McLeod Russel Re-Initiating Coverage Report By Sharekhan

Steaming hot; Re-initiate with a positive stance

Key points

Tea prices – At an inflection point: Global tea production is likely to record a decline in 2017, primarily on account of crop losses in Kenya (one of the world’s largest tea exporter). Kenya’s production for January 2017-September 2017 was significantly lower by 12.4% YoY at 303.55million kg (mkg) owing to unfavourable weather conditions experienced during the first quarter of the year. For the rest of the season, production is expected to be lower in Africa. In India, tea production up to August-end was ahead of last year’s production by 33mkg. However, in September, there was record loss of crop of around 44mkg due to bad weather and total production in September was down by 23.3% YoY. Nevertheless, there is continuous rise in tea demand in regions such as Europe and Iran, which enhances the gap of demand and supply. Reduced global availability of tea is likely to result in the continuation of an upward price trajectory across most international auction centres, which, in turn, would push tea prices in India to much higher levels over the next couple of years.

Rising tea prices to propel McLeod margins: McLeod Russel (McLeod) is the largest tea producer in India. Thus, the company will benefit from rising demand supply gap in the global tea market. For FY2018, though production is expected to be flat on a YoY basis, an uptick in realisation will help improve margins of the company. We expect realisation for the company to rise by 8% in FY2018. While for FY2019 and FY2020, we expect average realisation to increase by 15-16%. Moreover, as 45-50% of cost is fixed in nature (in terms of employee cost), operating leverage will lead to margin expansion going ahead. We expect operating margins to rise to 11.3% in FY2020 from 4.7% in FY2018.

Commoditised business with a lean balance sheet: Though McLeod is in the business of tea production, which is a commoditised business, it has a strong balance sheet with debt equity being 0.4 times in FY2017. Moreover, its working capital cycle was under control at 48 days in FY2017. With the expected increase in profitability, we expect cash flows to improve further, which will help the company to support its business operations in future. Further, return ratios are expected to improve with RoE and RoCE standing at 11.7% and 13.5% by FY2020E as a gainst 3 .3% a nd 6 .4%, r espectively, i n FY2017. ŠŠ View – Re-initiate coverage with a positive stance and expect 18-20% upside from here: McLeod is the largest privately held tea plantation company in the world. Reduction in global tea production and continued high demand for tea will lead to rise in tea prices, both in domestic as well as export markets. We expect revenue to report a CAGR of 17% from FY2017-FY2020E and profit to post a CAGR of 60% during the same period. The stock is currently trading at 6.6x its FY2020E earnings. We had booked out of stock at Rs.246 more than two years ago, sensing the downturn in tea prices. However, the scenario is changing for good now. Hence, we re-initiate coverage with a positive view on the stock and expect potential upside of 18-20% from here.