle India 3.2 3.2 3.3 3.4 3.4 3.4 3.4 3.3

GSKCH 3.5 3.8 3.9 3.3 3.5 3.4 3.3 3.2

P&GHH 4.1 4.9 5.2 5.4 6.2 5.0 4.9 4.7

Source: Company

e) Dependence on HFD segment remains high

The HFD segment continues to contribute ~94% of overall sales. Plans for diversification into categories like noodles, nutribars and biscuits have not succeeded in reducing dependence on the HFD segment. While we have no doubt that the HFD category will do very well in the long run, we believe that likely pressure on profitability in the next few years and consequent sharp earnings slowdown compared to historical and peer average will lead to a de-rating.

Exhibit 22: Dependence on HFD segment remains high

Sales break-up (%) CY00 CY01 CY02 CY03 CY04 CY05 CY06 CY07 CY08 CY09 CY10 CY11 CY12

HFD 93.5 92.1 92.8 94.5 94.6 94.9 95.2 95.9 96.0 95.0 94.0 93.8 93.8

Biscuits/ nutri bar/ noodles 5.4 4.7 4.0 3.7 4.0 4.2 4.1 3.5 3.5 4.4 5.6 6.0 6.1

Ghee (by-product) 0.0 2.5 2.0 1.0 0.8 0.7 0.6 0.5 0.5 0.4 0.5 0.3 0.1

Others 1.1 0.7 1.2 0.8 0.4 0.3 0.1 0.0 0.0 0.0 0.0 0.0 0.0

Source: Company

While we are excited by the progress shown in the oats business, the category is unlikely to contribute significantly to overall earnings for the next few years. South India, where GSKCH has a strong brand franchise through its Horlicks brand is where 70% of oats consumption in India takes place. This market is largely unorganized and Horlicks is well placed to take advantage of high growth being witnessed in the overall breakfast product segment including oats. The organized oats market at ~Rs 7bn is growing rapidly at ~30% and Horlicks oats has 17% market share in South Indian market. But the category itself accounted for less than 20% of GSKCH’s annualised sales in FY14.



12

f) Nestle India’s re-entry in HFD

A few years ago, Nestle India exited from the HFD category as its brand Milo was not getting enough traction. Given the facts that: (a) Nestle has sourcing advantage as well as distribution superiority over GSKCH, (b) The category is highly profitable with over 60% gross margin, a neat fit with Nestle India’s new focus on premium and profitable segments, and (c) Milo is a billionaire brand for Nestle globally and India, with a low category penetration of 30%, is an attractive market, and therefore we believe that Nestle India could potentially make a re-entry into the category, thereby exacerbating the competitive intensity on GSKCH.

Even Amul, which has tremendous sourcing advantages over peers on milk, a key raw material, has ambitious plans for Amul Pro.

g) Open offer story has already played out, delisting unlikely

Unlike many other MNCs in India, the open offer story has already played out. After successful completion of the open offer in the March 2013 quarter, the parent’s stake increased from 43.16% to 72.46% in GSKCH. We do not envisage a possibility of a further open offer. Moreover, we also believe that delisting of large MNCs in India is a prohibitively expensive process and, thus, delisting is unlikely. This is particularly true, especially under the new Companies Act, wherein two-thirds of minority shareholders need to sign off on any material transaction. Potential delisting could now involve transactions at a prohibitively higher price, perhaps even going up to 2x-3x the prevailing share price. Yes, there was an instance where the parent did acquire a minority stake in its consumer business in Indonesia earlier this year, but that was an unlisted entity and the minority partner was a single private equity investor.

h) Limited success in northern and western regions

While HFD penetration is low at ~30% across India, it is much higher in the southern and eastern regions where GSKCH has more than a 75% market share. In the potentially larger growth areas in the northern and western regions, we reckon that market share is only around 33% (mainly through Boost, but also Viva and Maltova to a small extent) with strong competition from Bournvita and Complan, which are the market leaders in many states. Headway into these markets for GSKCH has not been very successful. Both Bournvita as well as Complan have renewed aggression in recent years, making it difficult for GSKCH. The reason for the discrepancy is that northern and western regions are chocolate-based drink markets while southern and eastern regions are malt and milk-based drink markets.



13

Financials

Exhibit 23: 5QFY14 and trailing 12MFY14 results

Y/E March (Rsmn) 1QFY14 4QFY14 5QFY14 YoY (%) QoQ (%) 12MFY13 12MFY14 YoY (%)

Net sales 9,754 8,690 11,198 14.8 28.9 33,260 38,932 17.1

Net raw material & Purchase of finished goods 3,559 3,067 4,178 17.4 36.2 11,753 13,837 17.7

% of sales 36.5 35.3 37.3 - - 35.3 35.5 -

Advertising 1,593 1,648 1,858 16.6 12.7 5,466 6,513 19.2

% of sales 16.3 19.0 16.6 - - 16.4 16.7 -

Staff costs 890 827 1,003 12.8 21.3 3,240 3,811 17.6

% of sales 9.1 9.5 9.0 - - 9.7 9.8 -

Other expenses 1,649 2,264 1,859 12.7 (17.9) 6,874 8,106 17.9

% of sales 16.9 26.1 16.6 - - 20.7 20.8 -

Operating Profit 2,063 884 2,300 11.5 160.2 5,927 6,665 12.4

OPM (%) 21.2 10.2 20.5 - - 17.8 17.1 -

Interest 1 4 2 21.4 (61.4) 14 9 (34.1)

Depreciation 107 112 169 57.7 50.6 349 519 48.7

Other income 324 446 480 48.0 7.7 1,237 1,745 41.1

PBT 2,279 1,213 2,610 14.5 115.1 6,802 7,882 15.9

Tax 715 416 893 24.9 114.8 2,190 2,698 23.2

Effective tax rate (%) 31.4 34.3 34.2 - - 32.2 34.2 -

Reported PAT 1,564 797 1,717 9.8 115.3 4,612 5,184 12.4

Adjusted PAT 1,564 797 1,717 9.8 115.3 4,612 5,184 12.4

NPM (%) 16.0 9.2 15.3 - - 13.9 13.3 -

EPS (Rs) 37.2 19.0 40.8 9.8 115.3 109.7 123.3 12.4

Source: Company

GSKCH reported better-than-expected sales numbers, but operating margin and PAT were below our and Bloomberg consensus expectations. Net sales and operating income were up 14.8% YoY at Rs 11.2 bn. This was led by 14.7% and 14.8% YoY growth in net sales and other operating income, respectively. Net sales were 1.3% above our estimate and around 2.0% above Bloomberg consensus estimate. Sales growth was also healthy, considering a 16.6% growth in the corresponding quarter a year ago.

There was disappointment on the EBITDA margin front, and particularly on gross margins. Gross margins were down 82bps YoY compared to our and Bloomberg consensus expectations of an improvement. Low barley prices seem to have been offset by the rise in milk and sugar prices. The outlook on both the costs of both these items is expected to worsen in the coming quarters.

EBITDA margin was down 61bps YoY at 20.5%. We were expecting a 40bps improvement. Absolute EBITDA was 3.4% below expectations, despite sales outperformance. EBITDA for the quarter was up 11.5% at Rs 2.3bn.

Depreciation and interest costs were exactly in line, but other income was above our expectations, leading to PBT at 1.6%, which was below expectations compared to EBITDA at 3.4% below expectations. Tax rate at 34.2% was above our estimate of 32%.

PAT was up 9.8% YoY at Rs 1.72bn, around 5% below our expectations and 4.5% below Bloomberg consensus estimate.

Dividend payment was Rs45 per share for the 15-month period ended March 2014. Payout was 28% on 15-month EPS of Rs 160. We were expecting Rs50 per share as dividend.

While inventory was under control, the small debtors amount grew 2.67x in March 2014 over December 2014. From a net working capital perspective, this was partly offset by a 40% increase in creditors for this period.



14

Risks to our call

a) Novartis consumer products business

GSKCH India has been kept out of the recent merger of the global consumer products business of GSK and Novartis. Thus our forecasts have not factored in revenue or distribution commission from these products. Novartis’s OTC business revenue in India (key product Otrivin nasal drops) was Rs 1.26bn in FY14. Growth has been tepid in the past two years as revenue was up 13.6% in FY14 after a decline of 5.7% in FY13. Even if we assume a 15% distribution commission on the Rs1.26bn Novartis OTC product sales in FY14, this adds only ~15% to the existing annualised auxiliary commission that GSKCH India earned (~Rs 1.2bn) in FY14.

b) Utilisation of cash balance

So far the cash balance that GSKCH has built (currently around Rs18.4bn) has been RoE and RoCE dilutive. If the company makes an acquisition which is value accretive, then RoCE and RoE will improve.



15

Financials

Exhibit 24: Income statement

Y/E March (Rsmn) CY12 FY14 FY15E FY16E FY17E

Net sales 31,875 48,686 44,304 50,950 58,083

% growth 15.3 52.7 (9.0) 15.0 14.0

Raw material costs 11,519 17,393 15,967 18,362 20,932

Staff costs 3,011 4,700 4,254 4,867 5,499

Advertisement costs 4,965 8,107 7,597 8,660 9,916

Royalty costs 1,056 1,584 1,521 1,749 2,011

Others 5,590 8,173 7,390 8,498 9,734

Total expenditure 26,141 39,958 36,729 42,136 48,093

EBITDA 5,734 8,728 7,576 8,814 9,990

% growth 13.7 52.2 (13.2) 16.3 13.3

EBITDA margin (%) 18.0 17.9 17.1 17.3 17.2

Other income 149 501 301 331 364

Net Interest (965) (1,557) (1,621) (1,500) (1,466)

Depreciation 361 625 706 861 1,032

Profit before tax 6,487 10,161 8,792 9,784 10,788

% growth 20.1 56.6 (13.5) 11.3 10.3

Tax 2,119 3,413 2,902 3,229 3,560

Effective tax rate (%) 32.7 33.6 33.0 33.0 33.0

Net profit 4,368 6,748 5,891 6,556 7,228

% growth 23.0 54.5 (12.7) 11.3 10.3

Adjusted net profit 4,368 6,748 5,891 6,556 7,228

Reported net profit 4,368 6,748 5,891 6,556 7,228

% growth 23.0 54.5 (12.7) 11.3 10.3


Note: FY14 is a 15 month period, hence FY15E sales and PAT show a decline. Normalized sales growth in FY15E at 13.8% and PAT is 9%

Exhibit 26: Balance sheet


Equity 421 421 421 421 421

Reserves 13,189 17,573 20,990 24,792 28,985

Net worth 13,610 17,994 21,411 25,213 29,405

Liabilities 13,610 17,994 21,411 25,213 29,405

Gross block 6,562 10,135 12,635 15,135 17,635

Depreciation 4,624 5,250 5,955 6,816 7,848

Net block 1,938 4,885 6,679 8,319 9,786

Capital work-in-progress 1,972

Inventories 3,696 4,074 4,908 5,421 6,354

Debtors 1,126 2,934 1,922 3,662 2,703

Cash 14,642 18,842 18,009 18,579 19,021

Other current assets 2,169 3,775 4,152 4,567 5,024

Total current assets 21,634 29,624 28,991 32,230 33,102

Creditors 4,784 6,716 6,151 8,646 8,222

Other current liabilities 7,151 9,800 8,109 6,690 5,262

Total current liabilities 11,935 16,516 14,260 15,336 13,484

Net current assets 9,699 13,109 14,731 16,894 19,619

Total assets 13,610 17,994 21,411 25,213 29,405


Exhibit 25: Cash flow


EBIT 5,373 8,103 6,870 7,953 8,958

(Inc.)/dec. in working capital 2,090 790 (2,455) (1,593) (2,283)

Cash flow from operations 7,463 8,893 4,414 6,360 6,675

Other income 149 501 301 331 364

Depreciation 361 625 706 861 1,032

Net Interest 965 1,557 1,621 1,500 1,466

Tax paid (2,119) (3,413) (2,902) (3,229) (3,560)

Dividends paid (1,895) (2,364) (2,474) (2,753) (3,036)

Net cash from operations 4,924 5,800 1,667 3,070 2,942

Capital expenditure (773) (1,600) (2,500) (2,500) (2,500)

Net cash after capex 4,151 4,200 (833) 570 442

Cash from financial activities - - - - -

Others (725) - - - -

Opening cash 10,797 14,642 18,842 18,009 18,579

Closing cash 14,642 18,842 18,009 18,579 19,021

Change in cash 3,846 4,200 (833) 570 442


Note: FY14 is a 15 month period, hence FY15E sales show a decline. Normalized sales growth in FY15E at 13.8%

Exhibit 27: Key ratios

Y/E March CY12 FY14 FY15E FY16E FY17E

Per share (Rs)

EPS 103.9 128.4 140.1 155.9 171.9

DPS 45.0 45.0 58.8 65.5 72.2

Book value 323.6 427.9 509.1 599.5 699.2

Valuation (x)

P/E 43.2 34.9 32.0 28.8 26.1

P/BV 13.9 10.5 8.8 7.5 6.4

EV/EBITDA 30.3 24.3 22.5 19.3 17.0

EV/sales 5.5 4.4 3.9 3.3 2.9

Return ratios (%)

RoCE 32.4 31.5 27.2 26.0 24.7

RoE 34.9 34.2 29.9 28.1 26.5

Margins (%)

Gross margin 63.9 64.3 64.0 64.0 64.0

EBITDA margin 18.0 17.9 17.1 17.3 17.2

PBT margin 20.4 20.9 19.8 19.2 18.6

PAT margin 13.7 13.9 13.3 12.9 12.4

Turnover ratios

Fixed asset turnover ratio (x) 8.2 8.0 6.6 6.1 5.9

Avg. inventory period (days) 42 36 37 37 37

Avg. collection period (days) 12 19 20 20 20

Avg. payment period (days) 48 54 53 53 53

Other ratios

Dividend yield (%) 1.0 1.0 1.3 1.4 1.6

Growth (%)

Sales 15.3 52.7 (9.0) 15.0 14.0

EBITDA 13.7 52.2 (13.2) 16.3 13.3

PAT 23.0 54.5 (12.7) 11.3 10.3





16

Disclaimer

Stock Ratings Absolute Returns

BUY > 15%

HOLD 0-15%

SELL < 0%

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