Retailing Stocks: Dotcom bubble or crisis of conviction

May 27, 2005

The surge in Retail stocks has confused a lot of analysts and experts. While one fundamental analyst classified the Retail sector as another dotcom a technical chartist called these stocks as sure shot bubbles. The set of assumptions and calculations employed to put the sector under that category defies logic and sense. The Indian Retailing story has a long way to go (See my earlier reports on this web site). The patient investors should keep their seat belts fastened and look at the broader picture rather then get into a micro analysis of PE, dividend pay out etc. These stocks are still in the nascent stages of development, the sector is in the process of being identified, Retail money has still not been able to participate in these stocks, their market cap to Sales are still in the vicinity of 2:1, the leader (Pantaloon Retail) trades at a market cap of Rs 2700 crores). Dotcoms during their hype traded at phenomenal market caps, Zee was at Rs 60,000 crores, HFCL at Rs 20,000 crores, DSQ at Rs 10,000 crores, those companies had faulty business models they assumed growth rates in excess of 100% but the future was a smoke screen you could not look ahead for 2000 in the year 1999 due to the fear of the Y2k bug. At the peak of the dotcom bubble all Internet stocks traded at PE's in excess of 200. So comparing Retail stocks to bubbles is an extended case of mental imagination. The harder you try to put numbers and arithmetic into a stock the more difficult it becomes for you to hold it .As they say as soon as the ship is ready to leave the harbor passengers are being asked to disembark. I am not selling these stocks inspite of holding Pantaloon from Rs 50 and Trent from Rs 160. I hold my entire quantity and would have only added some at various levels.

Instead of continuing with jargon and rhetoric let us see the psychological side to any sectoral rally. All great sectoral rallies start with disbelief and caution. Analysts and Investors had similar opinions on technology they said the same when Bharti was in the process of being discovered and scoffed at a great man by the name of Samir Arora who came and gobbled up what ever was offered to him. Samir as a person had great insight and forecast. He once confessed to have made his biggest money in Amazon and AOL two of the greatest global dotcom plays. Feels quite out of place to know that one of the best fund managers played on eyeballs and web site hits. Samir was also the one to spot retail very early he bought a 5% stake in Pantaloon when the stock was at Rs 70 odd.. His popular investment themes were based on the logic that once a sector is in fancy valuations do not matter.

Does this mean that I am inviting all investors for a round of momentum investing? Certainly not. A new sector will always have growth and the market would play and pay for growth and nothing else. In terms of stock price all these stories of stocks being asset plays, dividend yields and low PE's are tools that protect the downside but to get multibaggers one would have to buy stocks with growth.

There are just a few listed players Pantaloon, Trent and Shoppers Stop. These companies have varying business models. The preferred choices within the sector have been Pantaloon and Trent since they cater to the more average Indian. India as a country is still a middle class market. While it is true that people are willing to pay for quality service the engine for growth has to ride on the aspirations of the middle class only. Pantaloon and Trent seem to have captured that theme quite well. They have established their own Indian version of discount stores Big Bazaar and Star India Bazaar respectively. Shoppers Stop's inability to get its own hypermarket in place is a drag from the scalability point of view. While the promoters have indicated their desire to transfer the discounted store format " Hyper City" in favour of the listed company the road map for growth is still in the nascent stages of construction.

Growth stocks have classic in built valuation checks. The longer you can see them the cheaper they appear to get. Let us suppose that a stock like Pantaloon becomes expensive on fy 06 basis and an investor unfortunately picks up some shares at Rs 1325. Since prices are ahead of fundamentals they may come drop by even upto30%. This is perfectly possible. It does not however mean that the bubble has been burst only means it only means that the horse is panting for breath. In case the investor holds on to this stock for about a year the price remaining indifferent the stock suddenly starts to look in line with market valuations. This is so because these companies are growing their top line and bottomline by about 100% each year. Broadly the bottomline should grow faster then the topline. In case the investor holds on to these stocks for another year the stock would start looking extremely cheap again.

It is normally beneficial to apply broad logic to company's financials and that is what I am doing right now. Assuming a net profit margin of 4% and based on the management's internal benchmark of achieving a turnover of Rs 4,000 crores by 2007 and Rs 8,000 crores by 2008 or 2009 a broad case of number crunching can be developed for Pantaloon Retail.

One of the better ways to accumulate wealth over a period of time is through the mutual funds route. These funds are managed by expert fund managers having in-depth knowledge and experience about markets. All along we have tried investing directly and the results have been quite discouraging. As a result of this stock investing is looked upon gambling. Due to paucity of time we have really been part time investors. But investing is really a full time job (24x7x52). If you can go to a dentist for your teeth, cobbler for your shoes, barber for your hair then why can't you go to an expert for your wealth.

Note: There could be some equity dilution in these years because of outstanding warrants but those would be quite nominal and would not have a material impact on the calculations.

The basic dichotomy that I find in most of the brokerage reports that I see and the calculations that I have presented above is fact that while most of these reports assume a 50% growth I am assuming a 80 to 100% growth. The fact that the management has come out on Television stating that kind of growth should be sufficient evidence for us to see what a company is capable of achieving.

Now if Biyani can do a turnover of Rs 8,000 crores whether in FY 08 or 09 the company should reflect an EPS of Rs 152. Give it a 35 times discounting and the stock seems ready to sail past Rs 5,000 over a 2 to 3 year period. In 2012 Pantaloon should overtake HLL in sales. It should do a sales of Rs 16,000 crores and could very well be valued at a conservative market cap of Rs 24,000 crores giving it a per share value of Rs 12,000.

All over the world Retailers have enjoyed greater market capitalization compared to their FMCG manufacturers. All these years the FMCG players enjoyed greater bargaining power, as they had to sell to the local mom and pop grocery stores. In times to come the larger Retailers would bring about a shift in bargaining power towards them and away from the FMCG players. This shift has already started to happen.

(Figure in Rs crores)

Source: Yahoo Finance

Many investors get uncomfortable with the 4 % margins that Indian Retailers are currently enjoying. A comparison with their global counterparts indicates that these are the level of margins prevailing across the universe. Also note that the lower net profit margin also reflects internal Industry dynamics. A lower margin always discourages new entrants. It keeps the efficient companies going along while punishing the inefficient ones along the way. Scalability & supply chain management are all methods to keep the processes efficient and margins higher. A scalable model spreads the fixed cost over a larger number of units. Consider this if a Retailer has 200 stores in a country then it becomes easier to advertise on Television. Normally a smaller Retailer would not be able to advertise on TV since the target audience is quite limited in terms of the number of stores it opens up. Recent advertisements of Big Bazaar on the electronic media are a case in point. While all this is perfectly in order the Return on Equity should be above 20%. This is so because the ROE is a better indicator of financial efficiency. The Indian Retailing Industry is characterized by two different formats. Department Stores and Hyper Markets (includes groceries). While Pantaloon has maintained its net profit margin at about 4% inspite of obtaining more then half of its revenue from the hyper market space (where margins are lower) Shoppers Stop's margins at less then 4% is a concern primarily because it derives all its revenue from the department stores business.

Retailing Stocks would continue to grow at north of 50% for the next 3 to 4 years but for the sake of being conservative I have taken a growth rate of 50%. Finally all companies would come within the more realistic band of 20 to 25% growth but that stage is about half a decade away. KSA Technopak believes that Organized Retailing in India is still in the 2 nd gear and would reach 3 rd gear in 2007. The real boom with regard to Retailing would happen towards the fag end of this decade but since markets are smarter this would be discounted well before that may be by 2007 or 2008

Over the past couple of years Pantaloon has emerged the fastest and largest Retailing player in India. In his own ad hoc, unstructured, sporadic and impulsive style of operations Biyani's attempt to block all prime properties seems to be paying off quite well. Retailing in India is quite different from that in the West. In Europe and US Wal- Mart has its stores located on the outskirt of city premises. In India however that strategy might not work It is highly debatable whether a person would drive 20 miles off the city to get some grocery. The importance of having the stores in the right places gets magnified .For a foreigner coming into Retailing in India he cannot ignore Pantaloon. My sense is that Kishore Biyani would do in Retail what Sunil Bharti in telecom. Inspite of all odds Bharti competed very well against the likes of Tatas, Orange (Hutch), Reliance and BSNL.

Trent on the other hand has been unable to match Pantaloon in its growth mode. The company plans to open 17 stores during the next 3 years. It already has 16.It is discounting its FY 06 EPS of Rs 28 by around 22 times which is a big discount to its peers like Pantaloon (34.78 times) and Shoppers Stop (50 times). The re-rating if any could come in Trent. For investors still waiting to ride the journey ahead it would make sense to add Trent at current levels and hold on to Pantaloon.

To conclude I would like to reproduce a paragraph from my earlier report titled "Is there a Wal Mart on Dalal Street". Being a new Industry there is a possibility that both Trent and Pantaloon might not be able to keep up to the exponential growth rate and give way. This danger however far fetched it may seem is present should work like a caveat emptor for prospective investors. The development of a new sector throws up a lot of churns and twists and many companies are left at the wayside. It is here that Management capability and the ability of the leadership to co-exist with the changing dynamics of the Industry is to be taken into record. Many would rightly argue that the model for showing these companies as multi bagger is too simplistic and naive. How ever the arguments given above only reflect to some kind of an expected event in terms of price over the long term. Hope as many would say is a four-letter word but as they say there is no life without hope

Basant Maheshwari is a Cost Accountant and a Post Graduate Diploma in Equity Research and Analysis from ICFAI Hyderabad) and also an AMFI certified mutual funds advisor He advises people on making portfolio investments through mutual funds.. He has investment positions in Pantaloon and Trent Comments and suggestions are invited at   &  

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