jyothy laboratories initiation jun 7breport.myiris.com/mapespl/jyolabor_20110607.pdf ·...

JYOTHY LABORATORIES

Mr. White buys Mr. White

June 7, 2011

Laxmi Deepak, CFA

[email protected]

+91.22.6154.4593

BBG code : JYL IN

Market Data

Rating BUY

Price (6 Jun'11) (INR) 205.9

52 Week Range (INR) 322.8/ 174.8

TP – Mar’13 (INR) 300

O/S Shares (Mn) 80.6

Mkt Cap (INR Mn) 16,602

Mkt Cap (US$ Mn) 371

Daily average volume 183,748

Share Holding Pattern : 31-Mar-2011

Promoter and Promoter

Group

63.16%

FII 15.59%

DII 15.13%

Non-Institutions 6.12%

Relative performance to Sensex

© MAPE Securities Private Limited. For private circulation only. Please read important disclaimers on the last page. This document has been prepared from

publicly available information and is not an investment advice.

Attractive Entry Point for Transformation Story

We initiate coverage of Jyothy Laboratories (“Jyothy”) with a BUY rating. Our March

2013 price target of INR 300 implies 45% return over the next 22 months. Following the

sharp sell-off in the last couple of months due to weak results over the recent quarters

and skepticism regarding the Henkel India acquisition, Jyothy currently trades on a

FY2013E PEG ratio of 0.8 (versus the peer group average of 1.3), on our numbers.

Dependence on Ujala Supreme to come down, Detergents and Dishwash hold the

key. Post the acquisition of Henkel India, we believe Jyothy’s dependence on its

flagship product Ujala Supreme, which dominates a category that is in structural long

term decline, will come down from 31.1% in FY2011 to 18.4% in FY2012E. As a result,

the overall growth profile is likely to improve as we expect Jyothy to drive penetration

and distribution-led growth in detergents and dishwash.

Building blocks in place for a bullish long term thesis. Significantly higher growth and

profitability in a revitalised Henkel India business coupled with continued growth at

Jyothy’s detergent and dishwash brands drives our very conservative price target of

INR 300. Over the last two quarters, the rollback of trade margins for Maxo has driven

a deceleration in volume and a higher advertising spend behind the national rollout of

the detergent brands has resulted in a contraction in operating margins. Further,

investors have not been convinced regarding the suitability of the acquisition of Henkel

India. All these factors have resulted in the share price falling 23.7% YTD compared to

the 10.2% decline in the broader market Sensex and a gain of 4.8% in the FMCG index.

But we believe sentiment could be near a bottom, as the decline in volume growth at

Maxo should moderate and the increased advertising spending will start to result in

detergents gaining traction with increasing volumes in FY2012. So while the market

concerns should be taken seriously, it seems from here that more might go right than

go wrong as we move through FY2012.

We believe the concerns of investors regarding the ability of Jyothy to turnaround the

Henkel India business, while legitimate and well founded, are perhaps running ahead of

the real near and long-term risks, as we show in our analysis in this report.

Transformation drives visible and achievable EPS growth. Jyothy has undergone a

major corporate transformation with its acquisition of Henkel India to become one of

India’s leading FMCG companies. The merger with Henkel India gives Jyothy a portfolio

of well recognised brands like Henko, Mr. White, Fa, Pril, Margo and Neem, entry to

the personal care segment and immediate scale compared to its current operations in

the detergent segment. We project 50% EPS CAGR in FY2012-15E fuelled by: (a) strong

organic revenue growth in both the Jyothy and Henkel India businesses and (b)

substantial margin expansion on the back of cost synergies at Henkel India. We expect

the robust earnings growth to support the re-rating of the stock into FY2012 and

FY2013.

Risks. Integration of the Henkel India acquisition remains a key monitorable.

Initiating Coverage

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Jyothy Laboratories

Sensex index

FY2012E FY2013E FY2014E FY2015E

Revenue 11,289 13,785 16,345 19,171

growth (%) 8.4% 22.1% 18.6% 17.3%

EBITDA 860 1,615 2,134 2,640

margin (%) 7.6% 11.7% 13.1% 13.8%

EPS 6.41 13.05 17.51 21.61

PER (x) 46.8 23.0 17.1 13.9



FMCG MAPE Securities Private Limited

We initiate coverage of Jyothy Laboratories with a BUY rating. Jyothy has undergone a major

transformation with its acquisition of Henkel India to become one of India’s leading FMCG

companies. It has expanded its presence in the fabric care and dishwash segments and gained

entry to the personal care segment after its acquisition of Henkel India.

Exhibit 1: Product basket post acquisition

Source: Company

We think that the recent sell-off provides an attractive entry point for the stock, which trades

on a FY2013E PEG ratio of 0.8, well below its peer group average of 1.3, on our numbers. We

believe Jyothy offers highly achievable and visible EPS growth over the next three years. The

key EPS drivers are:

• Strong revenue growth (19.3% CAGR in FY2012-15E) fuelled by a) organic growth in the

dish wash and the detergent segments, which are benefiting from national rollout of the

Exo and Ujala Technobright brands respectively b) acceleration of the Henkel India

business driven by new management

• Significant EBITDA margin expansion (615 bps in FY2012-15E) driven by cost synergies

between Henkel India and Jyothy businesses that look achievable to us

We see two main risks to our investment thesis …

• a mature detergent market where growth is modest and competition is intense; and

• integration risks associated with any large merger.

… but the risk-reward trade-off looks highly favourable

Our base case fair value of INR 300 implies 45% upside potential from current levels and

assumes more conservative long-term growth rates and margins relative to management

guidance.

FabricCare MosquitoRepellent DishwashingProducts Personal Care

Product Basket post Acquisi on



MAPE Securities Private Limited Jyothy Laboratories

Exhibit 2: Company guidance versus our assumptions for Henkel India

FY2013E FY2014E FY2015E

COMPANY GUIDANCE

Sales Growth (%) 47.1% 40.0% 43.0%

EBITDA Margin (%) 10.0% 12.0% 14.0%

Adv/Sales (%) 16.0% 14.0% 12.0%

OUR ASSUMPTIONS

Sales Growth (%) 22.0% 22.3% 15.7%

EBITDA Margin (%) 2.3% 6.0% 6.8%

Adv/Sales (%) 16.0% 16.0% 16.0% Source: Company, MAPE Securities Estimates




Jyothy’s acquisition of Henkel India

Acquisition details

On May 6, 2011 Jyothy announced that it had successfully acquired a majority stake in Henkel

India. The acquisition will catapult Jyothy Laboratories into one of the leading FMCG

companies in India. Jyothy currently controls 65.87% of Henkel India and has launched a

mandatory open offer for an additional 20%. Jyothy will pay INR 3,308 million to acquire the

85.87% stake in Henkel India. In addition, Jyothy bought Henkel AG’s outstanding preference

shares for a cash consideration of INR 439 million. The implied Enterprise value works out to

INR 8,042 million as Jyothy has also taken over the debt of INR 4,296 million on Henkel India’s

balance sheet. The implied EV/Sales multiple for the deal is 2x based on Henkel India’s FY2010

revenue. We believe the acquisition of Henkel India by Jyothy has a strong strategic rationale

and leaves room for relevant value creation opportunities.

Our view

In our view Henkel India is a good fit for Jyothy and our analysis suggests that a merger is

appealing on several fronts. While we highlight the benefits below we discuss the details in the

following section:

• The acquisition scales up Jyothy to one of the leading FMCG companies in India with

consolidated proforma FY2011E revenue of INR 10,412 million compared to a standalone

revenue of INR 6,195 million

• The acquisition helps Jyothy pave the way for a more balanced revenue stream by

significantly enlarging the portfolio of products and reduce its exposure to Ujala Supreme.

In our estimates, Jyothy’s exposure to Ujala Supreme would reduce to 18.4% of

consolidated revenues in FY2012E versus 31.1% of standalone revenues in FY2011E

• Value creation through both revenue and cost synergies. We believe the acquisition will

create significant value given the existence of revenue and cost synergies

Consolidated Financials

Jyothy has raised short term debt of INR 6,000 million to fund the acquisition. We have

considered two scenarios in our analysis:

• Scenario 1: This assumes Jyothy funds the acquisition of Henkel India with debt of INR

6,000 million

• Scenario 2: This assumes Jyothy dilutes 15% of its equity at INR 300 per share and uses the

proceeds to repay the debt raised to finance the acquisition of Henkel India

We assign a high probability that Scenario 2 is the likely outcome in FY2012 and our estimates

are predicated on Jyothy raising fresh equity from a private equity placement and returning to

a debt free status.

In this report we have consolidated Jyothy and Henkel India from FY2012E. The combined

entity should generate:

• Revenue - we estimate INR 11,289 million of revenue in FY2012E, of which INR 7,609

million is from Jyothy and INR 3,679 million is from Henkel India. We estimate the

consolidated revenue will be boosted by the turnaround in the Henkel business from

FY2013 onwards.

• EBITDA - we estimate INR 860 million of EBITDA in FY2012E, of which INR 1,099 million is

from Jyothy while Henkel India would contribute a loss of INR 240 million. For the

following years we expect EBITDA to grow much faster than revenue supported by the

benefits flowing through from synergies.

• Net debt - According to our estimates, the consolidated entity will continue to have a

healthy balance sheet in FY2012E with a net cash position of INR 1,582 million.

We opine that the acquisition will be EPS dilutive in the near term as Jyothy makes the

necessary investments to grow the Henkel India business. We note however, that longer term

the incremental earnings potential from this acquisition should be significant once Henkel India




is fully integrated and Jyothy has more time to leverage a larger platform with a more diverse

product offering. Based on our pro forma forecasts, the FY2012E and FY2013E EPS will drop by

49.6% and 16.1% compared to our standalone forecasts but from FY2014E onwards the

acquisition will be increasingly EPS enhancing with an EPS uplift of 9.1% in FY2014E and 13.3%

in FY2015E.

Exhibit 3: Near term dilution but significant long term accretion

INR FY2012E FY2013E FY2014E FY2015E

Standalone EPS 12.72 15.56 16.05 19.08

Consolidated EPS - Scenario 1 3.19 10.48 15.78 20.64

Accretion/Dilution -74.9% -32.7% -1.7% 8.2%

Consolidated EPS - Scenario 2 6.41 13.05 17.51 21.61

Accretion/Dilution -49.6% -16.1% 9.1% 13.3% Source: MAPE Securities Estimates




Why Henkel India and Why Now?

Revenue diversified from dependence on Ujala Supreme fabric whitener

Jyothy’s flagship product Ujala Supreme is dominant in the liquid whitener market with a ~72%

market share by value. However, the fabric whitener segment is in structural decline and

Jyothy has been trying to diversify its revenue to reduce its dependence on one single product.

While Jyothy has been attempting to diversify into new product categories by piggybacking on

the Ujala brand name, we believe the brand was getting stretched and in the long term the

brand equity would have suffered. Jyothy extended the Ujala brand into detergents and

entered the Mosquito repellant and dishwash markets through the Maxo and Exo brands. This

has resulted in a decline in contribution from Ujala Supreme but it still contributes 31.1% of

total revenue in FY2011E.

Henkel India’s brand portfolio includes Henko and Mr White in detergents, Pril liquid dishwash,

Margo soap, Fa deodorants, Neem toothpaste and Bref surface cleaners. Jyothy has been

interested in acquiring the Henkel India business for a long time in order to acquire this

bouquet of brands to hasten the process of reducing its dependence on Ujala Supreme. The

biggest standout for Henkel India was that its product offering was the closest in nature to

those of Jyothy and it represented the most natural fit for Jyothy. From a commercial

standpoint, we believe that the transaction will enable Jyothy to reduce its dependence on

Ujala Supreme (Exhibit 4) while complementing the other products offered by Jyothy, namely

detergents (Ujala Supreme and Ujala Technobright), dishwash (Exo) and personal care (Jeeva).

Also, the Henko, Fa and Pril brands are players in the premium segment and are well-

positioned in the context of the ongoing consumer shift towards premium brands.

Exhibit 4: Contribution of Ujala Supreme to total revenue falling

30.6% 31.1%

18.4%16.5%

15.1%14.1%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

FY2010 FY2011E FY2012E FY2013E FY2014E FY2015E

Source: Company, MAPE Securities Estimates

Enhanced distribution network

Jyothy has one of the most extensive distribution networks among Indian FMCG companies

with a total reach of 2.9 million outlets through 3500 distributors. However its reach in the fast

growing modern retail channel is limited and modern trade accounts for only 2% of its

revenue. Henkel India on the other hand has only 750 distributors and a total reach of 750,000

outlets but is extremely strong in the CSD and modern trade formats which account for 33% of

its total revenue. Henkel India's predominantly urban presence (70% of sales) neatly

complements Jyothy Lab's semi urban and rural strengths (70% of sales). The Henkel India

acquisition gives Jyothy access to the modern trade distribution network and will also enhance

its skills in marketing and management of modern trade channels, which is relevant in a

changing Indian retail environment. On the other hand the acquisition provides an opportunity

for Henkel India to gain exposure to the large rural and semi-urban market through the

distribution network of Jyothy. Distribution is always a key for success in the FMCG sector and




with Henkel India's distribution network being complementary to Jyothy's own network, the

combined distribution can be leveraged to vend existing brands to new consumers. While the

considerable scope for cross selling opportunities will have a positive impact on sales growth,

we have not explicitly built in any revenue synergies into our estimates, leaving room for

upside to our estimates.

Opportunity to benefit from the turnaround in the business

Another fact that attracted Jyothy to Henkel India was the potential to engineer a turnaround

and reap the benefits. The Henkel India business has been making operational losses since

FY2004 despite revenue growth in the range of 15% per annum and gross margins in the low

30’s. In fact, in 2005 Jyothy and Henkel AG came close to finalising a merger of Henkel India

and Jyothy but the deal fell apart over disagreement about majority control of the combined

entity. However, by 2010 Henkel AG seems to have given up hope that it would be able to

affect a turnaround in the Henkel India business on its own and elected to cut its losses by

selling out.

Substantial merger synergies should significantly accelerate EPS growth

Raw material procurement. Henkel India currently sources the main raw material linear alkyl

benzene (LAB) exclusively from Tamilnadu Petroproducts, who was the JV partner in the

business along with Henkel AG. Prior to the acquisition of Henkel India by Jyothy this exclusive

contract has been terminated and Jyothy will now be able to procure its LAB requirements

from its current suppliers at a much more favorable rate. Jyothy will also benefit in

negotiations with its current suppliers due to the larger scale of the combined entity. The

combined savings from the new sourcing arrangements is expected to be around 2% as per

management guidance. Jyothy uses the same suppliers as its competitors and we believe these

suppliers will not have any capacity constraints to cater to Jyothy’s additional requirements.

Optimisation of manufacturing. Henkel India outsources almost 80% of its production to third

party manufacturers in line with its business strategy of concentrating on marketing and

distribution activities. On the other hand Jyothy prefers to manufacture its products in its “in

house” manufacturing facilities. Post the acquisition Jyothy intends to move Henkel India’s

outsourced production in house leading to a 2 – 4% savings in manufacturing costs. Jyothy

expects to benefit from the savings on an immediate basis without any additional investment.

We believe apart from the production of Fa, which will continue to be the responsibility of

Henkel AG, Jyothy has the spare capacity and the technical knowhow to easily transfer the

production to its own facilities. Jyothy has confidence in its ability to reduce manufacturing

costs as a result of a detailed review the company undertook prior to the acquisition to

benchmark the manufacturing costs of Henkel India’s products at its facilities compared to the

current structure.

Jyothy has stated that it will be able to increase Henkel India gross margins from 32% to 36 –

38% in FY2013E post the changes to the manufacturing and supplier setup. Sustainable gross

margins for the Henkel India business post FY2013 is likely to be in the range of 38 – 40%.

Loss carry forwards. Jyothy’s unit in Uttaranchal enjoys tax exemption status till FY2013

enabling Jyothy to pay only the Minimum Alternate Tax. Once the merger with Henkel India is

complete in the next 6 – 9 months, Jyothy will receive a tax shelter from Henkel India's INR

5,000 million accumulated losses. Jyothy will benefit to the extent of INR 1,500 million and will

be able to extend its tax breaks beyond FY2013.

We also believe that the following additional synergies could be extracted:

• Cost reduction savings from overheads optimisation as Jyothy runs a much leaner business

compared to Henkel India

• Rightsizing the workforce at Henkel India by retaining only the top performers




A look at the issues of the day

In our view, there are six key concerns among investors regarding the acquisition of Henkel

India.

#1: Lackluster revenue growth in the Henkel India business

In Henkel India’s most recent FY2010 (December Year ending) results, sales were lower by

9.9% and a loss was recorded at the EBIT and EBITDA level. The deceleration was evident

across product categories with the Detergents & Cleaners segment and the Cosmetics segment

revenue down by 10.1% and 9.3% respectively while the EBIT margins contracted by 420 bps

and 289 bps respectively.

Henkel India has been unable to grow its top line at a sustained rate as shown in Exhibit 4.

Exhibit 5: Henkel India revenue trends

FY2007 FY2008 FY2009 FY2010 FY2011

Revenue growth 13.5% 15.6% 12.8% 9.7% -9.9% Source: Company

We believe that there were a few fundamental reasons for the below par performance:

• Within the global footprint of Henkel AG, the Indian business represented a very small

portion (~0.6% of total global turnover in FY2010), which resulted in inadequate attention

from the German parent towards the Indian subsidiary

• The budgets and marketing strategy for each product line were driven by the global

headquarters of Henkel AG in Germany with limited input from the team in India

• There was significant churn among the coordinators appointed by Henkel AG for the India

business which resulted in a disruption to the business strategy at periodic intervals

• There was a reluctance to invest behind the brands and on expanding the distribution

network which resulted in a lack of momentum for the business

• In our view, Henkel India adopted a flawed marketing strategy by depending on a

promotions led push strategy to drive sales instead of investing behind the brands through

advertising campaigns to ensure a pull from the consumer end

We believe the Jyothy has the expertise and the right strategy to dramatically alter the

performance at Henkel India due to the following:

• Focused attention on the business as ensuring the success of the acquisition will be of top

priority to management

• Marketing and product positioning strategy to be driven by Jyothy management who have

extensive insights into the behaviour of Indian consumers and the requirements for

brands to succeed in the Indian market place

• Ability to pursue a long term strategy with stable management in place

• Strong distribution network already in place with access to 2.5 million outlets

• A willingness to invest behind the brands with management indicating that they will spend

16% of sales on advertising at Henkel India compared to Jyothy’s current spend of 8% and

an industry average of 8 – 12%

• Significant reduction in the promotions strategy of Henkel India in order to ensure the

premium positioning of the brands among consumers

In our view if volumes are declining for any prolonged period of time, there is clearly

something wrong with the consumer proposition. If fewer consumers are buying the product,

that means either the brand equity is too low, pricing too high or the quality of product isn’t




good enough. In Henkel India’s case we believe the product quality is comparable, if not better,

than competitor products and while there are issues with sub-optimal pricing, the low brand

equity for the various products is the primary reason for the subdued performance. We believe

that the willingness of Jyothy’s management to invest on reviving the brand equities will result

in short term pressure on margins but will pay off in the long term with a healthier and

sustainable business.

#2: Competitive intensity in the detergent segment

The INR 80 billion detergent powder segment is broken down into 3 tiers: the mass tier (80% of

overall volume, 60% of overall value), mid tier (12% volume share, 20% value share) and

premium (8% volume share, 20% value share).

The top three players in each tier are shown below:

Exhibit 6: Top players in the detergent segments

Tier Price range (INR/kg) Value Market Share

Wheel (18.3%)

Ghari (16.9%)

Nirma (7.2%)

Tide (9.8%)

Rin (5.3%)

Sunlight (2.4%)

Surf (11.5%)

Ariel (6.1%)

Henko (1%)

Mass 30 – 35

Mid 65 – 75

Premium 140 - 160

Source: MAPE Securities Estimates

The consolidated entity will be the fifth biggest player in the detergent powder segment

behind Hindustan Unilever, Ghari, Nirma and Procter & Gamble. In our view the established

players are unlikely to change their strategies due to the combination of the Henkel business

with the Jyothy business as Jyothy intends to be a rational player focusing on value share with

no intention to disrupt the market.

We believe the focus of all the major players would be to gain share from the smaller and

regional brands instead of competing amongst themselves. The wildcard among the major

players in the segment is Procter & Gamble who could intensify its focus on gaining volume

share at the expense of margins forcing all competitors to follow suit. We believe that this

scenario is quite unlikely in the future as margins for all competitors have fallen drastically

from historical levels reducing the flexibility to pursue a volume only strategy. We note that

following price cuts in early 2010, Hindustan Unilever hiked Rin prices by 8% while Procter &

Gamble indirectly hiked prices of Tide by 12% in September 2010 in order to protect margins in

the face of rising input costs. Also in a change of strategy under the new Unilever Global CEO

Paul Polman, Hindustan Unilever has decided to focus on maintaining volume share

irrespective of the impact on its margins in case a price war breaks out. The new strategy

reduces the incentive for Procter & Gamble to cut prices to gain market share unlike in earlier

years when it was able to gain market share while Hindustan Unilever concentrated on

maintaining margins.

In the detergent market the mass tier has the maximum competitive intensity due to the

presence of a large number of local players who are price warriors. Jyothy’s exposure do this

segment is through the Chek brand, which we estimate will contribute only 5.9% of Jyothy’s

total detergent revenue in FY2015E. As such, while Jyothy would still have to negotiate a very

competitive environment we believe it will avoid the brunt of the competition by focusing on

the mid-tier and premium segments.




We have assumed conservative growth rates for the detergent business and the success of the

acquisition will not be contingent on a rapid increase in market share. We estimate Jyothy will

be able to increase its market share in the detergent segment from 3.6% currently to 4.0% by

FY2015E.

Exhibit 7: Detergent Revenue by Brand

Brand

Revenue

(FY2011E)

(INR mn)

Value Share of

detergents

(FY2011E)

Revenue

(FY2015E)

(INR mn)

Value Share of

detergents

(FY2015E)Henko 1,317 1.60% 1,878 1.50%

Ujala Detergent 722 0.90% 1,497 1.20%

Mr. White 516 0.60% 788 0.60%

Chek 206 0.30% 333 0.30%

Ujala Techno Bright 150 0.20% 497 0.40%

Combined Total 2,911 3.60% 4,993 4.00%


We estimate the Henkel India detergent revenue declined by a substantial 24.7% in FY2011.

The primary reason we believe was the failure of Henkel India to reach out to consumers in the

midst of a price war in the detergent market. The price war began after the entry of Procter &

Gamble into the mass market with its Tide Naturals brand in December 2009. Hindustan

Unilever responded with price cuts across its Rin and Surf Excel brands by 15-30% while

Procter & Gamble cut prices by 12-20% across Tide, Tide Naturals and Ariel. While Henkel India

responded with price cuts of its own, its total advertising spend dramatically declined from INR

573 million to INR 266 million in FY2010. In contrast Hindustan Unilever and Procter & Gamble

followed up the price cuts with aggressive advertising campaigns to battle for mindshare

among consumers. We believe the decision of Henkel AG to exit the India business is also

partly responsible for the dramatic decline due to a reduced focus on the business by the

German parent and management inertia at the Indian business.

We forecast a further decline in revenue of 10.2% in FY2012E while the merger with Jyothy is

in process. However, to put our medium term estimates for the Henkel India detergent

business into context we believe we should compare our forecasts with the revenue Henkel

India managed to achieve in FY2010. We believe FY2010 was the last year when the Henkel

India business was running under a business as usual scenario and the revenue generated

could be a sustainable base for the business over the long term. Jyothy has targeted achieving

the FY2010 revenue in FY2013 but we have been conservative and forecast that Jyothy would

be able to get to the FY2010 level only in FY2015.

Exhibit 8: Forecast revenue growth of Henkel India detergent brands

(INR mn) FY2010 FY2011E FY2012E FY2015E 3 yr CAGR 4 yr CAGR 5 yr CAGR

Henko 1,656 1,317 1,186 1,878 16.6% 9.3% 2.5%

Mr. White 722 516 439 788 21.6% 11.2% 1.8%

Chek 401 206 185 333 21.6% 12.8% -3.6%

Total 2,779 2,040 1,810 3,000 18.3% 10.1% 1.5% Source: Company, MAPE Securities Estimates

#3: Need for huge advertising budget to revive demand for Henkel brands

FMCG companies account for their revenue net of trade discounts, rebates, sales taxes and

excise duties. However Henkel India accounts for the cost of the company's products given free

as incentive with the sales of various other products under marketing expenses instead of

netting out revenue. On our estimates Henkel India had a marketing budget of INR 1,281

million in FY2011. Due to Henkel India’s strategy of using a very high level of promotions to

ensure volume takeoff, 80% of the marketing budget is accounted for by promotional spend

leaving an advertisement budget of only INR 266 million. On a like for like comparison with




other FMCG companies the estimated advertising spend works out to only 6.3% of total

revenue. This compares unfavorably with peers which spend 10 – 12% of their revenue on

advertising.

The lack of advertising spend by Henkel India has resulted in low brand equity for its products

among consumers. In order to enhance consumer perception and recall of the Henkel product

portfolio, Jyothy will change the mix of the marketing budget to focus primarily on advertising.

While we expect that a reduction in promotions could negatively affect volumes and revenue

in the short term, the new strategy will enable Jyothy to spend 16% of Henkel India’s revenue

as advertising expenditure despite a reduction in overall marketing spend.

Exhibit 9: Marketing expense forecasts for Henkel India

(INR mn) FY2011 FY2012E FY2013E FY2014E FY2015E

Reported marketing expenses 1,388 589 718 879 1,016

Promotional expenses 1,122 0 0 0 0

Advertising expenses 266 589 718 879 1,016

as % of sales 6.3% 16.0% 16.0% 16.0% 16.0% Source: Company, MAPE Securities Estimates

Over the medium and long term we believe consumers will adapt to the withdrawal of the

perennial promotions on the Henkel products and Jyothy will be able to drive volume growth

as a result of the enhanced brand equity from well funded advertising campaigns.

#4: Control of the international brands Pril and Fa

As part of the acquisition Jyothy gets the ownership rights to all the Henkel brands, except Pril

and Fa, for India, Bangladesh and Sri Lanka. The international brands, Pril and Fa, will be

licensed to Jyothy in return for a 2% royalty payment under a contract with Henkel AG that is

renewable every 5 years. In case Henkel AG decides not to renew the contract after 5 years it

will have to compensate Jyothy at an independently arrived amount.

Jyothy is mandated to follow Henkel AG’s global strategy regarding brand building, quality and

design for the international brands. Jyothy also get the rights to Henkel AG's future launches

under these brands and the option to introduce new products from the brands’ current

portfolio into India. We do not foresee any issues with Henkel AG interfering with product

launches by Jyothy in these brands due to the symbiotic nature of the relationship.

We estimate the Fa brand currently generates only INR 221 million in revenue down from

around INR 350 million in FY2009 despite the strong growth in the cosmetics and personal care

segment in India. Jyothy believes that Fa has the potential to become a INR 1000 million brand

within the next 3 – 4 years. The current Fa portfolio in India comprises deodorants, men’s

shaving products and body talc. The global portfolio also encompasses shower gels and liquid/

bar soaps. The Fa range of soaps have a high coconut oil content and we believe that Jyothy

could see significant potential for the range in the Kerala market to begin with due to

abundant supply of coconut oil and consumer preference in the state for coconut and

vegetable oil based soaps like Medimix and Chandrika.

#5: Management

The senior management team at Jyothy consists of Mr. M. P. Ramachandran, Chairman and Mr.

Ullas Kamath, Managing Director. While Mr. Ramachandran founded the company in 1983, Mr.

Kamath has been associated with Jyothy for the last twenty years. We believe that it would be

difficult for the current management team to effectively run an enterprise with a turnover of

INR 12 billion and a multitude of brands in the absence of other supporting senior

professionals. As per our conversations with management they recognise the fact that it

would not be possible for them to oversee the expanded business with the same intensity as

before. We believe Jyothy is actively looking to hire experienced senior managers to bolster




the management bandwidth at the company and would view any news in the near term on

recruitment positively.

#6: Need to service the interest costs on debt raised to fund the acquisition

We estimate Jyothy has around INR 3,364 million of cash on its balance sheet at March 2011.

The total cost of acquiring the 85.87% stake in Henkel India works out to INR 7,723 million. To

fund the acquisition Jyothy has raised INR 6,000 through a) non convertible debenture from

Kotak Mahindra Bank for INR 4,500 million and b) working capital loans from various banks for

INR 1,500 million. The non convertible debenture is a zero coupon bond with a tenure of a year,

a 10% rate of interest and an option to be redeemed at a premium every 90 days. The

premium will be payable out of Jyothy’s reserves and will not have an impact on the P&L.

Jyothy plans to dispose unutilised assets primarily in the form of real estate worth INR 1,500 –

2,000 million to reduce the debt burden to INR 2,000 – 3,000 million within the next 3 to 6

months. Reaching this disposal target would require a sale of the Karaikal manufacturing

facility of Henkel India. We assign a low probability that the facility can be sold in the near term.

However we believe Jyothy Laboratories can dispose the real estate assets in Ambattur

(suburb of Chennai) and Bhubaneshwar in relatively quick time for a combined value of INR

600 million and have assumed the same in our estimates.

While companies like Godrej Consumer Products, Emami, Nirma and Wipro Consumer Care

had expressed interest in some of Henkel India’s brands during the sale process, Jyothy does

not intend to sell any of the brands it has acquired in order to reduce the debt burden.

In view of uncertainty regarding the funding strategy for the Henkel India acquisition, we have

detailed two scenarios in our financial analysis in Page 14 - debt of 100% and equity dilution of

15% with no debt. We believe that Jyothy’s management has always been conservative and

debt-averse so we assign a high probability that the short term debt will be retired post equity

dilution. Irrespective of the choice of funding we believe the debt levels will be comfortable

compared to the cashflow generation and will not strain the P&L or the balance sheet.

Exhibit 10: Key metrics under debt funding scenario

(INR mn) FY2012E FY2013E FY2014E FY2015E

Cash Flow before Financing (1,614) 368 825 1,258

Capital Inc./Dec. 0 0 0 0

Change in Debt 1,470 (3,000) (1,000) (1,000)

Cash Flow after Financing (144) (2,632) (175) 258

Net Cash/(Net Debt) (3,732) (3,364) (2,539) (1,281)

Net Interest (485) (396) (310) (189)

Net Debt to EBITDA (x) (4.34) (2.08) (1.19) (0.49)

EBIT/Interest (x) (1.38) (3.60) (6.26) (12.92) Source: MAPE Securities Estimates

Exhibit 11: Key metrics under equity dilution scenario

(INR mn) FY2012E FY2013E FY2014E FY2015E

Cash Flow before Financing (931) 1,134 1,607 2,097

Capital Inc./Dec. 3,628 0 0 0

Change in Debt 1,470 (6,000) 0 0

Cash Flow after Financing 3,779 (5,300) 992 1,372

Net Cash/(Net Debt) 191 892 1,884 3,256

Net Interest (105) 71 151 247

Net Debt to EBITDA (x) 0.22 0.55 0.88 1.23

EBIT/Interest (x) (6.39) 19.96 12.87 9.90 Source: MAPE Securities Estimates




Private Equity

The Indian FMCG industry is over INR 1,300 billion in size and accounts for 2.2% of the Indian

GDP. The industry has tripled in size over the last 10 years, growing much faster than in past

decades. Over the next decade robust GDP growth, opening up of rural markets, increased

income in rural areas, growing urbanisation along with evolving consumer lifestyles and buying

behaviours are expected to continue to impact the industry positively. Booz & Company

believes that the FMCG industry will grow at a base rate of at least 12% annually to become an

INR 4,000 billion industry by 2020. Additionally, if policy and supply constraints are eased, Booz

& Company forecasts 17% growth over the next decade, leading to an overall industry size of

INR 6,200 billion by 2020. (FMCG Roadmap to 2010, Booz & Co & CII)

This rising demand for FMCG products in India has led to heightened levels of interest from

private equity players in the sector. Besides, private equity interest in the sector has revved up

after Actis made a good return on its investment in Paras Pharma. Reckitt Benckiser acquired

Paras Pharma for INR 32,600 million in December 2010 valuing Actis’ 63% stake at INR 20,538

million. Actis had invested approximately INR 6,690 million to obtain its 63% stake in Paras

Pharma in 2008 and exited the investment with an annualised return of 42%.

There have been numerous reports in the media mentioning that Jyothy is also in talks with

private equity firms to raise fresh equity to retire the short term debt it raised to fund the

Henkel India acquisition. While Jyothy’s management has indicated that they are not currently

in talks with any PE player we believe that Jyothy could strike a deal within the next 6 months

and return to being a debt free company. Jyothy has had a positive experience with private

equity players as partners. CLSA, Actis and Baring Private Equity Partners were shareholders in

Jyothy in the 2000 – 2007 timeframe. While the private equity players made impressive

returns on their investment, they in turn helped Jyothy improve its internal controls and

management information systems. We believe private equity firms are positive on investing in

Jyothy based on its track record of rewarding investors handsomely. On the other hand, Jyothy

will seek a partnership with a private equity firm not only to pay back the debt but to also gain

strategic and operational expertise.

Exhibit 12: Historical returns of private equity players in Jyothy

Investor

Investment

Date

Amount

(INR mn)

Exit

Date

Amount

(INR mn) CAGR

Barings India Jun-00 159 Nov-03 363 27.3%

Actis (CDC) Nov-03 664 Nov-07 1,220 21.2%

CLSA Nov-03 664 Nov-07 1,220 21.2%

ICICI Jun-06 1,362 Nov-07 1,978 30.1%

Under the terms of the acquisition Henkel AG also has an option to buy up to 26% in Jyothy in

five years, which we believe could pave the way for a decent PE exit.

In August 2010 Jyothy had raised INR 2,279 million through a 10% dilution via a Qualified

Institutional Placement (QIP) process at an issue price of INR 282.62. We believe any private

equity placement that Jyothy finalises will have to take into account the desire of some of the

QIP investors to exit through a simultaneous secondary sale at a reasonable profit. Press

reports have indicated that Jyothy is seeking to sell fresh equity at INR 300 - 330 per share. A

share sale at INR 330 and INR 300 would generate a 17% and 6% return respectively for the

QIP investors. Since the QIP, Jyothy’s share price has fallen 26.4% while the Sensex is up 1.3%

and the FMCG Index is up 16.8%. In case of equity dilution we believe Jyothy will try and

provide returns to its QIP investors comparable to the FMCG Index but we have been

conservative and assumed a share sale at INR 300.




Quarterly Update

Jyothy reported its Q4 FY2011 results on May 30, 2011. Net revenue for the quarter was down

18.2% with the Soaps and Detergents segment revenue declining by 6.8% and the Homecare

segment revenue declining by 33.1%.

The renegotiation of the distribution margins has impacted growth adversely due to the low

take off from distributors while the negotiation process is on. We believe while Jyothy works

on aligning the margins it provides to its current distributors and the Henkel India distributors

that it has gained as part of the acquisition sales growth would continue to be hampered.

Jyothy is reducing the margins it pays is distributors to 6% from the 8% level currently while it

plans to increase the margins paid to the Henkel India distributors from 5% to 6%.

The renegotiation of distribution margins has come as a surprise as we did not expect Jyothy to

have initiated the process before the confirmation of the acquisition of Henkel India. The

proactive strategy has led to inventory de-stocking at the distributor’s end. Super stockists

carry roughly 25 - 30 days of inventory, which Jyothy has tried to bring down to the bare

minimum by the end of FY2011.

Jyothy is also planning a shift in its distribution network by reducing its dependence on the

super stockist model (currently c70% of sales) by moving to a Carrying & Forwarding (C&F)

model which was used by Henkel India. Jyothy has said that sales to consumers have not been

affected as the market share for all the products has remained stable over the period. We

believe the changes to the distribution network are likely to negatively impact sales for the

next quarter as well but we do not believe the changes will have a long term impact on the

revenue generating potential of Jyothy.

.

While the distributor inventory destocking impacted revenue growth for the quarter we

believe some proportion of the decline is linked to lackluster performance of all the brands in

the Jyothy portfolio. The volumes of the Soaps and Detergents segment have been negatively

impacted by the price hikes that Jyothy took on Ujala Supreme and Exo detergent bar in order

to protect gross margins in the face of rising raw material costs. For Ujala Supreme while Q3

FY2011 volumes were flat post the 16% price hike, the full impact was felt in Q4 FY2011

leading to 8 – 9% volume decline. We also believe Jyothy consciously slowed down the rollout

of its detergents as raw material prices have severely impacted margins for all players in the

business. We believe volumes are likely to remain sluggish in Q1 FY2012 but expect Jyothy to

return to an aggressive rollout from Q2 FY2012 as Jyothy has raised prices on its detergents in

June by 5% to improve the margins.

The Homecare segment volumes were dragged down by the continuing decline in Maxo

volumes. Jyothy had decided to reduce its distributor margins to 21% from 28 – 29% in Q2

FY2011. As a result Maxo volumes had declined 16% in Q3 FY2011 and the volume decline

seems to have worsened in the current quarter. Apart from the impact from the reduction in

distributor margins we believe volumes were hit as Jyothy elected to maintain margins by not

replicating the consumer offers for Maxo that were rolled out by Mortein and Goodknight.

Jyothy’s focus on margins has resulted in a 600 bps improvement in gross margins but the

EBITDA margin declined by 620 bps as marketing costs and staff costs rose while revenue

declined. Jyothy was able to improve the profitability of the Soaps and Detergents segment by

258 bps but the overall margins were dragged down by the 1856 bps decline in margins at the

Homecare segment.

The PAT margin was stable at 14.3% despite the decline in EBITDA margins due to the impact

of a lower tax rate as a result of a MAT credit in the quarter and higher interest income from

the proceeds of the QIP in August 2010.




Pro Forma Forecast & Valuation

In the summary forecast table below, we present two scenarios.

Scenario 1: This assumes Jyothy funds the acquisition of Henkel India with debt of INR 6,000

million

Scenario 2: This assumes Jyothy dilutes 15% of its equity at INR 300 per share and uses the

proceeds to repay the debt raised to finance the acquisition of Henkel India

We assign a high probability that Scenario 2 is the likely outcome in FY2012 and our target

price is predicated on Jyothy raising fresh equity from a private equity placement and

returning to a debt free status. The primary reasons we feels Scenario 2 will pan out are:

• Conservative debt averse management

• Provides greater flexibility to maneuver in case turnaround at Henkel India takes longer than

expected

• Positive experience of management with private equity players historically

Our target price of INR 300 is based on FY2013E PEG ratio of 0.8, which is a 40% discount to

peers (Exhibit 14). As a result of the Henkel India acquisition, Jyothy’s product profile has

changed significantly. Ujala Supreme, which contributes 31.1% of net sales in FY2011E, will see

its contribution falling to 16.5% in FY2013E, as per our estimates. This is a key positive from a

valuation point of view as well as Jyothy has traded at a discount to peers due to its

dependence on a single product. With a diversification of revenue post the acquisition, we

believe the valuation gap could close and provide further upside to our valuation.

Exhibit 13: Summary Pro forma Forecast & Valuation Table

Income statement (INR mn)

FY2012E FY2013E FY2014E FY2012E FY2013E FY2014E

Total revenue 11,289 13,785 16,345 11,289 13,785 16,345

EBITDA 860 1,615 2,130 860 1,615 2,130

margin (%)

Net Income 257 845 1,272 555 1,210 1,624

Fully Diluted Weighted avg. shares (mn) 81 81 81 87 93 93

EPS 3.98 12.40 18.09 6.41 13.05 17.51

Net Debt (3,732) (3,364) (2,539) 191 892 1,884

P/E Multiple

19.0x 121.7 248.0 332.7

21.0x 134.6 274.1 367.7

23.0x 147.4 300.2 402.8

25.0x 160.2 326.3 437.8

27.0x 173.0 352.4 472.8

Scenario 1 Scenario 2

Acq funded by debt Acq funded by equity

Implied Share Price





Exhibit 14: Benchmarking Jyothy vs. Peers

PEG Ratio

Company FY2012E FY2013E FY2014E FY2012E FY2013E FY2014E FY2012E FY2013E FY2014E FY2013E

Colgate-Palmolive India Ltd 17.3% 13.7% NM 22.6% 15.1% NM 18.1% 14.9% NM 1.53

Dabur India Ltd 24.2% 15.6% 14.8% 19.5% 16.3% 14.2% 23.3% 17.8% 13.5% 1.35

Emami Ltd 18.8% 18.4% 17.9% -7.9% 16.8% 13.9% 24.9% 18.3% 12.7% 1.09

Godrej Consumer Products Ltd 17.5% 15.6% 17.9% 22.3% 16.2% 14.8% 22.1% 17.9% 12.9% 1.13

Hindustan Unilever Ltd 4.7% 18.4% 17.1% 14.5% 12.2% 18.4% 17.8% 12.9% 16.1% 1.93

Marico Ltd 18.3% 15.4% 17.2% 24.1% 16.2% 29.4% 45.5% 21.3% 23.1% 0.96

Average Peers 16.8% 16.2% 17.0% 15.9% 15.5% 18.1% 25.3% 17.2% 15.6% 1.33

Jyothy Laboratories 8.4% 22.1% 18.6% NM 87.8% 32.1% NM 103.7% 34.2% 0.80

Premium/(Discount) to Average Peers (%) -40%

Sales Growth EBITDA Growth EPS Growth

Source: Bloomberg, MAPE Securities Estimates

Risks

Despite the obvious benefits and synergies that the new entity will enjoy, a merger between

two large groups with established operations and management structures is always a complex

procedure. The key challenge facing the company over the next two years include effectively

integrating the two businesses considering the inherent cultural and system issues that have to

be absorbed. We believe Jyothy’s management recognises the challenge ahead and has

formed a team comprising current employees and new hires with relevant experience to

address all integration issues in order to ensure a smooth transition.

In addition to the issues related to the creation of the new entity, there are also risks

associated with the business environment in which the company operates. An issue that can

be a source of concern is the possibility of irrational competition in the detergents market,

which would leave limited scope for Jyothy to maneuver. Another factor that needs to be

considered is the additional pressure on profitability by the increasing costs associated with

raw materials, in case Jyothy is unable to increase its selling prices appropriately.




Financial Summary

Income statement (INR mn)

Particulars FY2012E FY2013E FY2014E FY2015E

Net Sales 11,289 13,785 16,345 19,171

growth (%) 22.1% 18.6% 17.3%

COGS (6,432) (7,570) (8,926) (10,501)

Gross Profit 4,856 6,214 7,419 8,669

margin (%) 43.0% 45.1% 45.4% 45.2%

Employee expenses (1,181) (1,289) (1,481) (1,701)

% of sales 10.5% 9.4% 9.1% 8.9%

Distribution expenses (559) (718) (851) (989)

% of sales 4.9% 5.2% 5.2% 5.2%

Marketing expenses (1,197) (1,438) (1,720) (2,010)

% of sales 10.6% 10.4% 10.5% 10.5%

EBITDA 860 1,615 2,134 2,640

margin (%) 7.6% 11.7% 13.1% 13.8%

EBIT 669 1,424 1,943 2,449

margin (%) 5.9% 10.3% 11.9% 12.8%

Net Interest (105) 71 151 247

Profit Before Tax 564 1,495 2,094 2,696

Tax (127) (336) (471) (606)

tax rate (%) 22.5% 22.5% 22.5% 22.5%

Profit After Tax 555 1,210 1,624 2,004

Diluted EPS 6.4 13.1 17.5 21.6

growth (%) 103.7% 34.2% 23.4%

Balance sheet (INR mn)


Goodwill & Intangible Assets 4,967 4,967 4,967 4,967

Tangible Fixed Assets (Net) 5,064 4,404 4,343 4,282

Total Fixed Assets 9,979 9,918 9,857 9,797

Inventories 1,679 2,006 2,358 2,803

Trade Receivables 1,282 1,566 1,854 2,176

Cash & Cash Equivalents 6,882 1,582 2,574 3,946

Total Current Assets 10,787 6,098 7,731 9,869

Total Assets 20,765 16,016 17,588 19,665

Trade Payables (2,005) (2,397) (2,817) (3,348)

Debt (6,668) (668) (668) (668)

Total Liabilities (10,150) (4,675) (5,239) (5,951)

Share Capital 93 93 93 93

Share Premium 6,952 6,952 6,952 6,952

Reserves 3,062 3,839 4,847 6,126

Total Shareholders' Equity 10,616 11,341 12,349 13,714

Cash flow (INR mn)


Net cash from Oper. Activities 1,185 1,264 1,737 2,227

Net cash from Inv. Activities (2,116) (130) (130) (130)

Net cash from Fin. Activities 4,711 (6,433) (615) (725)

Net Increase or Decrease 3,779 (5,300) 992 1,372

Free Cash Flow 1,655 1,134 1,607 2,097 Source: MAPE Securities Estimates




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Important Information Related to The Research Report The research analysts responsible for content of this report, whether whole or in part, certify that with respect to securities or issuers covered in this report all the views expressed accurately reflect their personal views; and no part of their compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed. Definitions of Research Ratings

BUY We expect this stock to appreciate by 20% or more over the next 12 months from the price mentioned on the note.

HOLD We expect this stock to stay in the range of -20% to +20% over the next 12 months from the price mentioned on the note.

SELL We expect this stock to go down by more than 20% over the next 12 months from the price mentioned on the note.

Our target prices are on a 12-month horizon basis unless otherwise specifically mentioned.

Investment Banking Disclaimer MAPE Advisory Group Pvt. Ltd. is representing Jyothy Laboratories in its transaction with Henkel India. Disclaimer MAPE Advisory Group Pvt. Ltd. and MAPE Securities Pvt. Ltd. (“MAPE”) are investment bankers, advisors and securities traders on behalf of their clients globally. This report has been prepared by MAPE for its intended recipients only and not for public distribution and should not be reproduced or redistributed without prior approval. Information provided herein with respect to the industry and the competitors has been compiled from publicly available sources, including official publications and research reports, and is given as general information. It has not been independently verified either by MAPE or its Client. Neither MAPE nor its Client or any of their directors, officers, employees, affiliates, representatives and advisors makes any representation or warranty with respect to the accuracy or completeness of the information contained herein. The information contained herein shall not form the basis of any contract. The report may also include analysis and views expressed by our internal research teams which operate independent of the investment banking teams. The report is purely for information purposes and does not construe to be investment recommendation/advice or an offer or solicitation of an offer to buy/sell any securities. The opinions expressed are our opinions as of the date appearing in the material and may be subject to change from time to time without notice. Investors should make their own investment decisions based on their own investigation and analyses of information contained in this report and other sources and they should not solely rely on the information contained in this document. Recipients should not construe any of the contents herein as advice relating to business, financial, legal, taxation or investment matters and are advised to consult their own business, financial, legal, taxation and other advisors concerning any information in the report. MAPE or its affiliates, its clients and/or employees may or may not hold positions in any of the securities mentioned in the document.

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