Local fmcg companies in india

Valuation Of An Unusual FMCG Company In India

September 15, 2019

Tuhin Harit | Vikram Kuriyan | Geetika Shah

PATANJALI AYURVED: VALUATION OF AN UNUSUAL FMCG COMPANY IN INDIA

On August 1, 2017, Lee Smith was in his office thinking about what might be a good investment opportunity for his firm, Singaporean Wealth Fund (SWF). He had just been promoted to senior investment analyst, and his new responsibility was to scout for long-term investment opportunities in developing countries. In 2017, SWF had witnessed a dip in its returns; the fund had warned that global economic and geopolitical uncertainty, high valuations and low economic growth rates might weigh on future returns. In July 2017, the fund had announced that the 20-year annualized real rate of return on its portfolio was 3.7% above global inflation for FY17, which was a 0.3% drop from FY16. Given the fund’s performance, the demands on Smith to zero in on some good investment opportunities were high. His personal inclination was in the direction of the fast moving consumer goods (FMCG) sector, which was also his forte. Smith had a good amount of experience analyzing the sector for a private investment bank before joining the sovereign wealth fund. Over the years, he had become convinced about some of the inherent advantages of investing in FMCG companies. Among the things he liked about this sector were significant cash flows and low balance sheet leverage, giving companies the ability to weather through macroeconomic shocks; the high entry barrier; high talent retention; the ability to influence customers through marketing; and brand loyalty.

Armed with this strong rationale, Smith got the nod from his seniors and was advised to look for FMCG investment opportunities in India. In contrast to its global peers, the Indian FMCG industry had witnessed spectacular growth. The sector had grown at an average of ~11% over the previous decade and was expected to continue at 14.7% till 2020. FMCG companies in India were either local subsidiaries of multinationals such as Procter & Gamble (P&G), Nestle and Unilever, which had outpaced the growth of their parents by several times, or Indian companies such as Dabur and Britannia, which had exploited their competitive advantages and grown their businesses substantially.

Tuhin Harit, Professor Vikram Kuriyan and Geetika Shah prepared this case solely as a basis for class discussion. This case was developed from published sources. This case is not intended to serve as an endorsement, a source of primary data, or an illustration of effective or ineffective management. This case was developed under the aegis of the Centre for Learning and Management Practice, ISB.

Copyright @ 2019 Indian School of Business. The publication may not be digitised, photocopied, or otherwise reproduced, posted or transmitted, without the permission of the Indian School of Business.

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Smith decided to dive deeper into the Indian FMCG industry starting with the two leading companies — Dabur and Britannia. He noticed the high multiples at which these companies were trading (Exhibit 1) and decided to value them using different internal valuation methods to complement and compare their market valuation.

After analyzing the public market, Smith shifted his attention to private FMCG companies. Here he was surprised by a 10-year-old private company called Patanjali Ayurved Ltd that had outpaced the growth of its FMCG counterparts in India. Smith was amazed at the speed at which Patanjali had scaled. Further research unfolded some unconventional facts about the company. Patanjali was not managed as a typical FMCG company, yet its operational metrics were impressive. Smith had to decide whether Patanjali fit in with the investment rationale and philosophy of SWF and whether its high growth would be sustainable. On the other hand, Indian public FMCG companies were famous for their low betas and stable returns over several decades. Smith had to choose which route the fund should pursue.

PATANJALI AYURVED LTD

In September 2017, Patanjali Ayurved Ltd was looking for funding options to support its future expansion. Patanjali was engaged in producing staples, Ayurvedic1/ herbal products and fast-moving consumer goods and had a pan-India presence. Patanjali’s co-founder, a charismatic yoga guru-turned businessman, Baba Ramdev, said that the company would need to borrow INR 50 billion (US$780 million) to expand its production capacity as it aimed to become the largest packaged goods company in the country by March 2019. Patanjali planned to add five manufacturing facilities and double its distributor count to 12,000 by the end of 2018.

Patanjali was founded in 2007 by Ramdev and Acharya Balkrishna (Balkrishna). Ramdev was born into a family of farmers. When he grew older, he moved to Gurukul Kangri Vishwavidyalaya, a university in the northern Indian city of Haridwar, to learn yoga and study Hindu scripture. In January 2015, Ramdev was named among the awardees of the Padma Vibhushan, the second-highest civilian award in India, which he declined on the grounds that as an ascetic, he should refrain from accepting “rewards or honors”. Balakrishna was born in Nepal. Together, Ramdev and Balakrishna started Divya Pharmacy, followed by Patanjali a few years later. Balkrishna held 93.47% of the company’s shares. The balance was owned by Sunita and Sarwan Poddar, a Scotland-based non-resident Indian couple. Ramdev had no stake in the company.

The duo had earned national and global fame for promoting yoga and Ayurveda. They preached moral and social values to their ardent followers on spiritual TV channels. Patanjali was headquartered in Haridwar, an ancient city on the banks of the river Ganges and a famous Hindu pilgrimage site in North India. Most of Patanjali’s manufacturing and sourcing operations were also concentrated in and around Haridwar. The foundation of Patanjali was the philosophy of swadeshi2 whose core idea was to promote nationalism by boycotting products made by foreign multinationals. Patanjali’s fundamental value proposition was to offer quality products at affordable prices.

1 Ayurveda is an ancient Indian system of medicine and natural healing. 2 The Swadeshi movement was part of the Indian independence movement and developing Indian nationalism. It was an economic strategy aimed at removing the British Empire from power and improving economic conditions in India, which had some success. Strategies of the Swadeshi movement involved boycotting British products and the revival of domestic products and production processes. (Source: L. M. Bhole. (2000). Essays on Gandhian socio-economic thought. Delhi: Shipra Publications. See Chapter 14: Swadeshi: Meaning and contemporary relevance)

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Ramdev’s vision to make Patanjali the largest packaged goods company in India was backed by a credible growth story. In 2017, the company had clocked INR 105.61 billion in revenues, a 100% increase over FY16 revenues (see Exhibit 2). To put that growth in perspective, the competition had merely grown at an average of 4-5% that year. Looking forward, Ramdev predicted that Patanjali’s revenue would double by March 2018 and that the company had the potential to cross INR 1,000 billion (US$15 billion at the current exchange rate) in sales in the next three to four years.3

Funding such growth was clearly a challenge. Interestingly, thus far the company had managed to grow with a minimal debt of INR 3.2 billion. In January 2017, ICRA, a credit rating agency, had upgraded Patanjali’s long-term rating from A− to A+, citing the company’s strong growth and increased brand penetration. In a press report, ICRA also ascribed the ratings to the continuous growth of Patanjali’s product portfolio, which was one of the widest product portfolios among Indian FMCGs.4 ICRA stated:

These factors combined with partial backward integration and relatively lower selling and administrative overheads have enabled Patanjali to maintain its healthy profitability margins and return indicators, in spite of high competitive pressures ... Patanjali’s liquidity remains strong on the back of healthy internal accrual generation, sizeable cash balances and limited debt repayment liability resulting in moderate utilization of the working capital limits availed from the bank. This coupled with a sizeable net worth has continued to result in low gearing levels and robust debt protection metrics.5

Patanjali enjoyed higher profitability than its peers, which was partly attributed to its very low investment in marketing. Instead, over the years, Patanjali had developed strong brand loyalty, largely driven by Ramdev’s growing following and the nationalist ideologies for which the brand stood. Ramdev himself played the role of product evangelist and brand ambassador. Experts attributed the success of the Patanjali brand to getting “two insights right, which had helped the brand scale up quickly: ‘First is the general tendency among the Indian people to go towards natural/ herbal products with a heritage and Baba Ramdev epitomizes that trend. The second is the rise of nationalistic pride and patriotism, which has definitely helped Patanjali. It is the perfect brand fit. ’”6 It was this spiritual moat created by Patanjali that clearly differentiated it as a brand from its competition, which comprised mostly of local arms of MNCs.

To raise funds, the first objective for any investor was to valuate Patanjali by considering its future cash flow and comparing it with its peers. There were two key challenges in valuing Patanjali. The first was the unconventional way in which the firm was managed. To many observers, the shareholders of Patanjali did not appear to be particularly driven by the profit maximization theory. Looking at the company’s debt position and phenomenal growth, one could see that the retained earnings had been reinvested only in future growth. The second challenge was the nature of the FMCG industry itself.

PATANJALI’S BUSINESS MODEL

Patanjali started its business operations by producing a range of niche Ayurvedic products that required very little processing or labor-intensive operations. The first two product segments Patanjali entered within the Ayurveda range were personal care and digestives. The raw materials for such

3 Mitra, S. (2017, September 28). Baba Ramdev: Patanjali needs to borrow Rs 5000 core to support expansion. Mint. 4 ICRA upgrades long-term rating on Patanjali Ayurved. (2017, January 19). The Economic Times. 5 Ibid. 6 Laghate, Gaurav. (2017, January 31). Baba Ramdev advertises his presence on TV 20 hours a day. The Economic Times. Quoted in the article is Ashish Bhasin, CEO South Asia, Dentsu Aegis Network. Retrieved from https://economictimes.indiatimes.com/industry/services/advertising/baba-ramdev-advertises-his-presence-on-tv-20- hours-a-day/articleshow/56881020.cms.

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products were sourced from farmers who were not able to sell their produce in the open market at competitive prices. Thus, Patanjali was able to bring inclusivity into its model right from the beginning and thus had partly backward integrated its operations. For Patanjali, building a distribution network had been very challenging in the early days; it had been shunned by most retail chains. However, the company later discovered that franchising was the most effective way to scale. Under the franchising model, a franchisee could open a Patanjali branded retail store in an existing or new store. Patanjali offered only a 10% margin to its retailers against the 15-20% margin offered by its rivals, but the sales volumes compensated for the low margins. Initially, Patanjali sold its products exclusively through three retail formats: Arogya Kendras, which sold medicinal products; Swadeshi Kendras, which was dedicated to non-medicinal products; and Chikitsalayas, outlets for consultative selling that housed an Ayurvedic doctor along with an inventory of medicinal products.

In 2012, Patanjali tied up with the Pittie Group for the sole distributorship of its products as a means to extend its reach beyond its own franchisees and onto the shelves of modern retail formats. The Pittie Group began to sell Patanjali products in general trade. By 2014, Patanjali had made its entry in modern retail at chains such as Reliance Retail, Spencer’s and D’Mart. This increased the company’s brand visibility and market penetration and made it ready to challenge established players like Nestle and Hindustan Unilever (HUL). However, the big trade-off was that Patanjali had to raise the margin it offered to its new retailers and bring it up to the level of its competitors.

The space offered by modern retail enabled Patanjali to extend its product line to 600 products by 2017. Apart from healthcare products, Patanjali was selling beverages, groceries and staples, and personal care and ready-to-eat products. However, its top five products, including cow’s ghee, Ayurvedic medicine, toothpaste, shampoo and soap, contributed 45% of its revenue. Patanjali’s value proposition was affordable pricing and some of its “me too” products undercut the competition, but contrary to popular perception, not all of Patanjali’s products were cheap. For instance, Patanjali’s clarified butter was sold at a 10% premium and contributed 12.5% to the company’s topline. Ayurvedic/ natural products continued to be Patanjali’s forte, but the rate at which the company was launching new products in every FMCG product segment was a clear indication that niche ayurvedic products alone wouldn’t make it the biggest FMCG company in India as envisaged by its founders.

In 2017, the business was reaching a point where it would need external funding to sustain the growth Ramdev had projected. By year end, Patanjali had could boast of having built a very wide product portfolio for a 10-year-old company. From a working capital perspective, a portfolio of this size was expensive to maintain owing to the high level of inventory it demanded. Also, due to its high product rollout, Patanjali’s reliance on contracted manufacturing was on the rise. The company believed that scaling operations through contracted manufacturing would not only be cost intensive but would also put pressure on the quality of products in the near future. As a result, it was seeking funds to build its own manufacturing facilities. Over the years, Patanjali had strengthened its distribution, not only in terms of numbers, but also in terms of adding intermediaries to its distribution channels. It remained to be seen whether the company would be able to maintain its high margins with the multifold increase in distributors and retailers.

Lately, Patanjali’s spend on advertising had also witnessed a steep rise. In 2016, Patanjali had entered the ranks of the top 10 advertisers in India. By 2017, it was the third largest ad spender in the country. Eighty percent of those ads were played on Indian news channels. The choice of this genre was a deliberate bid by the company to reduce the risk of overdependence on the popularity and following of Ramdev and Balkrishna. The company was also planning to expand into apparels and services such as providing security personnel. Its ambitious plan to quickly diversify into unrelated businesses was heavily critiqued by industry experts.

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Patanjali had to be well capitalized to take on mature and established players in an industry known for high competition intensity. Funding options ranged from an initial public offer (IPO), to debt, to private equity. Rumors in the media indicated that Patanjali was looking at debt as a first option. Balkrishna, Patanjali’s Chief Executive Officer, ruled out the possibility of an IPO. In a 2018 interview, he said:

If we go for an IPO, it is natural for an investor to expect returns on his investment. If we don’t meet his expectations and sentiments, we would end up hurting them. And if we meet them, we may face difficulty in having the peace with which we are doing our work, the fun and the free spirit with which are carrying out our work. That’s what we feel and hence there is no plan for an IPO.7

VALUATION OF PATANJALI

Valuing Patanjali was not easy math, given the dynamism it had exhibited over the last 10 years. It was essentially a startup unicorn that was determined to become the largest company in the FMCG sector. However, unlike a normal unicorn, Patanjali was founded by yoga teachers turned entrepreneurs cum spiritual leaders. The lack of experienced, professional management gave the founders a free hand to run the company as they desired. Furthermore, Ramdev was known to be close to the Indian Prime Minister, with whom he also shared a Hindu-centered ideology.8 How these conflicting factors would play out in the less than transparent Indian corporate world was difficult to predict and quantify. One way to incorporate the uncertainty associated with the strategic direction the company could take was to consider different scenarios that might unfold.

For Patanjali, growth meant expanding into new product categories and launching products at breakneck speed. Thus far, the results had been phenomenal. Patanjali had grown 22 times in five years with a compounded annual growth rate (CAGR) of 70%. The company had a small debt of INR 3.2 billion, a loyal customer following, strong liquidity and internal accruals.

For a relative valuation, Patanjali did not have a clear and obvious peer in the industry for an apple to apple comparison. Given its vast and ever-increasing product portfolio, it faced competition from most of the established players in the industry. However, its closest peer, given its roots in Ayurveda and dominance in healthcare, was Dabur, a 134-year-old company that began operations in 1884 as an Ayurveda products company and had evolved, by the late 20th century, into a full-fledged FMCG company. Nevertheless, it remained one of the largest Ayurveda and related products manufacturers in the world. Its business segments included hair care, oral care, healthcare, skin care, home care and foods. It had a vast network and presence across the Middle East, SAARC countries, Africa, US, Europe and Russia. Its overseas revenue accounted for ~30% of its total revenue. As of 2018, Dabur’s market value was INR 693 billion.

Britannia served as another useful counterpoint to Patanjali in the valuation of FMCG in public markets. It was established as a biscuit bakery company in 1882 with an investment of INR 295. By 1983, it had crossed INR 1 billion in sales, and by 1997, it had also entered the dairy products segment. In 2017, the company delivered its products across five categories including biscuits, breads, dairy,

7 Tripathi, D. (2018, January 17). Patanjali’s CEO aims to double sales, rules out IPO to preserve “free spirit”. Moneycontrol.com. 8 Bhatia, R., & Lassiter, T. (2017, May 23). Special report: As Modi and his Hindu base rise, so does yoga tycoon Baba Ramdev. Reuters. Retrieved from https://in.reuters.com/article/india-modi-ramdev/special-report-as-modi-and-his-hindu- base-rise-so-too-does-yoga-tycoon-baba-ramdev-idINKBN18J1HJ.

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cakes and rusk through 4.2 million retail outlets. It was a predominantly domestic firm. As of 2018, Britannia’s market value was INR 745.66 billion.

VALUATION DETAILS FOR THE FMCG SECTOR

According to a report published by Ernst & Young (EY),9 the FMCG sector had the lowest cost of equity in India, averaging at 12.5%. The report also noted that most of the mature FMCG companies in India had negligible debt. The risk free rate or yield on government bonds ranged from 6.9% to 8.7%. The results confirmed that discounted cash flow (DCF) methodology was the key approach for valuation analysis along with peer company multiples or transaction multiples. Companies typically considered a horizon of five years for the DCF approach before applying the terminal value. There were two ways to arrive at the discount rate: use the organization-specific hurdle rate or the capital asset pricing model (CAPM). In the CAPM approach, the equity risk premium (ERP) or market risk premium had a wide range of values owing to subjective estimates and multiple approaches. The ERP for the broader Indian market, based on a report from Grant Thornton,10 ranged from 6.7% to 8%. The average additional risk premium suggested by the respondents in the EY report for a startup was approximately 8%.

SMITH’S CHOICE

Smith had to recommend an investment decision to his superiors at SWF. As ultra-long horizon investors, the fund did not mind illiquid investments that could be quite successful over the long term.

Smith had to make judgments about the long-term trajectory of Patanjali. So he divided Patanjali’s possible valuation space into three possible scenarios:

Case 1. Company continues its diversification into the FMCG space, leaving its spiritual moat, though it makes rapid organizational changes to transform itself into a truly profit-seeking shareholder corporation. Case 2. Company continues with its swadeshi rhetoric and philosophy but tries to diversify into the FMCG space. Case 3. Company does not leave the Ayurveda market and rather strengthens its spiritual moat.

On the other hand, as disciplined value-driven investors, the natural alternative for the fund was to invest in publicly-traded companies that had a successful track record and a long runway for future growth.

For all his possible investments, Smith had to compute the real cost of capital, as the cost of capital was crucial to the long-term profitability of all investments. Reading the EY report, Smith realized that cost of capital for Indian FMCG companies was very low. Interestingly, despite its low beta value, the sector was known to give consistently high returns to its shareholders.

Before arriving at any decision to invest, Smith decided to make his own valuation estimation of select FMCG equities that would also qualify as a peer group for Patanjali (i.e., Dabur and Britannia). He had to decide upon an appropriate method to perform his analysis. He took a quick look at the balance sheets of some FMCG companies and found that the book value did not reflect the intrinsic value of

9 Ernst & Young. (2017). Cost of capital — India Survey. Retrieved from http://www.ey.com/Publication/vwLUAssets/ey- cost-of-capital-india-survey-2017/$FILE/ey-cost-of-capital-india-survey-2017.pdf. 10 Saxena, M. (2015, October). Valuation insights: Equity risk premium (ERP) for Indian market. Grant Thornton. Retrieved from http://www.grantthornton.in/globalassets/1.-member-firms/india/assets/pdfs/grant_thornton-valuation_insights- october_2015.pdf.

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the companies. The price-to-book (P/B) ratio was high as most of the value of FMCG companies was locked in their brands. Smith then considered the low cost of equity (COE) of the FMCG companies. Should he go by the textbook method of arriving at COE (also given in the EY report) or arrive at his own estimation? After all, the real cost of equity for an industry giving such extraordinary returns must be much higher. Also, as a conservative investor, Smith needed to figure out if the risk of investing in a non-controlling stake in Patanjali far outweighed the risk of investing in select FMCG equities with a long history of stable returns.

Smith had to make a recommendation to his superiors.

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Exhibit 1 Multiples

Share price P/E ROCE Beta Hurdle Rate (WC-Cash)

/ CL Tax

Rate Ad

spend Ad as %

rev

Dabur 391 50.5 x 34% 1.196 12% 24% 21% 1040 12%

Britannia 6214 74.3 x 52% 0.55 12% 0% 32% 636 7%

Nestle 9809 70.5 x 40% -.081 12% 47% 33% 615 6%

HUL 1642 67.9 x 116% -.401 12% -26% 28% 4452 14%

P&G 9900 79.0 x 140% -0.323 12% 60% 36% 186 7%

Source: Company financials, Moneycontrol and Screener.in.

Exhibit 2 Patanjali Revenue and EBITDA

Patanjali EBITDA, EBITDA Margin and Growth

Year Revenue Growth

Revenue (INR bn)

EBITDA (INR bn) EBITDA Growth EBITDA Margin

FY 2017 100% 100.0 20.0 100% 20% FY 2016 148% 50.0 10.0 119% 20% FY 2015 69% 20.1 4.6 91% 23% FY 2014 41% 11.9 2.4 58% 20% FY 2013 87% 8.4 1.5 12% 18% FY 2012 50% 4.5 1.4 0% 30% FY 2011 50% 3.2 1.4 82% 45%

Source: Company website: http://patanjaliayurved.org/company-overview.html.

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Exhibit 3

Patanjali Product Portfolio

Grocery and Staples

Dals (lentils) and pulses, edible oil & ghee (clarified butter) flour / atta (wheat flour) staples / spices, ghee, mustard oil, besan (gram flour), others spices, salt, rice

Ready-to-eat Food Confectionery — biscuits, cookies, candies, snacks & honey; papad (crisps), sauces & pickles, ketchup, sweets, murabba (fruit preserve), soan papdi (flaky layered sweet)

Beverages Juices & fruit drinks (apple, amla (gooseberry), lychee sharbat & squash)

Personal Care

Face care: Face cream, lip care, face wash; Body care: Body wash, hand wash, soaps; Foot care: lotions; Hair care: Shampoo, conditioner, hair oil; Oral Care: Toothbrushes, toothpaste; Make up: Kajal (kohl); Shaving and grooming: Shaving gel, shaving cream

Health Care Health drinks, Chyawanprash, nutrition & supplements, digestives

Households Worship-related items, cleaning & washing products, herbal gulal (colored powder)

The company claimed that its shampoo had a 15% market share, toothpaste 14%, face wash 15%, dish wash 35%, and honey 50%. Some of its popular products included Patanjali cow ghee (sales of ~INR 15 billion), Dant Kanti toothpaste (~INR 9.4 billion), Kesh Kanti shampoo (~INR 8.5 billion), herbal soap (INR 5.7 billion), and honey (~INR 3.5 billion).

Source: Company website.

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