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What Was I Thinking When I Valued D-Mart?

Mar 22, 2017

In this issue:
» The Bonanza of listing gains in Indian Markets
» Government's attack on the Cash Transactions Continues
» Market roundup
» ...and more!
00:00
Rohan Pinto, Research analyst

The months of frenzy surrounding the D-Mart IPO have finally passed. The company saw a stellar listing gain of 102% on its debut.

The fact that the IPO was oversubscribed 106 times means there was a huge demand for the company. Listing gains seemed to be a given.

Even before there was any public information available on the company, I was impressed by the company's business model and superb execution capabilities.

So much so that I wrote about the merits of D-Mart's business model in The 5 Minute WrapUp long before the IPO details were made public. The company made me believe the low-price strategy can build great businesses too.

So when the IPO was announced, I was excited to attend the analyst meet. It was a big event. We'd read through the company financials and were keen to know more. The management, as you'd expect, reaffirmed our faith in the company's superior fundamentals.

But then it went south after that. And when they announced the price of the IPO, we were shocked.

  • Buy stocks like you buy your groceries, not like you buy your perfume. - Warren Buffett

The grocery store built by an investor was priced like a perfume.

What's worse is we were the only analysts who asked the company about its valuations. They told us it was a once-in-a-lifetime opportunity and we were crazy to even bring up valuations.

So it was clear what we had to do. The company's fundamentals were superior and the management seemed able, ethical, and driven. But the pricing was ridiculous.

We have a fiduciary duty to our subscribers. Regardless of what the herd is doing, we provide our honest opinion and clearly state our rationale.

The D-Mart IPO report (subscription required) included a detailed note regarding our valuation of the company.

Let me share the highlights:

  1. Expected price to earnings: 40 times
  2. Most recent posted profit margins looked inflated

Allow me to explain. Over the long run, the valuation multiple of a company should be a function of the company's sustainable return on equity - not its near-term growth capabilities.

D-Mart has an average return on equity of 20% for the past three years. Thus the valuation multiple of 40 times for the company is very expensive.

Also, a retailer operates on thin profit margins of around 3%. The company's latest profit margin (4.5%) might not be sustainable. Profit margins of 4% or higher questions the business model of the company itself. Since the company aims to keep prices lower every day. Lower prices cannot translate to ever expanding profit margins.

The business model is thus a play on huge volumes rather than high margins. Projecting even further margin expansion to justify valuations is a recipe for disaster.

  • Man is not a rational animal, rather a rationalising one. - Robert Heinlein

We believe there is a fair price to be paid for any business - regardless of the popular narratives and rationales. The rationale on the street for D-Mart's valuations is the scope of the company's expansion opportunities. But any valuation can be justified if growth is projected to infinity.

Greed and euphoria is leading many investors to forget the most crucial aspect of value investing: the price to be paid.

D-Mart currently trades at 80 times expected earnings for the year ending March 2017.

The company is no doubt a gem of a business. However, the markets seem to have gone overboard on narrative and forgotten how to value a business.

While evaluating IPOs, we value the business from a long-term perspective and try to cut out the-short term noise.

We are glad to tell it like it is...even if we are proven wrong temporarily.

03:10 Chart of the Day

The excitement around the D-Mart IPO has been huge. The excitement cum over optimism about the future bought it an over subscription of 105.9 times. The pre-listing euphoria was so much that high net worth individuals leveraged themselves to buy the shares.

The stock debuted with a whopping listing gains of 102.1%. It is one of the biggest listing in thirteen years and the fourth best since 1990. The highest listing gain was in Indraprasta gas which was 150% in 2003.

Bonanza of Listing Gains

However, the big question here is why we asked to avoid the IPO (Subscription Required).

Well we think valuation plays a very important role in creating long term wealth in equity markets. These listing gains do not fascinate us. The reason being, it is the greed that is helping the business command valuations over and above it deserves.

We like the business model of D-Mart. However, there is a certain price that can be paid for a retail business. In fact, the market cap of D-Mart has exceeded the market cap of large FMCG companies like Marico and Britannia Industries.

In fact, at current price the stock is trading at 80 times estimated earnings of FY17. We believe, these kinds of valuations for a retail business are unsustainable.

03:40

It is believed one of the key factors behind accumulation of black money and corruption is cash transactions. In fact, the current government believes if it can reduce cash transactions, it will win half the battle.

What started with Notebandi is now getting to day to day banking/spending habits. To discourage cash transactions, finance Minister proposed a limit of cash transactions of Rs 3 lakh.

Interestingly, after the effect of demonetisation normalized, the sudden spurt in cashless transactions also normalized. As my colleague Vivek Kaul puts it:

  • As far as ATM transactions using debit cards go, they have bounced back post demonetisation. In fact, the total number of transactions in January 2017 was more than that in January 2016.

The increase in usage of cash is a clear sign of cash over cashless. However, government in order to promote cashless over cash has bought some amendments to the budget document.

The proposed limit of cash transactions has been reduced to Rs 2 lakhs. Further, it comes with a penalty of amount equal to the cash transaction, to be recovered from the receiver of the cash.

Even though it is still arguable how much of these forced moves would help in curbing cash transactions, the current government is trying to make it really difficult for the black money hoarders.

04:45

After opening the day on a negative note, have continued their downtrend. Sectoral indices are trading on a negative note with stocks in the Consumer Durable, telecom sector and metals sector witnessing maximum selling pressure..

The BSE Sensex is trading down 219 points (down 0.7%) and the NSE Nifty is trading down 70 points (down 0.8%). The BSE Mid Cap index is trading down by 0.9%, while the BSE Small Cap index is trading down by 0.5%

04:55 Today's Investing Mantra

"I insist on a lot of time being spent, almost every day, to just sit and think. That is very uncommon in American business" - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Rohan Pinto (Research Analyst) and Kunal Thanvi (Research Analyst).

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4 Responses to "What Was I Thinking When I Valued D-Mart?"

Rama Rao

Mar 23, 2017

"What's "worse" is we were the only analysts who asked the company about its valuations".... instead of "worse" it shud be "best"....you shud be proud that u dared to ask this.. for a lotus blooms in mud and not in the lush green gardens .. continue with your unbiased views.. God bless u all..

Like (1)

Desa

Mar 23, 2017

With Equitymaster being probably the only research houses missing out on a investment opportunity which doubled - mind you DOUBLED - in a matter of days, all of your justification will be ignored.

Let me attempt at giving you gyaan the way you'd understand my friend. "It is better to be approximately right than precisely wrong.", a quote that you'd probably would already know.

There are a few flawed assumptions in your analysis.

Margins not sustainable you say, when it was clear that the company would be using IPO proceeds to pay off debt, leading to lower interest expenses. Take out the post tax interest costs and you have savings of about 60-70 cr each year, which would boost profits by so much. In effect, your argument of 40x of EPS goes for a toss right away.

And if you would've studied the cash flows of the business, you would realize that they have very much improved in recent years - in a retail business, this is gold! In the IPO meet (in which you were present), the company's management did clearly state it is not chasing growth as it would be looking at increasing a fixed number of stores each year. This leads to a broadly fixed capex figure per annum.

You failed to give a lot of weightage to the management in an industry where other players are not really known to be the best capital allocators.

And Equitymaster talks alot about higher quality franchise businesses. Wasn't this the perfect example of one?

What happened to all of the qualitative aspects that go into analysis?

Perhaps, it was not as crazily priced an IPO as you made it out to be. Again let me reiterate - the stock DOUBLED on day one!

Justify it all you want. But deep down inside you know, this should be a learning experience for you.

Like (2)

Mitesh Shah

Mar 23, 2017

First and foremost, you have gone horribly wrong on this one. And now instead of being apologetic, you start givng rubbish reasons. Thankfully, I am not your client but i can sense many abusive emails from clients to you. Anyways, Firstly, you do not understand Management quality in this business, strong moat it has built, the opportunity lying ahead and hence a big growth. Now I have no problems with you guys being contrarians but Mr. Market has aleardy proven you wrong and it will continue to do so. Every day DMart stock (as long as it sustains over Rs 450 ) will remind you of your horrible mistake.
Now how your analysis is junk:
" Over the long run, the valuation multiple of a company should be a function of the company's sustainable return on equity - not its near-term growth capabilities." I do no understand who taught you guys this. If a company's ROE is 20% and PE of 30x and you have huge growth potential with strong moats, its a screeming buy from a longer term perspective.
It may take time for you guys to learn this.

Like (1)

V MANOHARAN

Mar 22, 2017

NO doubt, D MART is a well managed company, but only can be bought at between Rs.450 to 500

Like (1)
  
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