How a multibagger stock could be a threat to your portfolio

The longstanding rivalry between Pepsi and Coca-Cola, a staple of countless Indian television advertisements over the decades, seems set to spill over into the Indian stock markets.

Ravi Jaipuria, chairman of RJ Group, began his career as a vendor for Coca-Cola before switching allegiance to Pepsi in the 1990s. His group's flagship company, Varun Beverages, now stands as the largest bottler of PepsiCo's beverages globally, outside the US. The company produces and distributes a wide range of carbonated soft drinks, non-carbonated drinks, and packaged water under PepsiCo trademarks.

In addition to Varun Beverages, the RJ Group controls Devyani International, a franchisee for Pizza Hut, KFC, and Costa Coffee in India. Both companies have caught the attention of investors, but it's Varun Beverages that has seen a significant re-rating, with its stock surging 1,270% since April 2020. Its P/E multiple soared from 35 times in 2020 to over 100 times by May 2024. In contrast, Devyani International's 47% gain since its September 2021 listing pales in comparison.

Does Varun Beverages deserve a rerating?

Varun Beverages' unique position as the only listed bottling vendor for a global beverage brand is a key advantage, but there's more to its story. The company's operations span six countries, including India, Sri Lanka, and Nepal, which account for 85% of total revenues. The remaining 15% comes from its African operations in Morocco, Zambia, and Zimbabwe.

The company's extensive network covers urban, semi-urban, and rural markets, supported by 37 manufacturing facilities in India and six internationally. Varun Beverages boasts a robust supply chain with 110 owned depots, 2,500 owned vehicles, over 2,400 primary distributors, and nearly a million installed coolers. Its product portfolio is diversified, with 70% of volumes from carbonated soft drinks, 23% from packaged drinking water, and 7% from non-carbonated beverages. Notably, 80% of sales volume is generated in India.

To increase international revenue, Varun Beverages is expanding its footprint in Africa through capacity expansions, acquisitions, and licensing rights from PepsiCo. The acquisition of BevCo in South Africa and distribution rights in Namibia, Botswana, Mozambique, and Madagascar have strengthened its presence. Additionally, the company is set to manufacture Cheetos and Doritos in Morocco.

The Indian soft drinks market is projected to grow at a compounded annual rate of 5% over the next four years, reaching $9 billion by 2027, according to estimates. To meet this demand, Varun Beverages has added new bottling plants in Uttar Pradesh, Maharashtra, and Odisha. The company has also established backward integration facilities to produce essential packaging materials, ensuring operational efficiencies and higher quality standards.

Varun Beverages also owns a 55% stake in Lunarmech Technologies, which produces PET bottle caps and crown caps. Annually, the company uses about 66,000 million tonnes of PET resin as packaging material. To improve its ESG standing, it has partnered with GEM Enviro Management for the phased implementation of 100% recycling of used PET bottles.

The company has also taken a 15% stake in two special purpose vehicles that supply solar power to Maharashtra and Uttar Pradesh. With a compounded growth rate of 26% in sales and 47% in profits over the past five years, and an average return on equity of 25%, the stock meets most fundamental criteria. A debt-to-equity ratio of 0.8 times does not pose a significant risk to the balance sheet.

Potential risks: Enter Coca-Cola

Despite its strong fundamentals, Varun Beverages faces significant risks.

The biggest concern for a franchisee company is the longevity of its licence agreement. Fortunately, Varun Beverages provides sufficient visibility in this regard. In 2019, PepsiCo extended its bottling appointment and trademark license agreement until April 30, 2039.

However, what could potentially impact the stock's valuations? Enter Coca-Cola. The competitor is planning to sell a part of its wholly-owned bottling business, Hindustan Coca-Cola Beverages (HCCB). To facilitate this, Coca-Cola has approached the promoters of at least four corporate groups, including Jubilant Group, Dabur, Pidilite Industries, and Asian Paints. Coca-Cola is seeking an investment of about $800 million to $1 billion to expand its business in India.

The sale of a stake in the bottling franchise could pose a double-edged sword for Varun Beverages. Firstly, it could allow HCCB to leverage the extensive distribution networks of these corporate groups. Secondly, investors might opt to capitalize on the potential gains from another leading beverage brand's distribution network through a different stock. Moreover, HCCB is reportedly considering an initial public offering (IPO), which would end Varun Beverages' monopoly.

As much as the sharp run-up in Varun Beverages' stock is exciting, investors should not overlook the significant downside risks.

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such.

This article is syndicated from Equitymaster.com