My Best Pick 2016

Saurabh Mukherjea

Ambit Capital's CEO zeroes in on Trent for its strong Westside and Zara franchises

Women’s clothing is an $18-billion opportunity in India. Yet, there are less than half a dozen properly organised womenswear retailers. Trent, a Tata Group company, being the only listed organised player (unlisted players include Fabindia and Biba) in this segment, is not a retail stock. You will not find it in the portfolios of investment legends despite the fact that Trent contains two highly profitable businesses: the women’s clothing retailer Westside, which accounts for almost 80% of the company’s profits and its joint venture (JV) with Spanish retailer Zara, which makes up for the balance 20%.

It is not hard to understand why investors have avoided Trent. Historically, Trent’s consolidated operating performance has been marred by losses in bookstore chain Landmark and the incubation costs of the supermarket JV with British retailer Tesco. These factors led to cumulative Ebitda losses of ₹100 crore in FY15. However, with the winding down of Landmark and the envisaged expansion of the JV with Tesco, Ambit’s retail analyst Abhishek Ranganathan reckons that these losses will lessen by more than 50% to ₹40 crore in FY16.

Under-absorption of the Tesco JV overheads, which is the cause of negative Ebitda, is also set to improve as new stores are added. This venture will add 18 stores in FY16 over a base of 16 in FY15. Consequently, the venture will reach Ebitda break-even in FY18 as store additions gain steam. I will come back to the company’s Tesco venture and lay out its positives and strengths later because it is not exactly central to why I like Trent. my investment hypothesis for buying into the company is underpinned by the strength of the Westside and Zara franchises.

 Twin attraction

Trent’s biggest competitive advantage in womenswear retailing is control over the product as well as point of sale in the Westside and Zara JVs — both women-centric formats and both highly profitable with operating margins of 12% and 19%, respectively. This translates into high gross margin (above 50%), product exclusivity (90% of its own labels) and the ability to attract affluent customers. 

Trent’s joint venture with Zara has already clocked annual sales of $110 million and continues to be the fastest growing and largest international brand in India. The country has the potential to absorb at least 60 Zara stores over the next decade (compared with the dozen or so Zara stores currently open in India). Even more interestingly, Trent’s learning curve in transforming Westside has been accelerated by its learnings from the venture with Zara.

Westside began the journey to improve its sales density (by 6% CAGR over FY13-15), as it introduced sharper brands (LOV and Nuon) across categories, including underperforming ones. Going forward, this should drive like-for-like sales growth (11% over FY15-17) and margin expansion by 270 bps to 10.9% by FY17, as operating leverage kicks in at the store as well as at the corporate level.

Westside currently offers considerable operating leverage. With sales of ₹8,000 per sq ft (psf) at 50% gross margin, its stores break even in the first year of operation, thus indicating a low threshold of store-level fixed costs. Therefore incremental sales will be disproportionately accretive at the Ebitda level. As a result, Westside’s current Ebitda psf of ₹540 on revenue psf of ₹8,000 can move to Ebitda psf of ₹700 if like-for-like for sales grows 10% (and costs by 7%). This implies a 23% increase in Ebitda without any change in gross margin.

The question then is what will drive like-for-like sales growth for Westside? The answers, I believe, come from several sources: (a) Westside, like Zara, is a ladies-dominant departmental store format in a country where such formats are rare; (b) Westside’s refreshed women wear section with in-house brands such as Gia, Zuba and LOV has helped the segment grow faster; and (c) the Westside offering is now targeted to a larger and younger audience with brands such as Nuon, ETA and Y&F. 

To be sure, the trajectory of Westside’s entire portfolio is moving up. FY15 like-for-like growth was 12% and the total revenue growth was 18% (new store revenue growth of 6%). In contrast, the time-weighted capacity addition was 3%, therefore implying significant ramp-up in the performance of new Westside stores.

With no incremental capital being deployed in the Landmark business and with Trent’s management now freed up to spend more time on Westside, the listed entity’s H1FY16 Ebitda margins of 7.9% (up 260 bps Y-o-Y) are a reflection of Westside’s performance. It is reasonable to expect these consolidated Ebitda margins to move into double digits over the next couple of years. 

 The worst is over

Before I move towards valuation, let me address the issue of Trent’s JV with Tesco; after all, barring Reliance Fresh, no one has been able to make the grocery or hypermarket formats work in India. The venture with Tesco continues to make losses largely because of significant corporate overheads (Tesco employees on the rolls) in a business with only 16 stores. With Tesco on board and investing ₹1,000 crore in the joint venture, the capital requirement for this business has now been taken care of. Also, the focus on private labels and the food business will give more impetus to gross margin.

Store additions are picking up, with 20-plus stores (10,000-15,000 sq ft) to be opened in FY16 with a throughput of ₹18,000 per sq ft, resulting in better absorption of corporate overheads. Lower competition, easing rentals, acceptance of food-centric supermarkets and higher scale (to 81 stores by FY17) should result in the Tesco JV turning profitable (FY18 Ebitda profit of ₹47 crore vs FY15 Ebitda loss of ₹68 crore). I am hoping that Tesco’s expertise in supply chain and private labels — the real drivers of hypermarket earnings — will ultimately help this JV make money in three years’ time. 

Trent’s current valuation (15x FY17E EV/Ebitda) do not reflect high Ebitda growth from the structural changes in Westside and the sustainability of the immensely profitable Zara venture. Having invested time in getting the model right, store expansion should translate in operating leverage for Trent (Ebitda CAGR of 78% over FY15-17). My colleague Abhishek’s discounted cash flow-based target price of ₹1,717 (which mirrors the sum-of-the-parts value) implies 19x FY17 Ebitda; we expect the highest value creation from Westside (FY17 Ebitda at ₹190 crore).

The writer does not hold any position in the  stock and the opinion expressed is personal

This is Saurabh Mukherjea's best pick for 2016, you might be interested in what he recommended for 2015 and 2014