USL Open Offer BY DIAGEO – Should Retail Investors Tender Shares ?

Diageo has launched an open offer to acquire an additional 26% stake in United Spirits (USL) at Rs3030 per share, a 15% premium to the USL closing price.
The open offer is for the acquisition of 37.79m shares. This amounts to a total offer size of Rs114.49bn. The current stake of Diageo in United Spirits is 28.78% which does not include the treasury stock of 2.38%. This implies that a full acceptance of the offer would take Diageo's stake up to 54.78% in the company and voting power to above 65% as the UB group has to vote in line with Diageo for 5 years from the initial deal.
The open offer is for public shareholders who currently own 59% of United Spirits
In the last 18 months Diageo has announced a second open offer at over 2x the initial one (announced in November 2012 at Rs1440 per share). We believe this indicates Diageo's confidence in the potential of the USL business as well as its commitment to India as a market.
We do not expect a full acceptance for the offer and believe longer term investors will wait for the premiumisation theme to play out in USL over the next 18-24 months.
With a 28.78% stake, for which Diageo had paid shelled out Rs 6600 crs, Diageo already has a strategic management control over USL, India's largest spirits player. Its second open offer, which aims to take the holding in the Indian company to 54.78% is estimated to cost Rs 11448 crs.
If this offer is successful, the London company's total investment in the United Spirits would reach Rs 18000 crs.
But why is Diageo investing so much in India?
Diageo is giving an aggressive push to its emerging-market plans and India is a place it sees a lot of value. Accordingly Diageo expects India would be among its top markets and is aiming to derive about 10% of its overall business from India. .
When Diageo starts consolidating USL numbers into its global profit-and-loss, likely from June this year, its global investors would start getting to feel the benefit of such a move. USL had a revenue of Rs 10000 crs and a PAT of around Rs 300 crs last financial year.

According to Diageo, its sales in India grew 35% during the October 2013-March 2014 period, against a 1.3% growth in all emerging markets put together. The company attributed the spectacular India growth to gains as USL began selling the London based-distiller's brands through 65,000 outlets.
According to Diageo it will be is trying to replicate in other markets the combination of scale and agility in USL operations. Also USL's distribution network - of reaching across 90% of the country was keenly sought by Diageo, which initially sought to buy 53.4 per cent of the company but settled for 25.02 per cent after hitting legal hurdles last July. Diageo has started selling its liquor through USL outlets since October 2013.
Also on the Whyte & Mackay front, Diageo is clear that it will be disposing this unit soon. In 2007, when United Spirits (USL) acquired Whyte and Mackay (W&M), it was considered a good fit as it filled the missing links in USL's portfolio. W&M's established brands and strong presence in European markets gave USL a huge advantage. But, this was a leveraged buyout.
The debt pertaining to the deal, which was valued at enterprise value of Rs 9480 crs ncluding Rs 4050 crs of equity, was designed to be funded by W&M's cash flows.
However, due to the acquisition debt and USL's own needs, consolidated debt continued to rise. So, although USL achieved scale and W&M continued with its good show, a large part of earnings was used for paying interest costs.
But, with Diageo planning to sell W&M to meet regulatory requirements, mosty analysts expect USL's balance sheet pressure to ease. In fact going ahead we believe Diageo's sale of W&M business will be positive for USL as it will reduce debt to the extent of around Rs 3267 crs and, consequently, cut interest cost by Rs 130-150 crs annually.
Also, it will bring down inventory level for USL, thereby improving working capital cycle.
But what should Retail Investors do Accept the open offer or HOLD ON ?
As on date the offer price premium to the current marlet price of USL has come down to Rs 9-10% which currently trades at around 2700-2750 levels.
We believe that within this kind of premium of just around 10% and a gain of Rs 200 per share it is unlikely that this open offer will go through easily. Also we believe that large HNIs and Institutional investors may not enter tender in their shares even at the relatively-attractive price as they believe that USLs prospects should change drastically once Diageo takes control of the business

Most Analysts including us believe that approximately 40% of USL's shares are held by foreign institutional investors (FIIs), do not have a good track record with tendering shares during open offers. The same is likely to be true with USL's retail investors as well.
The open offer starts on June 11, 2014, and closes on 24 June
If one takes a long term view over the next 3 years, we believe that the stock has the potential to easily double as USL is a market leader in the IMFL space which is rapidly growing at around 12-13% p.a and enjoys a strong set of brands.
With >50% of Indians below the age of 25 years and a rapidly expanding consumer base, the Indian IMFL industry is in a sweet spot. The social fabric of India is changing fast, wherein drinking is no more a clandestine affair; so much so that alcohol consumption by women too is gaining social acceptance. This has added a new set of consumers to the IMFL Industry.
The Indian liquor industry stands at 360m cases a year, including 200m cases of country liquor and 160m cases of branded IMFL. Notably, sale of the spurious country liquor is on the decline goaded by the ban on country liquor by some of the largest liquor consuming states like Karnataka.
At the same time, IMFL space has been growing at 12-13% per annum in volume terms and 15%+ in value terms from 100m cases in FY05. Within IMFL, vodka, whisky and gin are the fastest growing categories. Going forward, we expect the Indian IMFL space to maintain the growth rate of 12%+ per annum to reach 360m+ cases by FY17.
Hence it will be prudent if Retail investors wait and HOLD on to there investments here as the real big opportunity for a big re rating of the USL stock is likely to be seen now after Diageo has come in and would benefit shareholders immensely provided they are patient and long term oriented here.