27 September 2012 Europe Equity Research Beverage (Food Producers & Processors/Personal Care & Household Products/Beer & Alcoholic Beverages) / UNDERWEIGHT/OVERWEIGHT

Indian Spirits Market Research Analysts Alex Molloy 41 44 333 05 83 [email protected] Charlie Mills 44 20 7888 0325 [email protected] Nicolas Sochovsky 44 20 7883 8075 [email protected] Sanjeet Aujla 44 20 7888 0353 [email protected] Jimmie Bork 44 20 7883 9941 [email protected] Michael Bleakley 44 20 7888 0336 [email protected]

INDUSTRY PRIMER

Indian spirits: All aboard ■ The India spirits market is huge – number 3 globally by volumes, boasts some of the largest brands in the world, growing mid-teens last 5 years and showing healthy signs of premiumising. It has been largely inaccessible to foreign players due to punitively high import tariffs. The market is highly complex with local and national taxes and operates more like 28 separate markets. However its potential seems clear, and any signs of deregulation would represent a material opportunity to the global spirits players.

■ Pernod: Though India only represents 6% of Pernod’s sales, it is probably closer to 20% of the group’s organic growth. Pernod’s track record in the region has been very strong indeed and its business there is perhaps the hidden jewel in the Pernod crown.

■ Diageo: The news that Diageo is in discussions about taking a stake in the industry leader, United Spirits (44% market share), has understandably been well received. We await details of quite what shape this might take. If fully consolidated the potential impact on the shape of Diageo’s key financial metrics outweighs its near term financial impact - United Spirits has close to 120m cases sold (vs Diageo’s 157m), but an EBITA equal to just 4% of Diageo’s EBITA. We continue to rate Diageo and Pernod as Outperform, with 1,900p and EUR100 target prices, respectively. rd

Figure 1: India is the 3 largest market by volumes 40% 35% 30% 25% 20% 15% 10% 5% 0% China

Rus

India

US

S Korea

Japan

Brazil

Thai

Phil

Germ

Source: IWSR 2010 (size by volume)

DISCLOSURE APPENDIX CONTAINS ANALYST CERTIFICATIONS AND THE STATUS OF NON-US ANALYSTS. U.S. Disclosure: Credit Suisse does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

CREDIT SUISSE SECURITIES RESEARCH & ANALYTICS

BEYOND INFORMATION™ Client-Driven Solutions, Insights, and Access

27 September 2012

The story in 6 charts.. Figure 2: India is the 3rd largest market by volume….

Figure 3: ….and one of the fastest growing major market

40%

20%

35%

15% 30%

10%

25% 20%

5%

15%

0%

10%

-5%

5%

-10%

0% China

Rus

India

US

S Korea

Japan

Brazil

Thai

Phil

China

Germ

India

US

S Korea

Brazil

Russia

Source: IWSR 2010 (size by volume)

Source: IWSR 2005-2010 CAGR (growth by volume)

Figure 4: It is principally made up of Whisky rum and

Figure 5: The market has been premiumising, 2005-10

brandy, 2005-10 70%

30%

60%

25%

50%

20%

40% 15%

30% 10%

20%

5%

10% 0%

0%

Whisky

Rum

Brandy

Vodka

Other

Value

Total Mk

Source: IWSR, Credit Suisse research

Source: IWSR, Credit Suisse estimates

Figure 6: USL is the market leader in total spirits, 2010

Figure 7: ….and in whisky, 2010

Other 29%

USL 44%

John Distillers 5%

Standard +

Other 14% USL 44%

Jagatjit 9% ABD 11%

Jagatjit 6% ABD 7%

Source: IWSR, Credit Suisse estimates

Indian Spirits Market

John Distillers 7%

Low Price

Pernod 9%

Pernod 15%

Source: IWSR, Credit Suisse estimates

2

27 September 2012

Diageo DGE.L Price (25 Sep 12): 1,754.00p, Rating: OUTPERFORM, Target Price: 1,900.00p Income statement (£ m) Sales revenue EBITDA Depr. & amort. EBIT (CS) Net interest exp. Associates Other adj, PBT (CS) Income taxes Profit after tax Minorities Preferred dividends Associates & other Net profit (CS) Other NPAT adjustments Reported net income

06/12A 10,762 3,572 (411) 3,161 (397) 213 — 2,977 (1,038) 1,939 (130) — 505 2,314 (409) 1,905

06/13E 11,470 3,940 (438) 3,502 (444) 245 — 3,303 (595) 2,708 (140) — — 2,568 — 2,568

06/14E 12,174 4,258 (465) 3,793 (396) 269 — 3,667 (660) 3,007 (152) — — 2,855 — 2,855

06/15E 12,938 4,586 (494) 4,092 (382) 296 — 4,007 (721) 3,285 (164) — — 3,122 — 3,122

Cash flow (£) EBIT Net interest Cash taxes paid Change in working capital Other cash & non-cash items Cash flow from operations CAPEX Free cash flow to the firm Acquisitions Divestments Other investment/(outflows) Cash flow from investments Net share issue/(repurchase) Dividends paid Issuance (retirement) of debt Other Cash flow from financing Effect of exchange rates Changes in Net Cash/Debt . Net debt at start Change in net debt Net debt at end

06/12A 3,161 (391) (521) (529) 218 1,938 (445) 1,493 (1,420) 51 — (1,814) 1 (1,036) — (4) (1,039) (27) (942)

06/13E 3,502 (444) (514) (135) 376 2,785 (555) 2,230 — — — (555) (1,150) (1,172) — — (2,322) — (92)

06/14E 3,793 (396) (595) (150) 562 3,215 (581) 2,634 — — — (581) (1,150) (1,250) — — (2,400) — 234

06/15E 4,092 (382) (660) (165) 613 3,498 (618) 2,881 — — — (618) (1,250) (1,318) — — (2,568) — 313

6,611 942 7,553

7,553 92 7,645

7,645 (234) 7,411

7,411 (313) 7,098

Balance sheet (£ m) Assets Cash and cash equivalents Accounts receivable Inventory Other current assets Total current assets Total fixed assets Intangible assets and goodwill Investment securities Other assets Total assets Liabilities Accounts payable Short-term debt Other short term liabilities Total current liabilities Long-term debt Other liabilities Total liabilities Shareholders' equity Minority interest Total equity & liabilities Net debt (£ m)

06/12A

06/13E

06/14E

06/15E

1,076 2,103 3,955 119 7,253 2,972 8,821 — 3,304 22,350

984 2,241 4,215 119 7,559 3,089 8,821 — 3,524 22,993

1,218 2,379 4,474 119 8,190 3,205 8,821 — 3,766 23,982

1,531 2,528 4,754 119 8,933 3,329 8,821 — 4,032 25,114

2,997 1,230 557 4,784 7,399 3,356 15,539 6,811 — 22,350 7,553

3,194 1,230 619 5,043 7,399 3,214 15,655 7,338 — 22,993 7,645

3,390 1,230 684 5,304 7,399 3,183 15,886 8,096 — 23,982 7,411

3,603 1,230 752 5,585 7,399 3,153 16,136 8,978 — 25,114 7,098

Indian Spirits Market

Per share data No. of shares (wtd avg) CS adj. EPS (p) Prev. EPS (p) Dividend (p) Dividend payout ratio Free cash flow per share

06/12A 2,503 92.45 — 43.50 47.05 59.65

06/13E 2,472 103.89 — 46.98 45.22 90.21

06/14E 2,412 118.35 — 50.74 42.87 109.19

06/15E 2,356 132.48 — 54.80 41.36 122.26

Key ratios and valuation Growth(%) Sales EBIT Net profit EPS Margins (%) EBITDA margin EBIT margin Pretax margin Net margin Valuation metrics (x) EV/sales EV/EBITDA EV/EBIT P/E P/B Asset turnover ROE analysis (%) ROE stated-return on ROIC Interest burden Tax rate Financial leverage Credit ratios (%) Net debt/equity Net debt/EBITDA Interest coverage ratio

06/12A

06/13E

06/14E

06/15E

8.3 9.6 11.1 11.0

6.6 10.8 11.0 12.4

6.1 8.3 11.2 13.9

6.3 7.9 9.3 11.9

33.2 29.4 27.7 21.5

34.4 30.5 28.8 22.4

35.0 31.2 30.1 23.5

35.4 31.6 31.0 24.1

4.7 14.2 16.0 19.0 6.4 0.48

4.4 12.9 14.5 16.9 5.9 0.50

4.1 11.8 13.3 14.8 5.2 0.51

3.9 10.9 12.3 13.2 4.6 0.52

29.8 14.6 0.94 33.7 1.3

36.3 19.2 0.94 18.0 1.2

37.0 20.1 0.97 18.0 1.1

36.6 20.9 0.98 18.0 1.0

110.9 2.1 8.0

104.2 1.9 7.9

91.5 1.7 9.6

79.1 1.5 10.7

Source: FTI, Company data, Thomson Reuters, Credit Suisse Securities (EUROPE) LTD. Estimates.

1694 1494 1294 1094 Oct-10

Feb-11 Jun-11 Price

Oct-11

Feb-12 Jun-12 Price relative

The price relative chart measures performance against the FTSE ALL SHARE INDEX which closed at 3022.74 on 25/09/12 On 25/09/12 the spot exchange rate was £.8/Eu 1. - Eu .78/US$1

3

27 September 2012

Pernod-Ricard PERP.PA Price (25 Sep 12): Eu88.45, Rating: OUTPERFORM, Target Price: Eu100.00 Income statement (Eu m) Sales revenue EBITDA Depr. & amort. EBIT (CS) Net interest exp. Associates Other adj, PBT (CS) Income taxes Profit after tax Minorities Preferred dividends Associates & other Net profit (CS) Other NPAT adjustments Reported net income

06/12A 8,215 2,114 — 2,114 (509) — — 1,605 (247) 1,358 (27) — (130) 1,201 (55) 1,146

06/13E 9,035 2,397 — 2,397 (530) — — 1,867 (448) 1,419 (33) — — 1,386 — 1,386

06/14E 9,682 2,657 — 2,657 (455) — — 2,202 (529) 1,674 (38) — — 1,635 — 1,635

06/15E 10,391 2,916 — 2,916 (395) — — 2,521 (605) 1,916 (44) — — 1,872 — 1,872

Cash flow (Eu) EBIT Net interest Cash taxes paid Change in working capital Other cash & non-cash items Cash flow from operations CAPEX Free cash flow to the firm Acquisitions Divestments Other investment/(outflows) Cash flow from investments Net share issue/(repurchase) Dividends paid Issuance (retirement) of debt Other Cash flow from financing Effect of exchange rates Changes in Net Cash/Debt . Net debt at start Change in net debt Net debt at end

06/12A 2,114 (548) (247) (94) 163 1,388 (260) 1,128 — — (333) (593) — (411) — (709) (1,120) — (325)

06/13E 2,397 (530) (448) (231) 199 1,387 (340) 1,047 — — — (340) — (421) — (17) (438) — 608

06/14E 2,657 (455) (529) (109) 213 1,778 (369) 1,409 — — — (369) — (486) — — (486) — 923

06/15E 2,916 (395) (605) (113) 229 2,032 (312) 1,720 — — — (312) — (573) — — (573) — 1,147

9,038 325 9,363

9,363 (608) 8,755

8,755 (923) 7,831

7,831 (1,147) 6,684

Balance sheet (Eu m) Assets Cash and cash equivalents Accounts receivable Inventory Other current assets Total current assets Total fixed assets Intangible assets and goodwill Investment securities Other assets Total assets Liabilities Accounts payable Short-term debt Other short term liabilities Total current liabilities Long-term debt Other liabilities Total liabilities Shareholders' equity Minority interest Total equity & liabilities Net debt (Eu m)

06/12A

06/13E

06/14E

06/15E

787 1,376 4,295 115 6,573 2,126 17,360 — 2,316 28,375

787 1,477 4,633 115 7,013 2,267 17,360 — 2,316 28,956

787 1,544 4,868 115 7,314 2,423 17,360 — 2,316 29,413

787 1,616 5,121 115 7,639 2,506 17,360 — 2,316 29,821

2,161 — 1,553 3,714 1,236 12,453 17,403 10,803 169 28,375 9,363

2,369 — 2,291 4,660 1,236 11,827 17,723 11,059 173 28,956 8,755

2,563 — 2,303 4,865 1,236 10,904 17,005 12,217 191 29,413 7,831

2,774 — 2,373 5,147 1,236 9,757 16,140 13,470 211 29,821 6,684

Indian Spirits Market

Per share data No. of shares (wtd avg) CS adj. EPS (Eu) Prev. EPS (Eu) Dividend (Eu) Dividend payout ratio Free cash flow per share

06/12A 265 4.53 — 1.59 35.09 4.26

06/13E 265 5.23 — 1.84 35.09 3.95

06/14E 265 6.17 — 2.16 35.09 5.32

06/15E 265 7.06 — 2.48 35.09 6.49

Key ratios and valuation Growth(%) Sales EBIT Net profit EPS Margins (%) EBITDA margin EBIT margin Pretax margin Net margin Valuation metrics (x) EV/sales EV/EBITDA EV/EBIT P/E P/B Asset turnover ROE analysis (%) ROE stated-return on ROIC Interest burden Tax rate Financial leverage Credit ratios (%) Net debt/equity Net debt/EBITDA Interest coverage ratio

06/12A

06/13E

06/14E

06/15E

7.5 10.7 9.8 9.8

10.0 13.4 15.4 15.4

7.2 10.8 17.9 17.9

7.3 9.8 14.5 14.5

25.7 25.7 19.5 14.6

26.5 26.5 20.7 15.3

27.4 27.4 22.7 16.9

28.1 28.1 24.3 18.0

3.9 15.1 15.1 19.5 2.2 0.29

3.5 13.1 13.1 16.9 2.1 0.31

3.1 11.4 11.4 14.3 1.9 0.33

2.8 10.0 10.0 12.5 1.7 0.35

11.4 8.8 0.76 17.4 0.87

12.7 9.1 0.78 24.0 0.80

14.0 10.0 0.83 24.0 0.65

14.6 10.9 0.86 24.0 0.50

85.3 4.4 4.2

77.9 3.7 4.5

63.1 2.9 5.8

48.9 2.3 7.4

Source: FTI, Company data, Thomson Reuters, Credit Suisse Securities (EUROPE) LTD. Estimates.

96 76 56 Oct-10

Feb-11 Jun-11 Price

Oct-11

Feb-12 Jun-12 Price relative

The price relative chart measures performance against the CAC 40 INDEX which closed at 3439.29 on 25/09/12 On 25/09/12 the spot exchange rate was Eu .78 /US$1

4

27 September 2012

Indian Spirits market Market size, growth India is the third largest Global spirits market by volume in the World, after China and Russia - larger than both the United States and South Korea. It is also one of the fastest growing over the last decade (+12% CAGR since 2001) and growth has even accelerated over the last five years (+17% CAGR since 2005).

India: One of the largest and fastest growing spirits markets

Only China has grown quicker since 2005 (+18% CAGR) with both markets growing at three times the rate of the global spirits market (+5%) over the same period. Figure 8: Indian Spirits mk. third largest in world….

Figure 9: …..and the fastest growing…together with China

40%

20%

35% 15% 30% 10%

25% 20%

5%

15%

0%

10% -5%

5%

-10%

0% China

Rus

India

US

S Korea

Japan

Brazil

Thai

Phil

China

Germ

Source: IWSR 2010 (size by volume)

India

US

S Korea

Brazil

Russia

Source: IWSR 2005-2010 CAGR (growth by volume)

Segmentation Like China (Baiju) and Russia (vodka) the market is dominated by low priced and value brands. However unlike in other big markets, India doesn’t have a dominant indigenous liqueur but instead the popular tipple is locally produced and adapted versions of European spirits with whisky by far the most important (c.60% of volumes), followed by Brandy and Rum (c.20% each). Figure 10: ….in India Western style spirits dominate….

Western style spirits dominate…especially Whisky

Figure 11: …..in particular whisky in both volumes & value

70%

80%

60%

70% 60%

50%

50% 40% 40% 30% 30% 20%

20%

10%

10%

0%

0% Whisky

Rum

Brandy

Vodka

Source: IWSR 2010 (volume share of Indian Spirits market)

Other

Whisky

Rum

Brandy

White spirits

Source: Euromonitor 2010 (value share of Indian Spirits market)

A combination of colonial history and trade policies explain this unique situation. A brief glance at the history of United Spirits (USL), the market leader, illustrates this well. The origins of USL date back to McDowell & Co, a Madras trading company established in 1826 to import fine liqueur and cigars. The British Raj set the tone and taste for brown

Indian Spirits Market

5

27 September 2012

spirits (mainly whisky but also rum and brandy) and after Indian Independence USL founder Vittal Mallya acquired McDowells (1951). In the 1960’s he started producing his synonymous brandy (McDowell’s No1 Brandy) and whisky (McDowell’s No1 whisky). Today USL brands make-up six of the top ten in India and are amongst the largest brands in their respective categories globally (by volume). These locally produced versions of Western spirits are known by the acronym IMFL (Indian Made Foreign Liquor). Indian made whisky is not only the biggest market segment (60% of spirits volumes, 70% of value) it is also growing strongly, particularly over the last five or six years, averaging +15-20% p.a. Locally made Brandy is growing slightly faster but is a much smaller category (20% of market volumes), while Rum is losing out.

Indian whisky key local and global growth driver..

Figure 12: ……18% CAGR for Indian Whisky volumes

Figure 13: ….only Brandy volumes have done slightly

between 2005-2011..

better in India between 2005-11

30.0%

25%

25.0%

20%

20.0%

15%

15.0%

10%

10.0%

5% 5.0%

0% Brandy

Whisky

Rum

Total Mk

0.0% 2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

Source: IWSR, company data, Credit Suisse estimates

Source: IWSR

India accounts for nearly half of global whisky volumes, which when multiplied by growth rates of 15-20% means that its basically driving nearly all of the category’s Global +7% growth since 2005. The contribution of Indian Whiskies to the global category’s value growth (as opposed to volume) would of course look very different as they would have both a much lower weighting and premiumisation is at a much earlier stage, although as we argue below we could be reaching an inflexion point here.

Figure 14: …India is nearly ½ of global whisky volumes in

Figure 15: …and nearly all of the global category growth

2010

between 2005-10 20%

50% 45% 40%

15%

35% 30%

10%

25% 20%

5%

15% 10%

0%

5%

India

France

Japan

US

UK

Other

0% India

Source: IWSR

Indian Spirits Market

US

France

Japan

United Kingdom

Other

-5%

Source: IWSR

6

27 September 2012

As a result Indian brands dominate the global volume charts, occupying nine of the top ten positions. Of the international brands, only Diageo’s Johnnie Walker can match them on this basis although given the big differences in average selling prices, (probably 4-5x higher) this ranking would look very different if it were done by value. Figure 16: ….Indian whiskies dominate the global TOP 10 as well…..

Brand Officer's Choice McDowells Johnnie Walker Bagpiper Royal Stag Old Tavern Original Choice Jagatjit Aristocrat Director's Special Imperial Blue Ballantines Jim Beam J&B Crown Royal Chivas

% global whisky mk 6% 6% 5% 5% 4% 3% 4% 2% 2% 2% 2% 2% 2% 2% 2%

No. of cases ('000 9L) >16000 >16000 >16000 >16000 >10000 >9000 >10000 >9000 >7000 >7000 >5000 >4000 >4000 >4000 >4000

brand owner ABD USL Diageo USL Pernod USL John Distillers Jagatjit USL Pernod Pernod Beam Diageo Diageo Pernod

Source: IWSR, company data, Credit Suisse research

Segmentation - by price point/origin This brings us nicely to the subject of premiumisation, one of the most important trends in the spirits market globally and one which can influence both growth and profitability. Given the particular structure of the Indian market it is instructive to look at the growth of the most important brands within the key price segments, which is not captured by the IWSR segmentation.

…..and premiumisation just beginning

On this basis we can see that the main Sub Premium and Premium IMFL (Indian Made Foreign Liquor) brands, such as Blenders Pride and Royal Stag, are growing faster than the key Regular and Economy brands (i.e. USL’s Bagpiper and Director’s Special). The CAGR’s over the last five years are +20% and +16% respectively. Figure 17: ….more premium local Indian brands growing

Figure 18: and International Brands growing faster still

faster than the market average…..

……..premiumisation in action……

25%

30% 25%

20%

20% 15% 15% 10% 10% 5%

5%

0%

0% Regular/Econ

Total Mk

Sub Prem/Prem

Source: IWSR, Regular/Economy is average of Bagpiper, Director’s Special, Jagatjit, OC. Sub Prem/Prem is Antiquity, Blenders Pride, Imperial Blue, McDowells, Royal Challenge, Royal Stag, Signature

Indian Spirits Market

Value

Total Mk

Low Price

Standard +

Source: IWSR, CS estimates

7

27 September 2012

If we then move onto the IWSR data the Standard and Premium segments are growing faster than both the market as a whole and the big ‘value’ segment. This is capturing the growth in ‘international brands’ like Teachers, Johnnie Walker, Black Dog, which can either be genuinely classified as Scotch whiskies (i.e. Bottled in Origin/BOI) or made from Scotch but bottled in India (BOI, i.e. Teachers). While growth here is impressive it is coming off a very small base and even today is only between 1-2% of the market. In short premiumisation has started in India with more expensive IMFL whiskies growing faster than their cheaper counterparts and the BII and BIO whiskies growing faster still.

Regulatory backdrop Different taxation regimes apply to locally manufactured spirits (IMFL) and imported spirits. •

Local spirits are essentially taxed by the individual states

•

Imported spirits are taxed at both the federal (import duties) and state level. The current system of taxation on imported spirits, both BIO (Bottled in Origin) and BII (Bottled in India) dates from 2001. Prior to this, as with many consumer goods, imports were simply restricted through a licensing system, essentially excluding all but a small quantity of imported spirits. Post an EU challenge to the WTO, India removed these quantitative restrictions but introduced the new measures with similar aims and results.

•

There are 28 states and taxation levels and methods vary significantly. As such India is often referred to as 28 separate markets, all with their own systems, and movement of liquor between states is not easy.

…..federal excise tax of 150% on imported spirits……

Figure 19: Taxation regime for spirits in India since 2001….

Basic Customs Duty (BCD) Additional Duty (AD)

Spirit Produced in India No No

0-10 USD per 9L case 10-20 USD per 9L case 20-40 USD per 9L case 40+ USD per 9L case

Spirits imported in Spirits imported in bulk bottle (BIO) (BII) Yes - 150% Ad Valorem Yes - 150% Ad Valorem Yes - sliding scale:

No

150% 100% 50% 25%

Extra Additional Duty (EAD)

No

Yes - 4%

Yes - 4%

State taxes (excise duty)

Yes

No

Yes

State taxes (other)

Yes

Yes

Yes

Source: EU Trade Section

As a starting point all imported spirits have to pay 150% import duty. This is implied on either the finished product if this is BIO (Bottled in Origin), for example Chivas or Johnnie Walker, or on the bulk spirit if BII (Bottled in India), for example Teachers (Beam). After that the treatment of BIO and BII varies slightly, with the so called Additional Duty (AD) applied to BIO but not to BII, but on the other hand individual states have the right to levy their own excise duties on BII product but not on BIO. So in summary BIO has to pay 3 types of import duty (BCD, AD, EAD) which can add up to between 250% and 550% depending on the value of the product (lower percentage the

Indian Spirits Market

8

27 September 2012

higher value the item) as well as indirect state taxes. BII has to pay 2 types of customs duty (BCD and AD) which adds up to 160%, state excise tax and indirect state taxes. Note that the duties are calculated off a so called CIF value per 9L case, essentially the taxable value of the case. Got all that? Despite occasional press stories that negotiations with the EU would lead to the reduction of these excise duties (i.e.Times of India Dec 2001, Economic Times Nov 2011), to date they remain firmly in place and this should remain the case until the EU and India can reach a free trade agreement, with the EU looking for tariff reductions on products like Spirits and India looking for increased access to EU markets for areas like agricultural exports and services.

….import duties here to stay?....probably for now

While there was a flurry of optimism last year that headway could be made, bilateral talks were unsuccessful and in our view the current environment is not particularly conducive to an agreement. The EU has well known internal problems while United Spirits (whose Chairman VJ Mallya is also a member of the India Parliament) faces issues in other parts of its empire. …..then different state taxes…….and these apply to locally produced spirits too… On top of this the individual states have their own distribution and related tax structures. In some taxes are applied ad valorem, others are specific taxes linked to the volume, alcohol content or price of the products concerned. Even for IMFL the overall level of taxation varies considerably, from state to state.. As stated above the Constitution of India does not grant the Indian States the authority to apply excise duties on BIO products, only on BII and IMFL spirits, but many States do apply other indirect taxes to BIO products, such as sales taxes, VAT, special duty.

Supply structure The India market is dominated by United Spirits which has a 44% share ahead of Pernod’s 8-9%. Pernod’s value share would likely be significantly higher given the positioning of their major brands (more on this below).

Figure 20: USL is No1 in the total market but losing share,

Figure 21: …through a clear focus on local whisky.. (2010)

Pernod No.2 and gaining share… in 2010 Other 29%

John Distillers 7%

USL 44%

John Distillers 5%

Other 14% USL 44%

Jagatjit 9% ABD 11%

Jagatjit 6% ABD 7%

Pernod 9%

Source: IWSR, Credit Suisse estimates, company data

Pernod 15%

Source: IWSR, Credit Suisse estimates, company data

The key brands in the market are highlighted in the figure below.

Indian Spirits Market

9

27 September 2012

Figure 22: …TOP 10 Indian Spirits brands dominated by

Figure 23: ….Pernod has two of the TOP 10 Indian whisky

whisky and by USL

brands…… Brand Officer's Choice McDowells Bagpiper Royal Stag Old Tavern Original Choice Jagatjit Aristocrat Director's Special Imperial Blue Hayward

Brand

% total mk

brand owner

Officer's Choice

7%

ABD

McDowell's Whisky Celebration Rum Bagpiper McDowell's Brandy Original Choice Royal Stag Old Tavern Director's Special Jagatjit Aristocrat

7% 6% 6% 5% 5% 4% 4% 3% 3%

USL USL USL USL John Distillers Pernod USL USL Jagatjit

Source: IWSR, Credit Suisse research, company data

% Indian whisky mk 11% 10% 10% 8% 8% 7% 6% 5% 5% 3%

No. of cases ('000 9L) >16000 >16000 >16000 >10000 >9000 >10000 >9000 >7000 >7000 >4000

brand owner ABD USL USL Pernod USL John Distillers Jagatjit USL Pernod USL

Source: IWSR, Credit Suisse research, company data

We estimate that Pernod has gained c.+400-500 bps of volume share in whisky over the since 2005, with all three of their major brands (Royal Stag, Imperial Blue, Blenders Pride) showing solid gains. The growth of Blender’s Pride, Pernod’s most premium IMFL whisky is particularly impressive (+44% CAGR since 2005), growing at more than twice the category rate.

Indian Spirits Market

10

27 September 2012

Summary – the India market So here is, in summary, how we see the Indian market: •

Indian market is 3rd largest in World (after China and Russia)

•

It is fast growing (mid-teens in volume terms)

•

The market is beginning to show signs of premiumisation

•

With taxes at both State and Country level, Indian is often better viewed as a collection of 28 markets rather than a single market.

•

There are big barriers to entry (both 150% import tariffs and local tariffs, along with the regional structure, difficulty in moving/selling across State, need for local production, etc.). Taxes on spirits in India are amongst the highest in the World.

•

United Spirits leads the market with a 44% share. Its leading brand (McDowells) sells more than Johnnie Walker

•

United Spirits far behind Pernod (#2 in India with 9%) in premium, and is more skewed to regular and economy segments. Pernod boasts 25% margins in the region, United Spirits mid-teens

Indian Spirits Market

11

27 September 2012

United Spirits: Diageo opportunity? Diageo has confirmed in a press release on 25th September 2012 that it is in discussions with United Spirits and United Breweries for Diageo to “acquire an interest in United Spirits Ltd”. At this stage there is no indication how large that interest might be, whether Diageo would want control, or how such a deal might be constructed.

Background on United Spirits United Spirits (USL) is the largest player in the Indian market, with 44% market share and 6 of the top 10 brands. The company is controlled by VJ Mallya, son of the founder, a wellknown businessman and a member of the Indian parliament and although USL and the wider UB Group (UB is United Spirits controlling shareholder) has faced some challenges recently, USL is still the dominant player in the Indian spirits by some distance. USL sold over 112m cases in 2011 (Diageo sold circa 121m cases of spirits). USL’s portfolio is well entrenched across all price points and categories, with the McDowell’s brand covering all three of the key categories, whiskey, brandy and rum, selling a total of 43.5m cases, making it the largest spirits brand in the world. USL’s volume growth has averaged 13% over the last five years in line with its ten year CAGR. In 2011, volume growth slowed sharply to 3% after a 20% rise in prices. Total sales growth has averaged over 26% on five and ten years. Figure 24: United Spirits sales and cases sold

100,000

120000

90,000

RMB mns

70,000

80000

60,000 50,000

60000

40,000

40000

30,000 20,000

cases mn

100000

80,000

20000

10,000

0

0 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Sales

cases sold (mn) RHS axis

Source: Company data, IWRS

USL’s volume growth has been driven by its largest brands. We calculate the six largest brands have enjoyed a volume CAGR of 17% between 2004-10, generating 76% of the group’s growth.

Indian Spirits Market

12

27 September 2012

Figure 25: Growth in cases for United Spirits leading brands, 2004-10 2004

Bagpiper Celebration Rum Mc Dowells Whisky Mc Dowells Brandy Old Tavern Director's Special Rest of portfolio TOTAL

2005

2006

2007

2008

2009

8180 11240 13300 14290 4900 5400 5975 7250 5500 6439 7203 9930 4700 5100 6350 7650 360 2050 2500 3050 4400 4750 4800 3830 18767 16249 18899 19593 46807 51228 59027 65593

15750 9670 12075 7500 4800 5590 22037 77422

16265 11150 12300 9100 6600 6275 27888 89578

2010 CAGR Chg in cases 16895 13825 13635 12060 9050 7480 32933 105878

13% 19% 16% 17% 71% 9% 10% 15%

8715 8925 8135 7360 8690 3080 14166 59071

% of total growth 14.8% 15.1% 13.8% 12.5% 14.7% 5.2% 24.0%

Source: IWSR, Credit Suisse estimates

Recent trading poor as business model changes The slowdown in volume growth is a result of very steep taxation increases in key Indian states like Maharashtra and West Bengal, where the company was forced to pass on steep price hike of over 40% in the past year. As USL has a large portfolio (over 75% of volumes) in the regular segment which is more susceptible to a slowdown, volume growth was impacted significantly. In addition, the company strategy has been focused on driving the premium brands (25% of volumes). And USL had a major issue in terms of not getting orders from one of its largest states Tamil Nadu post the change of government. This strategy is clearly visible in the 1QFY13 results of the company, where prestige and above segment saw 17% volume growth, while regular brands saw 6% volume decline. It is also helping keep the working capital in check, as the key component of working capital for spirits companies is debtor days from the state government bodies which buy IMFL which is linked to volumes of sales. As a result, USL has lost share, particulary in Whiskey largely due to the focus of both Pernod and ABD, the latter of which is almost a one brand company. Officer’s Choice (ABD) has been so successful that recent reports show it has overtaken USL’s Bagpiper as the leading Indian whisky brand. Figure 26: Volume growth, 1Q10-4Q12

20.00% 18.00% 16.00% 14.00% 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12 4Q12 Source: Company data

Indian Spirits Market

13

27 September 2012

USL EBITA margins progression has been volatile USL margins have been volatile, peaking above 20% in 2007 before falling to under 12% in 2011. Part of the volatilty is due to prices in the main being set by state governments. Therefore USL does not have pricing power in most states as the government needs to approve price hikes. As a result, the company price hikes in states where pricing is free, were not sufficient to offset the increase in crude prices and glass prices. Figure 27: USL EBITA and EBITDA margin, 2006-11

30.0 24.4 22.8

25.0 20.0

16.8 15.6

14.6 12.9

15.0

16.9 15.3

17.3 15.9 13.3 11.7

10.0 5.0 0.0 2006

2007

2008 EBITDA margin

2009

2010

2011

EBITA margin

Source: Company data, average of United Spirits (USL) and Radico Khaitan, Credit Suisse research

USL’s margins are lower and more volatile than Pernod’s Indian operation, where EBIT margins are in line with the company average of >25%, due to:

■

The differences in portfolio positioning. Pernod’s exposure is concentrated in ‘sub premium’ and ‘premium’ whereas USL has a large amount of volume, over 75%, in the much less profitable ‘regular’ and ‘economy’ segments. We estimate the average price achieved by USL is around £9.6 per case compared to over £16 per case for Pernod.

■ USL is reliant on outsourcing for distilling. In the recent past, outsourcing accounted for 70% of production The company undertook a major capacity expansion drive for primary distillation including purchase of 3 distilleries. The total purchase of fixed assets was over Rs10bn in the past 2 years. Today production from outsourcing is 55% and should underpin an improvement in margins.

■ In 2007, USL’s split between molasses and grain purchases was 80/20. This meant the group was exposed to the large swings in molasses prices. Since molasses peaked in 2010, management has sort to bring the ratio down to 60/40 with the aim of reaching a 50/50 balance in 2012.

Why now? Ownership structure VJ Mallya’s Promoter Group has pledged 32.4m shares in United Spirits, 88% of his 27.78% stake in the company, as a second tier/top up security for the airline business. According to the press, the airline buisness requires $600m in cash in the coming months to keep the planes in the air.

Indian Spirits Market

14

27 September 2012

Figure 28: USL's shareholder structure

Resident Individuals GDS 10% 0% Foreign Institutions 5%

Indian Institutions 55%

Promoter Group 28%

Resident Body Corporate 2%

Source: Company data, Credit Suisse research

Whyte & Mackay potential regulatory issues USL acquired W&M in 2007 for an EV of GBP 595mn. The strategic rationale for the deal was USL’s Indian whiskey business dependence on Scotch to blend with Indian malt whiskies. Acquiring W&M provided USL with their own source of Scotch rather than having to buy from the likes of Diageo, Wm Grant & Sons or Pernod. After purchasing the business, USL said it found W&M was too focused on trading in bulk Scotch whiskey rather than building its brands, such as Isle of Jura, Mackinlay’s. And so, at the end of 2010 USL discontinued bulk scotch sales (including a bulk contract with Diageo in 2010) and focused resources on its branded sales. This has hurt near term EBITDA falling to £30-35m from £50-55m in 2011. With Diageo already controlling 35% of the volume share of the global Scotch market. Acquiring W&M would take their share of Scotch production to over 40%. We would envisage the regulators will scrutinise any deal, if signed. If any brands had to be sold, given the long term attractiveness of Scotch category, we would expect much interest.

Potentially the largest Scotch market in the world One of the key strategic gains from the recent emerging market acquisitons made by Diageo has been its ability to increase the distribution reach of its international portfolio. Clearly, with the tariffs in place, this will occur more slowly than in other instances. But this is a time for patience, as the long term rewards of utilising the pan national distribution network of United Spirits are potentially huge. In an established whiskey market, which India certainly is consuming over 150m cases, Scotch on average tends to take a 15% share of the market. Applying these maths, India has the potential to be a 20-25m case Scotch market, twice the size of the current largest market by cases in the world, France. In the near term, we would expect Diageo to accelerate the premiumisation of the portfolio. First, giving up more volumes at the bottom end of the price pyramid, which make thin margins and second, pushing their premium portfolio brands into USL’s large sales system. As we show below, although United Spirits only equates to 4% of Diageo’s EBITDA and Enterprise value, in terms of cases sold, United Spirits would account for 44% of combined entity and dilute group EBITA margin by 160bp on our analysis.

Indian Spirits Market

15

27 September 2012

Figure 29:Impact on key Diageo metrics Yr end Jun 2012 Diageo

Yr end Mar 2012 United Spirits

Total cases sold (mn) % of combined Sales (mn) % of combined price per case

155 56% 10762 91.1% 69.4

120 44% 1046 8.9% 8.7

EBITDA EBITDA Margin % of combined

3609 33.5% 96%

139 13.3% 4%

3748 31.7%

EBITA EBITA margin % of combined

3198 29.7% 96%

122 11.7% 4%

3320 28.1%

Mkt Cap EV % of combined

43,071 50,592 96%

1675 2501 4%

44,746 53,093

14.0

17.9

EV/EBITDA

Combined 275 11808 42.9

Source: Company data, Credit Suisse estimates

Indian Spirits Market

16

27 September 2012

Pernod India – the hidden jewel? Pernod in India - Market position In our view Pernod’s position in the Indian market is very strong. While they are the Number 2 by volume, with around 8 or 9% market share, well behind the market leader United Spirit’s (44% share), Pernod’s value share would likely be significantly higher given the positioning of their major brands (more on this below).

Pernod is number 2 in the Indian market and the only international player currently with a significant position.

Figure 30: USL is No1 in the total market but losing share,

Figure 31: …through a clear focus on local

Pernod No.2 and gaining share (2010)

whisky….where its share is 15% (2010)

Other 29%

John Distillers 7%

USL 44%

John Distillers 5%

Other 14% USL 44%

Jagatjit 9% ABD 11%

Jagatjit 6% ABD 7%

Pernod 9%

Pernod 15%

Source: IWSR, Credit Suisse estimates, company data

Source: IWSR, Credit Suisse estimates, company data

While Pernod has only one brand (Royal Stag) in the TOP 10 when looking across the entire spirits market, the company is almost entirely concentrated in the key whisky category, where its volume share is higher at around 15% on our estimates. In addition, Pernod has been gaining share over the last five or six years, partly at the expense of USL (United Spirits). Figure 32: Evolution of Pernod’s Indian spirits portfolio 000' 9L cases

2004

2005

2006

2007

2008

2009

2010

2004-10 CAGR

Royal Stag Imperial Blue Blender's Pride 100 Pipers Chivas Regal Ballantines Absolut Rest Total

3100 1800 225 32 30 8 28 102 5324

3500 2200 375 35 34 8 31 145 6327

4100 2400 600 70 40 7 37 161 7415

5300 3100 1030 123 50 9 40 193 9845

6400 3900 1475 159 70 22 33 216 12274

8050 4930 1870 193 82 29 40 267 15461

10000 6050 2325 206 93 30 38 307 19049

22% 22% 48% 36% 21% 25% 6% 20% 24%

2004-10 % of total chg in growth cases 6900 4250 2100 174 64 22 11

50.3% 31.0% 15.3% 1.3% 0.5% 0.2% 0.1%

13726

Source: IWSR

We estimate that Pernod has gained c.+400-500 bps of volume share in whisky since 2005, with all three of their major brands (Royal Stag, Imperial Blue, Blenders Pride) showing solid gains. The growth of Blender’s Pride, Pernod’s most premium IMFL whisky is particularly impressive (+44% CAGR since 2005), growing at more than twice the category rate.

Indian Spirits Market

17

27 September 2012

Figure 33: ….Pernod has gained +400-500bps share in

Figure 34: ….with all brand posting solid gains….with

whisky over the last five or six years….

more premium Blenders Pride growing 2x the market.. 50%

16.0%

45%

14.0%

40% 12.0%

35% 30%

10.0%

25%

8.0%

20% 6.0%

15% 10%

4.0%

5%

2.0%

0% 0.0%

Blenders Pride 2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

Royal Stag

Imperial Blue

2011

Source: IWSR, CS estimates/company data, % volume share of Indian whisky market

Indian Whisky Market

Source: Company data, Credit Suisse estimates

Unlike the other major market participants Pernod’s portfolio is concentrated (over 95% of volumes) in the sub premium (Royal Stag, Imperial Blue) and premium (Blender’s Pride) segments. As with any market in the world this helps drive value and mix and in the Indian context is an important factor in explaining why Pernod’s profitability is well above the levels of the major competitors, which we discuss further below.

….Pernod’s brand positioning is its real differentiating factor…..

Figure 35: ……segmentation of the Indian whisky market…but note price points vary significantly between states due to different excise regimes…. Foreign Liquor Bottled in Origin (BIO)

Bottled in India (BII)

Segment S upe r Pre mium (>1300 Rupees/USD 23)

S upe r Pre mium (>1300 Rupees/USD 23)

P re mium (>1000 Rupees/USD 18) Indian Made Foreign Liquor (IMFL)

P re mium (650-1000 Rupees/USD 12-18) based on Maharashtra prices

Brand Chivas Regal

% share of Intl Whisky Dehli price 5%

Johnnie Walker JW Red

19%

R e gula r (200-300 Rupees/USD 4-5) based on Maharashtra prices Economy (