Retail Stock Therapy - Part 1

The churn in the retail sector over the past years has separated the men from the boys. On one end are players such as Avenue Supermarts (D-Mart) and V-Mart, which have delivered over the past five years. And on the other, is Shoppers Stop, which has struggled to hold its ground. Somewhere in the middle are Future Retail, Trent and Aditya Birla Fashion and Retail, who have managed a turnaround but have yet to prove that they have permanently migrated to a stable and sustainable growth trajectory.

The good news is that the policy environment has improved for organised retail over the past one year. The demonetisation exercise benefited the sector in the form of increased customers and the implementation of GST is expected to further boost footfall. The organised players are geared for GST not only in terms of front-end (billing, integration of software, etc) but also back-end ready as they procure directly from companies. The unorganised players, especially wholesalers, are witnessing tough times – demonetisation has derailed their business model and now GST-compliance costs will exert further pressure on non-compliant players. Keeping in view the intensely competitive environment, here’s a look at how the major players are poised.

Avenue Supermarts

The Radhakishan Damani-owned low-cost retailer often gets compared to Walmart and has delivered superlative financial performance so far. It has made truckloads of money not only for the promoter but for all those who subscribed to its IPO. Between FY12-17, its operating income and net profit has compounded at 40% and 52% respectively and the stock price has appreciated 4x from its IPO price of Rs.299.

Analysts believe D-Mart has perfected the art of deep discounting, the only metric which appeals to every Indian consumer. Its low pricing strategy has been successful because of its cluster-based approach and stocking of high turnover brands across different product categories. It pays its suppliers on the 10^th day – compared to 37 days for Hypercity, 33 days for Star Bazaar and 111 days for Future Retail – enabling it to demand a higher sourcing discount.

D-Mart’s asset-heavy owned-store model is also unconventional compared to other retail chains. It owns 85% of its 131 stores and has rented the rest on a 30-year lease. The management believes that the rental model gives a higher ROCE in the first 8-10 years, but thereafter gets impacted due to rental cost escalation. In the case of owned-store model, the trend is reversed. The owned-store model did result in piling up of debt from Rs.525 crore in FY13 to Rs. 1,481 crore in FY17. Post the IPO, however, the debt-equity ratio has fallen from 0.7 in FY16 to 0.39 in FY17.

Market analyst Ambareesh Baliga, though, is skeptical of the scalability of the owned-store model as D-Mart embarks on its expansion strategy. “Most of the D-Mart properties were purchased earlier, at a relatively low price. Real estate prices have escalated since then, even at non-prime urban locations, where majority of its stores are proposed to be located.” While the value retailer is currently present in four states, majority of its stores are in Maharashtra (60) and Gujarat (29).

To deal with the threat of e-commerce platforms, D-Mart is exploring omni-channel strategies. Groceries contribute 54% of its total revenue along with home delivery; D-Mart has neighbourhood pick-up points from where shoppers can collect what they have ordered. It currently has 41 pick-up points across Mumbai and intends to expand this to other regions as well.

The stock is richly valued at 68x FY19 estimated earnings but the low float and growth expectation have continued to power the stock. “Given that the promoter continues to hold 82%, there is demand from those wanting to increase their exposure to the sector. Although a Goldman Sachs report justifies the valuation based on FY27 earnings, a lot can change in the next few years especially in terms of competition,” adds Baliga.

V-Mart

While D-Mart owes its success to defying the rules of the game, V-Mart, a major player in Tier-II and Tier-III cities, largely owes it to consistently following them. Anand Agarwal, CFO, points out, “We have stuck to our 8,000 sq ft model at high street locations and do not open stores at malls. We have remained slightly cautious; many businesses try to expand very rapidly and when you try to do things beyond your capability, you stumble.”

V-Mart’s cluster approach (new stores are opened 100-150 km away from existing stores) and concerted efforts to improve operational efficiency have reflected in a consistently high return on capital employed. Over the past five years its ROCE has hovered around 22% and operating income and net profit have grown 29% and 31% every year. It’s FY17 same-store sales grew 13%, behind D-Mart’s 21%. Of its 141 stores, majority are concentrated in Uttar Pradesh (59) and Bihar (31).

V-Mart has also customised its offerings in sync with cost preference (price points are 20-30% lower than Tier-I cities) and tastes (special promotions/campaigns for local festivals) of Tier-II and Tier-III cities. The customers who visit their stores typically buy apparel two or three times a year. For them the satisfaction of judging the material in person is more important, and they go to different stores to find the best bargain.

Wide range of merchandise at bargain price points, the right store location, lower employee costs and cheaper rentals in Tier-II and Tier-III cities have contributed to the higher net margin of 8-9%. There is a micro-focus on keeping costs low at every level of operations, right from negotiating the best rentals to distribution and promotion. “We take extreme care to ensure that every new store we open becomes profitable in the first two months, not one or two years”, explains Agarwal. Due to its conservative expansion, debt at V-Mart is negligible and stood at Rs.35.7 crore for FY17. The stock is currently trading at 31x FY19 estimated earnings.

Trent

Another player that has managed to turn the tide, after reporting losses between FY12-14 is Trent, the retail arm of the Tata group. In FY17, consolidated net profit increased to Rs.85 crore from Rs.55 crore in FY16. While low margin is the norm in the retail sector, Trent has the best operating margin among its peers. Private labels brought in 93% of its revenue in FY17 and this coupled with an asset-light expansion model has resulted in the operating margin expanding from 3.1% in FY13 to 11.5% in FY17.

Trent has three major formats, Westside (108 stores), Star Bazaar (42 stores) and Landmark. Westside’s same-store sales growth was 17% in FY17, up from 14% in FY16. Trent plans to open 25 stores in FY18 and has also undertaken significant restructuring of the loss-making Landmark business. The store count for Landmark has reduced from 26 in 2011 to five independent stores in FY17, besides merchandise presence in select Westside locations.

According to Bharat Chhoda, analyst at ICICI Securities, the rationalisation of Landmark stores has aided improvement in the standalone margin.  Given the enhanced focus on omni-channel, Tata group had launched Tata CLiQ in H2FY17 to improve its online presence. Online revenue was Rs.8 crore in FY17 and the management is targeting Rs.40 crore in FY18.

The key risk factors going forward are high rental costs. At 13% of total sales, it’s the highest in the sector compared to 4.8% for V-Mart, 0.3% for D-Mart, 9.5% for Shoppers Stop and 8% for Future Retail. Also, Star Bazaar’s like-to-like sales growth declined to 2.1% in FY17 against 8.6% in FY16 and net profit from the segment declined marginally from Rs.54.38 crore in FY16 to Rs.52.49 crore in FY17.

The firm also operates Zara stores in a joint venture with Inditex group of Spain, which has a 51% stake. Within five years of entering India, Zara has hit the $100 million revenue mark but the Trent management has been explicit about the JV being a financial investment. Moving in that direction and in compliance of the new accounting standards, the joint ventures (Inditex and Tesco) were not included in the FY17 consolidated results. Inditex contributed 27.47% of the consolidated profit for FY17, down from 71.56% in FY16.

Competition from H&M (many stores are located in close proximity to Zara) and the imposition of countervailing duty of 12% in FY17 impacted the joint venture’s profitability, with its profit declining from Rs.80.35 crore in FY16 to Rs.47.62 crore in FY17. Even though the change in the manner of accounting for JV operations may have resulted in a downward revision of the FY17 earnings per share, analysts are pricing in a one-time bounty if and when Trent exits the joint ventures. The stock currently trades at 64.4x FY19 estimated earnings.

This is the first of a two-part series, you can read part two here.