Sula Vineyards, an Indian wine company, filed for their IPO in July this year amidst the market turbulence. With new issuances hitting an all time low in H1 22, this is an interesting proposition for the Indian market after a bunch of disastrous tech IPO's over the last couple of years. The valuation is a going to be a steep learning curve for me- I am not a wine connoisseur and know very little about the dynamics of the wine market or the difference between a Chardonnay and a Sauvignon Blanc. However, this lack of information might not be a bad thing after all as it helps reduce my bias in the process. With that being said, I take inspiration from one of my favourite characters from Game of Thrones i.e. Tyrion Lannister ("I drink and I know things") and dive into the realm of value creation for Sula.
Company history and overview
Sula Vineyards was founded in 1999 by Rajeev Samant, an expat working with Oracle in the US who returned to India in the 90s. A visit to his native land in Nashik brought the idea of growing wine grapes which subsequently led to working in a small winery in California for 3 months and then translated into the birth of Sula- a wine company which would symbolize rich Indian heritage. Over the last few years, Sula has become the largest wine seller and producer in the country and captured a market share in excess of 50% and across variants i.e. red, white and sparkling through strong brand recognition and a diverse portfolio catering to different price points. Moreover, the company has been the dominant player across four price segments in the market through 56 wine labels and with high market share in the "Elite" and "Premium" category.
The company generates revenues primarily through two sources: the "core business" which involves production, distribution and sale of wines and "wine tourism business" which is more of an experience complementing the core business and includes service revenues from wine tourism i.e. resorts and tasting rooms. This also reflects in the revenue split with wine tourism business generating less than 10% of revenues over across years. Below is the historical revenue trajectory along with split for revenue from operations reported by the company in the prospectus:
Note that revenue growth has declined due to the pandemic and lockdowns over last couple of years but the post COVID recovery is yet to be completed- F22 revenues are at 87% of pre-covid levels. The increased share of premium wines within the portfolio and strategic pivot to increase penetration of own brands vs third party brands drive the F22 sales growth. The company also benefits from tax subsidy- a VAT benefit from the state of Maharashtra under Wine Incentive Promotion Subsidy scheme wherein 80% of the VAT paid is refunded which they have included as other operating revenues. With the bulk of installed capacity in the state, the increase in manufactured goods in the state is directly correlated to the incentive realised.
In terms of inorganic growth, Sula has sparingly acquired assets of different wineries over the last 5 years with the acquisition of Heritage winery assets diversifying manufacturing operations to state of Karnataka with significantly lower taxes and duties. However, not all M&A activity has played out as intended with divestiture of majority stake in the beer business over last year.
The wine market diagnostic
To get a sense of the potential growth opportunity for Sula, I start by looking at the estimates and consumption patterns for the alcohol beverages and wine market in India and globally. The global alcohol consumption is estimated to reach 6.6 litres in 2025 with spirits dominating in terms of pure alcohol contribution. However, beer is the most popular alcohol beverage from a consumption standpoint with wine and sprits almost at an equal standing.
The country view of alcohol consumption reveals some interesting insights. While most of the major developed nations have considerable wine consumption, the wine consumption for developing countries remains low. In case of India, the overall consumption of wine is less than 1% vs 13% global average with 90% consumption coming from spirits. The obvious comparison with China is tempting but reflects the stark difference between two countries- total consumption for China is 4x more than India and wine consumption is 40x higher. While the company argues and positions this as a huge growth opportunity, I'm cautious in sharing their optimism on swift changes in consumer tastes and preferences. China has a higher per capita disposable income and bulk of the sales occur through ecommerce online marketplaces which isn't the case in India. Moreover, there is evidence of lack of wine knowledge and a considerable learning curve resulting in fewer new wine drinkers entering the market which is going to be a significant barrier for the Indian market as well.
The Indian alcohol market size is estimated to be $33 Billion in 2020. While the overall market has declined in 2021, it is expected to grow at an annualised rate of 11% with the potential market size of $43 Billion in 2025. In terms of category, 2/3rd of the market is currently captured by Indian made foreign liquor (IMFL) followed by country liquor and beer. The Indian wine market, although nascent vs other beverages, is expected to grow at a CAGR of 20% from 2021 and reach a total value of $425 Million (INR 32 Billion) in 2025. Based on the information provided in the prospectus (pain in the neck with more than 400 pages) and google search, the key themes for the Indian wine industry can be summarised below:
+ High concentration across market share and consumption- The Indian 100% grape wine market is dominated by 2-3 players which contribute ~ 80% in value terms- Sula, Fratelli Wines and Grover Zampa. The top wine producing states of Maharashtra and Karnataka are also the top consuming states with ~ 57% of the total market. With the consumption heavily skewed, low penetration is a challenge with wine consumption predominately restricted to metro cities. This outlines the challenge of educating the consumers and creating awareness in Tier 1 cities and beyond which is going to be an uphill task.
+ Growth momentum driven by premium segment- The growth trajectory of the wine market over the last few years has been driven by the top end of the value spectrum (in sync with global trends) as cheaper fortified wines lose market share at the expense of 100% grapes wines. Based on the price cohorts below, the elite and premium segments are expected to outgrow other segments over the next 5 years with all major players addressing the demand through higher portfolio options of elite and premium wines.
+ Diminishing returns for foreign wine players - The share of imported wines has remained considerable with 17% of market in 2020 and projected decline to 13% in 2025. Australia is leading country of import in terms of volume and the rest of the market is fragmented. Imported wines face stiff challenge vs domestic players as high import duty of 150% makes them less competitive. Alcohol giants like Diageo and Pernod Ricard have tried to locally manufacture wines and entered the domestic market but faced multiple roadblocks in penetration and scaling up and finally exited the space to focus on their spirts business.
+The labyrinthine of regulations- The regulatory complexity of Indian alcohol market cannot be understated. Each state has their own excise policy along with variation in legal drinking age limit and various duties etc. Moreover, advertising of alcoholic drinks is prohibited directly or indirectly in India which inhibits avenues to reach mass audiences through different media channels. This will be a considerable roadblock for alcoholic drinks like wine which require high consumer education to increase penetration.
Shaping the Sula business story
While the company lays out plethora of information on the business nuances across the prospectus (which pulls you in different directions), the below points standout:
+ Production cycle and facilities- The harvest period for grapes is restricted to 4 months from December to March 2020 followed by fermentation and ageing. While the below info graph from the prospectus summarises the production process in a nutshell, two key things stand grab my attention: the long gestation period across the value chain especially for premium wines which are aged in oak barrels. The second thing which stems out is a high cash conversion cycle- the long gestation period would lead to a high days inventory outstanding which means a lot of cash of the business is tied down in working capital.
The manufacturing capabilities are spread across 6 wineries with all of them located in Maharashtra and Karnataka. With an installed capacity at 14.5 Million litres, capacity utilisation for FY22 at 80% post the lockdown drop to 65% in 2021 with resurgence and demand and additional supply through York Winery acquisition.
+ Procurement and Distribution- Sula has de-risked supply through execution of long-term grape contracts with farmers for up to 12 years for almost 84% of the vineyards. The company also has an expansive distribution network in play with presence in 25 states and 6 Union Territories in India. The sales channels are split through On-Trade, Off-Trade and Direct to customer sales through wine tourism business with secondary sales dominated by off-trade channels. On the Wine Tourism side, the company operates two vineyard resorts with sales driven by room revenue, F&B and sale of wine/liquor.
I also took a quick look at the financial summary provided and highlight the bridge to EBIT along with some key KPI's below:
Note that EBIT margin improvement from cost standpoint is largely driven by cost of goods improvement whereas most of the other components have not seen material variation over last three years. The strategic shift through discontinuation of third party unprofitable brands, cost rationalisation across raw materials and packaging and divestiture of PADPL, the beer and spirits subsidiary reasons drive this positive trend. The upward margin trajectory is slightly offset in FY22 by higher other operating and wine processing expenses. Something that sticks out though is the cash conversion trajectory- large chunks of capital remains tied in inventory and payables with average cash conversion time worsening over time. The other key insight is that the company currently generates returns below the cost of capital- something that I need to keep in mind while building my endgame.
After an exhausting prospectus read and google search to get a flavour of the business and industry, I have the foundation for my Sula narrative which will play out across the following dimensions:
+ Market dominance through mainstream wine adoption- Sula's initial foray in the wine market over 26 years back and subsequent transformation of wine has enabled it to be a market leader in the domestic wine industry with strong competitive advantages across the value chain and a product portfolio that caters to the entire wine market. With a wide distribution network and strong penetration through on-trade and off-trade routes, I expect them to consolidate their market leadership going forward at the expense of other domestic players i.e. Grover Zampa and Fratelli wines which only have 10% of installed capacity vs Sula.
+ Industry tailwinds and strategy shift to drive margin uplift- The transition of industry trends and company product mix to premium wine categories should drive higher profitability going forward (in line with last 3 years) along with cost efficiencies. However, this also creates a dilemma- will the high premium prices be a stumbling block to market expansion, especially in a price sensitive market like India which is highly dominated by spirits? The company would also directly compete with foreign wines which might
+ Imported wines: Trade deals to drive resurgence? While the share of imported wines has been low, there might be an impetus in the next 5-10 years with import duties drastically reducing for the same. A case in point here is Australia: with the recent Australian-India free trade pact signed, the duties on imported Australian wines go down significantly after the pact is enabled which makes them highly price competitive to elite and premium offerings from Sula. The good news for Sula is that the impact of this change might be diluted by the fact that major tax reduction comes only after 10 years.
+ Customer penetration: Between rock and a hard place Wine market expansion is critical for Sula to achieve it's growth ambition but customer education is going to be an uphill task. To Sula's credit, they have tried to workaround the mass media advertising prohibition through innovative marketing concepts and live experiences like wine tourism business, product placement in TV shows and Sula festival. But the fact remains that most of the consumption is concentrated in a few metro cities with very low penetration beyond. With wine already behind the eight ball to spirits in India, Sula will have to continue to evolve selling proposition of wine vs other alcohols and leverage new avenues for customer outreach and consumption.
The Sula Narrative
"Sula is a wine company which will maintain its leadership in a growing market through brand recognition, scale and competitive advantages across the value chain. The company is well positioned to drive higher profitability through pivot from value to premium segments along with industry tailwinds. Capital intensity will remain high but move towards industry average over time and default risk remains low. While Sula will continue to drive visibility through experience driven marketing, the steep learning curve for wines and limited wine penetration beyond major cities will remain significant hurdles vs other alcoholic beverages"
Connecting the numbers
+ Revenue growth- The growth estimates for Sula are primarily driven by two key assumptions- the size of the wine industry and company's market share. As per the prospectus, the domestic wine industry is expected to grow at a CAGR of 23% from 2021 with total market size of INR 25 Billion in 2025. Based on my narrative, I assume that the company will continue to be the market leader, and give them a market share of 55% in 2025. In rupee terms, this implies revenues of 13.8 Billion which transitions to grow at economy growth rate of 4.6% in year 10. Over a 10 year horizon, revenues increase by almost 10x to INR 39 Billion. This might be a bit optimistic but I believe that if the market size grows as expected, then Sula should be able to capture a large piece of the pie based on their market position vs competition.
+ Operating margins- The current pre-tax operating margins for Sula are ~ 22%. For the endgame, I assume a pre-tax operating margin of 28% in year 10 which is in-line with the average margin for alcoholic beverage companies. This is not a clean sample based number as it will have mix of companies with different alcohol businesses rather than pure-play wine companies but hopefully the larger sample should work in my favour. The shift to higher end spectrum of wine portfolio propelled by changes in industry dynamics and pricing power by leveraging it's brand name should help Sula further accelerate profit trajectory. To keep things simplistic, I assume that margins follows a linear increase towards the target margin over the 10 year forecast period.
+ Reinvestment- The proxy for reinvestment would be capital turnover ratio and the wine business is quite capital intensive with high working capital requirements. The current sales to capital ratio for Sula is 0.7 which means that for every rupee invested in the business, the company generates 0.7 rupees in sales. I assume the ratio to stay constant at 0.7 initially but eventually transition to 1.3 in year 10. While ROIC is below cost of capital currently, the higher capital efficiency along with margin improvement means that I am assuming a positive ROIC-WACC value spread of ~ 7% in perpetuity, in line with industry averages.
Cost of Capital
The cost of capital for Sula is 12.4% in Indian rupees. Note that the key input of market value of equity of INR 37.5 Billion is based on media reports which expect avg. proceeds of INR 12-14K Million from sale of 25.5 million shares as the IPO has not been priced yet by the bankers. I pay homage to the old saying of "when in doubt- take averages" and use an average of this range to come up with the market value of equity. Post the high growth period, the cost of capital declines to median cost of capital of 11.2% for Indian companies.
From operating value to equity value
Using a 10 year explicit forecast period, I project out the free cash flows for first 5 years of high growth, transition period from year 6-10 and stable growth period post 10. For the terminal value, growth is capped at the current risk free rate i.e. 4.6%, ROIC of ~ 19% and cost of capital of ~ 11%. The value of operating assets is INR 26.5 Billion. Subtracting out debt and adding back cash and equivalents leads to a value of equity of INR 24.2 Billion. Taking out the value of options and dividing by the shares outstanding gives me a value per share of INR 300 which is 37% lower than the expected IPO price as per media reports of INR 478 per share. The pricing number might be refined once the book building process is over but based on my narrative there is a clear gap between price and value.
Factoring in the uncertainty
To capture the the risk in my key value driver assumptions, I looked at various combinations of revenue growth in the high growth phase and target operating margin in year 10 which solve for the current value per share. Note that the base case assumes ~ 34% growth at expected margins of ~ 28% for value of INR 300 per share. Is the speculated price of INR 478 possible? Of course! But to deliver those expectations, Sula will need to generate annualised growth of 40%+ in first five years and target margins of 28%+ in Year 10 and beyond. In my opinion, this would be hard to achieve as there will be roadblocks in terms of existing consumer preferences towards spirit and beer and limits to cost efficiencies.
To further capture the volatility in my key assumptions, I did a Monte Carlo simulation by assigning distributions to overall market size (lognormal), market share (triangular) and operating margin in year 10 (uniform). This helps me in incorporating the wide values around these key variables rather than just point estimates. After 500K simulations, the median share price of INR 247 which is below my base case value of INR 300. Based on my assumptions, the expected IPO price is close to 95th percentile of the distribution. There are possibilities to achieve this price but the pathways remain slim at best.
Final thoughts
The Sula IPO is an exception for the Indian markets rather than the norm: with a bunch of young money losing tech/fintech start-ups going public recently, this is a company which has a couple of decades of history behind it and a successful (profitable) track record of scaling the wine business. The next phase of publicly listing in the markets will be a challenging one- the company isn't tapping the market for capital yet but will be under the performance lens every quarter. It will also be interesting to see the price band of the IPO which should be out in the next few weeks and might warrant an update to my market value of equity. The rationale of buying into the Sula story is the strong brand recall and allure of the potential Indian market and parallels to growth in China. However, the expected IPO price based on media reports is still too rich even after factoring in the optimism in the story and the numbers. I am intrigued to see how these variables play out on the street. In the meantime, I'll sign out of this valuation for now (with a glass of whisky by my side).
Note: The content on this blog reflects the personal views of the author and should not be considered as an investment advice or recommendation.
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