Any concerns on the outlook for India tea prices for FY14 on the back of trends in Kenya may be a kneejerk reaction, says Nomura Equity Research

McLeod Russel’s stock price decline of 15% over the past two trading sessions is an excessive reaction, According to Nomura Equity Research in its Quick Note, to the recent tea price trends in Kenya, the outlook for domestic demand and prices in India remains robust at this point. This was reinforced during the brokerage’s discussion with J Thomas, the world’s largest auctioneer of tea. They suggested that any concerns on the outlook for India tea prices for FY14 on the back of trends in Kenya may be a kneejerk reaction. Key takeaways from the discussion:

• • The first flush tea crop is largely for the domestic market, and J Thomas indicated good demand visibility in the Indian market. They therefore do not see any impact on the first flush crop from Kenyan price trends. If at all, it is the second flush crop (starts from 10^th May and continues to end-June) which gets exported, where there may be some impact (assuming the trend in Kenya doesn’t reverse).

• • Given that some of the land has been diverted for orthodox production in India, CTC (McLeod mainly sells CTC) supply has become tighter.

• • Opening tea prices will be visible in the 17th week auction and are expected to be higher. The current prices of very small quantities have been higher by Rs10-Rs15, but they are still not representative and the full impact will be visible from the 17th week. More than a single data point on opening prices, they remain positive on the outlook for tea prices in India.

• • Typically there used to be inventory in the system of the prior season which continued until the early part of the new season. But now inventory levels have been running extremely low.

• • Global demand supply is still tight and is expected to remain that way for the next three years.

As per Nomura’s observations, two months of higher production in Kenya (Kenya has produced 83.9 million kg in Jan-Feb2013 versus 54.6 million kg last year, when the crop was impacted by weather) has meant that tea prices in Kenya in CY13 have gradually come down from $3.08 at the end of CY12 to $2.49 in the 13^th auction (average prices in Kenya in CY13 are at $3.02 still higher than last year similar period average of $2.96). Part of this is due to recovery of lost production in Kenya, which produced 369.2 million kg in CY12 (versus 377 million kg in CY11 and 398.7 million kg in CY10).

Ex-Kenya production is only marginally up in Jan-Feb, as Sri Lanka has produced 48.5 million kg in Jan-Feb (versus 45.3 million kg last year) and India has produced 34.9 million kg in Jan-Feb (versus 33 million kg last year), while Malawi and Indonesia put together have produced 20.2 million kg in Jan-Feb versus 23.8 million kg last year. Empirically in CY11 Kenyan tea price was down from $2.98 at the starting of the calendar year to $2.69 in the 13th week, but McLeod Russel average exports realization for FY12 closed at $2.93 versus $2.86 in FY11.

Nomura had a discussion with the CFO of McLeod Russel on the company’s outlook for Indian tea prices in FY14, especially in the context of recent production and price trends in Kenya. He highlighted the following points:

• • McLeod Russel expects Rs10-Rs15 increase on their own crop for FY14 as domestic demand remains robust, and in his view it would be premature to extrapolate production and price trends in Kenya.

• • April production in India has been good, and indications are that they may recover around 2.7 million kg of its own crop that the company lost last year in Q1.

• • The tea major plans to increase bought leaves production from around 18.5 million kg in FY13 to 25 million kg in FY14 (it is currently factoring in only a 2 million kg increase in bought leave tea production in FY14). Assuming an EBITDA/kg of rs35 (irrespective of prices), this alone could lead to incremental EBITDA of around rs210 million.

• • Normalized production in FY14 would mean a recovery of 6 million kg of lost production in FY13. This would mean that even if one assumes flat realization (own crop realization was around Rs176 in FY13), the company could generate incremental EBITDA of Rs950 million.

According to Nomura, McLeod Russel currently trades at 5.3x FY14F EBITDA (3.9x adjusted for treasury shares) and 7.2x FY14F EPS (5.7x adjusted for treasury shares). If one assumes that realizations remain flat, on normalized production the brokerage expects FY14 consolidated EBITDA close to around Rs5,549 million and EPS of Rs37.6.

The brokerage further adds, so in a flat realization scenario for FY14, the stock trades at around 5.8x FY14F EBITDA (4.3x adjusted for treasury shares) and 7.9x FY14F EPS (5.9x adjusted for treasury shares). “This is still a very attractive valuation, in our view, especially in the context of a strong free cash flow yield of around 9.8%,” said Nomura.