FY09 proved that Pantaloon’s ability to rapidly ramp up space is underpinned by strong profitability potential with the company’s focus on efficiency and margins delivering results. Looking ahead, the combination of leaner, more efficient operations alongside consistent space growth make it a compelling play on Indian retail with the only shadows being the funding uncertainty and less than ideal accounting, Pantaloon is the leading retailer in India with formats spread across a range of product categories as well as income segments. After years of torrid space growth, the company shifted focus to cost control and efficient space utilisation in FY09, yielding EBITDA margin gains in a challenging year. Given the wider discrediting of the retail story, continuing capital requirements for Pantaloon and a demanding rating of ~25x FY10 earnings, the question arises – is it an attractive investment?
STRENGTH IN ADVERSITY
We see Pantaloon’s as attractive company for three key reasons:
• Franchise strength: Pantaloon’s core formats have a strong presence in their respective categories. The combination of tried and tested formats alongside strong brands (reinforced by the company’s national presence) and scale benefits from consolidated sourcing gives Pantaloon’s stores a distinct advantage over potential competitors. This is backed by proven execution skills with an impressive track record of space growth (almost 5x in four years).
• Rising efficiency: the challenges faced in FY09 acted as a catalyst for Pantaloon to focus on costs and efficiencies, breaking the past pattern of prioritising space growth above all else. This has resulted in better margins in FY09 and is likely to lead to better efficiency in store operations as well as the back end – particularly in SKU rationalisation and improved stock management. This is likely to improve margins (by 50 bps) and cash conversion (by 24 days
of working capital) over the medium term.
• Set to capitalise on the market opportunity: despite the failures seen in organised retail over the past year, the broader opportunity remains intact. With the crowding in the sector having eased and focus shifting to profitability instead of just space, Pantaloon emerges as the strongest play on the sector opportunity. Its position is further strengthened by the easing of competition
(for example, Reliance, AV Birla, Subhiksha) for real estate and other inputs
FUNDING UNCERTAINTY REMAINS
We estimate that Pantaloon will need Rs. 12bn of fresh capital for its core business and Rs.3bn for its subsidiaries over the next two years. If the entire amount is funded through debt, its debt/equity will remain ~1.5x in FY10 and FY11 – well above the company’s comfort level of 1.0-1.1x. Whilst the earlier plan of forming a holding company has been abandoned, the company is considering its various options including the possible IPO of one of the subsidiaries or store formats. A vanilla equity raise of Rs.10bn at a share price of Rs.350 implies an equity dilution of ~15% (over the base of current fully diluted normal shares as well as ‘B’ shares – 195mn).
On a post-money basis, this implies a reduction of 3% in our valuation.
We expect Pantaloon to deliver strong top line performance (FY09-12 CAGR of 33%) alongside EBITDA margin gains in FY10 (30bps) with efficiency gains in gross margins and costs offsetting mix driven cost pressures. We value Pantaloon on a SOTP basis. The standalone retail business is valued on a DCF basis, contributing 86% of the overall implied EV. Home Solutions is valued at 0.2x trailing sales, contributing 1%, whilst Pantaloon’s holding in Future Capital contributes 6% (after a 25% holding company discount). The other subsidiaries contribute the remaining
7%, giving our target price of Rs.456, 38% upside after adjusting for debt.
Pantaloons Retail is India’s largest retailer by space as well as revenues. Its retail footprint is spread across categories (e.g. food, general merchandise, fashion, electronics etc), formats (supermarket, hypermarket, departmental stores, etc) and the value spectrum (discount to premium). The company has seen aggressive space growth over the last few years (see figure 17) and over the past year has refocused attention on the bottom line with EBITDA margins expanding 140bps in FY09. The company also has a number of subsidiaries, the most notable of which are Future Capital (listed financial services company), Home Solutions (homewares
retailer), Future Media, Future Logistics and Future Generali (JV – insurance
KEY RISKS AND SENSITIVITIES
The main drivers of our valuation are space growth, revenue densities (i.e. revenues per square feet), margins and working capital. A 5% reduction in our annual space growth assumption causes our valuation to drop by 4% whereas a 1% reduction in our annual revenue density growth rate causes the valuation to drop by 15%. A 100bps change in our overall margin assumption causes the valuation to drop by 15% while a 100 bps increase in the working capital/sales ratio causes our valuation to drop by 2%.
Pantaloons’ forthcoming Q1 results should provide visibility on margin momentum for the company whilst the other retailers’ Q2 results should shed light on demand conditions in the wider retail market. Monthly sales figures should provide visibility on trading in the festive season whilst the next round of quarterly results in January should provide visibility on margins.
NOBLE VERSUS CONSENSUS
Our expectation of Pantaloon being able to deliver on its space growth targets alongside a recovery in revenue densities (due to same store sales recovery as well as a focus on efficiency in new stores) leaves our revenue estimates ahead of consensus. This gap flows through to the EBITDA level and is indeed a little wider for FY10 on the back of our expectation of near term margin gains. The operating leverage effect from depreciation and interest causes the gap to widen at the PAT level.
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