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Are you buying a retailing story? - Views on News from Equitymaster
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  • Aug 23, 2006

    Are you buying a retailing story?

    Last week, we had touched upon the infrastructure stocks and studied how unjustified their current valuations are in relation to the risks that an investor will be assuming by purchasing them. This time, we will turn our attention to the retail sector, where we have serious issues with respect to the current valuations.

    In our view, retailing is not just about how many square foot stores does one has managed to set up. More important, and this is something that we wish to re-iterate, is the fact that majority of the retail stores are not owned by the retail companies! So, do not buy a retailing story based on 'the real estate story', which is very hot in the stock market. Most of the properties are based on lease agreements (ranging from 10 year to 20 years).

    "The secret of successful retailing is to give your customers what they want" is what Sam Walton wrote in his autobiography - Made in America. Wal-Mart started in 1969 with 15 stores in 5 states and currently has a network of more than 5,000 stores across the world. The company's topline growth, over the last 32 years, stands at a healthy CAGR of 4%. During this period, Wal-Mart has faced competition in form of local retailers, departmental stores, speciality retailers and the larger-format retailers like Kmart.

    The following is the excerpt from the Annual Report of Wal-Mart in 1972. The company's strategy was:

    1. Putting in dominant new full-line stores in the medium size and smaller communities in the five state areas within 300 miles of our distribution center.

    2. Continuing our policy of maintaining true discount prices and one of the lowest gross margins of any chain in the United States.

    3. Being extremely control and expense conscious, starting with our construction program all the way through our entire operating structure.

    4. Continuing to develop loyalty, morale and enthusiasm among all the personnel for the total Wal-Mart program. Of all our assets, I must count this last ingredient the most important.

    These principles still hold true! While every company has a vision, not many have the ability to translate it into actual financial performance. The table below highlights the performance of Wal-Mart since 1972! Consistent with its objective, the company's gross margins are in single-digits. More importantly, despite the rapid expansion in the number of stores (not just in the US but also in the international markets, which have been scaled down consequently), the average return on equity is commendable.

    Wal-Mart: Not a cakewalk!
    Criteria FY72 FY82 FY92 FY02
    Sales (US$ mn) 78 2,445 43,887 217,799
    No. of stores 51 491 1,928 4,414
    EBDITA 5 162 2,416 10,064
    EBDITA margin (%) 6.6 6.6 5.5 4.6
    SG&A 14 495 6,684 36,173
    SG&A to sales (%) 18.3 20.2 15.2 16.6
    Depreciation 0 26 475 3,290
    Profit before tax 6 149 2,553 10,751
    Net Profit 3 83 1,608 6,671
    Net margin (%) 3.7 3.4 3.7 3.1
    Inventory 18.5 490.6 7,384.3 22,614.0
    Inventory days 86 73 61 38
    Working Capital 10 307 4,035 1,951
    Working cap to sales (minus cash - %) 12.3 12.5 9.2 0.9
    Equity 16.9 320.7 6,364.0 35,925.0
    Return on equity (%) 17.2 25.8 25.3 18.6
    Total Assets 28 938 15,443 83,451
    Return on assets (%) 10.2 8.8 10.4 8.0

    While we are not disbelievers in what Indian retailing companies are aiming for in the long-term, we challenge the investor's blind assumption that 'these companies will grow'. We have heard this argument time and again. In the early years of post liberalization, cement stocks were bought as if there is no tomorrow. This was based on the premise that per-capita consumption of cement in India is among the lowest in the world, India's infrastructure is poor and the replacement cost of a cement plant is much higher than their current stock price. After almost sixteen years, all these factors still hold true. Take the case of software stocks in 2000. Time and again, 'these companies will grow' assumption has been tested big time and investors have lost money.

    Retailing: The fall...
    Company Current
    price (Rs )
    P/E - current
    price (x)
    P/E - high
    price (x)
    Pantaloon 1,661 2,050 1,091 -19.0% 75.6 93.2
    Trent 791 1,049 641 -24.6% 39.2 52.5
    Shopper's Stop 474 700 351 -32.3% 69.7 102.9
    Provogue 234 449 123 -47.9% 29.8 57.3
    *change from the 52-week high

    Here is our fundamental take on the retailing sector and their valuations.

    1. Perhaps the most misunderstood side of the retailing story is the fact that merchandise for sales at the retail outlet is not easily available. Even if they are available, for a Pantaloon or a Hypercity, the suppliers lack the scale. Discount stores are viable in the long-term provided they have scale, which is not a factor of how many square foot one has in a mall, but whether suppliers can meet the long-term requirement of retailing companies (i.e., supply-chain). Here is where the likes of Wal-Mart have mastered their skills on the sourcing front. Wal-Mart has acquired the scale over the years to source products from across the world in bulk (say, China and India) for selling in its US stores. For an India-based retailing company to achieve some kind of scale, it will take at least three years, if not more. And that too, if the expansion plans are as per the schedule.

    2. It is important for investors to focus in the long-term on not just the sales per square foot but also profit per square foot. Profit per square foot is influenced by a retailer's ability to manage supply-chain efficiently. Typically, especially on apparel sales, a retailer derives revenues from both private-labels as well as other branded products. As far as the private labels are concerned, the onus of selling the stock lies with the retailer (because he owns the stock), which is not the case in the case of other branded apparels (which are returned if not sold). Margins in private labels are higher and due to the lack of any advertisement or brand-related expenses, private labels are sold in the retail outlet at a cheaper price. The risk on the supply chain therefore, it to make sure that stocks are cleared faster, so that working capital is efficiently utilized. While Indian retailers have been fairly successful on this front till now, given the rapid expansion plans, challenges are huge.

    3. Availability of prime locales for new stores and more importantly, ability to attract and retain people is perhaps the other major challenge. Revisiting Wal-Mart's 1972 annual report, there is a specific mention about the human capital. "Continuing to develop loyalty, morale and enthusiasm among all the personnel for the total Wal-Mart program. Of all our assets, I must count this last ingredient the most important." The race for human capital has started and every company under coverage feels that this is one of the major challenges for executing their business plan over the next three to five years.

    Coming to the valuations side of retail stocks, hoping that retailing companies will grow earnings by over 50% to 100% over the next two years and paying price to multiples of more than 40 times trailing twelve months earnings is not justified. As per Pantaloon, as against the total square foot under management of approximately 3.5 m, by FY10, it is expected to touch 10 m! With all due credit to the management, there are huge execution risks involved. Many domestic and foreign retailing majors will expand in India. Remember, the once-feared K-Mart actually went bankrupt!

    US economy Vs Wal-Mart
    (CAGR) FY73-FY82 FY83-FY92 FY93-FY02
    Real GDP 2.4% 3.5% 3.2%
    Cons. Expenditure 2.5% 3.6% 3.7%
    Walmart revenues 46.6% 37.8% 19.5%
    Personal income 11.1% 6.9% 5.6%
    Compensation of employees 10.7% 6.6% 5.6%
    Sales per Sq. Feet 11.3% 12.8% NA

    Despite the fact that organized retailing is just 3% to 5% of total retail sales in India combined with robust GDP growth prospects of the Indian economy over the next ten years, we believe that investors should exercise caution. Fancy valuation metrics like 'enterprise value upon sales' are great for investment bankers, but not for retail investors!

    If one wishes to buy the retailing story, it will be a wise investment decision to buy into those stocks, whose products these retailers will be selling at their outlets (from soap to apparel manufacturers). While we do like some stocks in the retail sector, we suggest investors not to pay extravagant valuation multiples and justify the same by quoting their price to earnings growth multiples (PEG)!



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