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Pantaloon Retail
Near-Term Headwinds; Execution Key Stock Driver
What's Changed
Price Target Rs644.00 to Rs421.00
EPS FY11e, FY12e, FY13e -34%, -31%, -27%
We have cut earnings estimates by ~30% through
our investment horizon: This reflects 1) continuing
losses in the electronics business; 2) cost inflation-led
margin compression; and 3) higher interest costs. PRIL
is the worst performing stock in our coverage over the
past three months (down 46%). Our base case factors in
operating efficiencies from working capital improvement
and operating leverage. Management has put in
requisite measures to improve efficiencies, but
successful execution will be critical. It is difficult to judge
overall progress on a quarterly basis, but improvement
in inventory management in 1H is encouraging, in our
view. We retain our Overweight rating on PRIL and
continue to watch for 1) SSG across formats; 2)
improvement in working capital management; and 3)
potential monetization of investments.
PRIL reported disappointing 2QF11 numbers…
Revenues, operating profit and net profit were 7%, 10%
and 37% below our estimates. Key negatives for the
quarter: 1) 150bps decline in operating margins for the
company, driven by continuing losses in electronics
retailing; 2) Rs4.5bn increase in standalone debt for
1HF11 – investments in subsidiaries and higher working
capital. Key positives: 1) strong SSG and 2) continuing
improvement in inventory management.
…and following these results, we now apply a 25%
probability to our Rs200 bear case value: PRIL is
currently trading closer to this value, which factors in
significant deterioration in overall working capital
management, increased debt servicing cost, and
consequent slowdown in long-term growth. We do not
assign any value to subsidiaries or JVs and charge
Rs5bn pa cash outgo to fund subsidiaries. Our new
target price is Rs421 (a 35% cut); our base case intrinsic
value is Rs495 per share.
Pantaloon: Execution Is Key Stock Driver
We have cut our earnings estimates in F2011, F2012 and
F2013 by 34%, 31%, 27% respectively, driven by three key
reasons:
1) Continuing losses in the electronics retailing
business: According to management, competitive pressures
and operational issues in the electronics business are driving
lower realizations and affecting Pantaloon’s overall home
retailing business performance. With a view to managing it
more efficiently, management plans to transfer the electronic
business to a wholly-owned subsidiary. In our view, margins
may continue to suffer from losses in this business but we
believe the current stock price already discounts this. We now
expect the home business to break even only in F2014 vs.
F2012 previously.
2) Cost inflation led margin compression in F11: EBITDA
Margins for the core retail business are down 150bps yoy in
Q2F11. We believe lifestyle margins would have been
hampered by inflation in prices of both cotton as well as
agricultural commodities. Notwithstanding a cyclical reduction
in inflation, and re-pricing of stock (especially in the apparel
segment) due to depletion of lower-priced store level
inventory and stock at warehouse, we are now assuming flat
margins in lifestyle retailing business – assumptions that may
prove to be conservative unless inflationary pressures
intensify
3) Higher interest costs: Interest costs are up 12% yoy
driven by Rs 4.5bn increase in debt in 1HF11. In our view, this
debt is being used to fund increase in investments in
subsidiaries (~Rs 2bn) and higher working capital (~Rs2.7bn).
We now estimate a higher debt servicing cost for the company,
and have raised it by 50bps to 13% for F11-14e. We have also
raised our debt estimates to Rs 35bn as at June 2011 from Rs
29bn previously as we factor in slower improvement in overall
working capital efficiency.
What’s changed in our estimates for Core Retail
Business? Revenues estimates are slightly lower, mainly
driven by lower than expected new space addition. We have
significantly lowered our EBITDA margin estimates adjusting
for 1) continuing losses in home retailing – we now expect the
business to break-even only by F14 vs. previous expectation
of F12 and 2) cost inflation. Our net profit estimates having
been driven lower by higher interest costs (debt servicing
charges up 50bps across F11-14e) and a 100bps higher tax
rate.
We Think the Long-Term Story Is Intact
Based on our analysis of the pro-forma core retail financials,
we estimate that PRIL generated a large operating cash flow
(and indeed free cash flow) for the first time ever in F2010.
This improvement in operating performance was driven
largely by a sharp improvement in working capital
management, in our view. If this trend is sustained it will likely
be the most important driver of stock performance.
PRIL has been the worst performing stock in our coverage
universe over the past three months (down 46% vs. the 12%
decline in the Sensex). Our base case factors in operating
efficiencies driven by working capital improvement and
operation leverage. Although management has put in
requisite measures to improve operating efficiencies,
successful execution will be critical in driving these numbers.
However, if the management is not able to improve working
capital management and benefit from operating leverage,
then we believe the stock would continue to trade closer to our
revised bear case value of Rs200 per share, rather than our
current base case of Rs495. It is difficult to judge working
capital management on a quarterly basis, but improvement in
inventory management in 1H is encouraging, in our view. We
retain our Overweight rating on PRIL.
The strength of its core retail business: PRIL’s underlying
retail business is continuing to show signs of strength, with
continuous improvement in same-store growth and improving
cash flow from operations. Pantaloon has demonstrated its
ability to develop appropriate business models to capture a
dominant share of consumer spending in India. PRIL has built
strong ecosystems in fashion, food, home products, general
merchandise, and consumer durables over the last few years.
We believe that the outlook for PRIL’s business fundamentals
is improving, driven by positive free cash flow from operations,
rising same-store sales growth (SSG) due to gains in
consumer confidence and recovery in IIP growth, a decline in
store rentals, and relatively benign competitive activity.
We continue to track:
1) SSG across formats
2) Further improvements in overall working capital
management
3) Investment in subsidiaries and
4) Potential monetization of investments.
PRIL is currently trading closer to our bear case value (Rs
200), which factors in significant deterioration in overall
working capital management, increase in debt servicing cost
and consequent slowdown in long-term growth for the
company. Also, we do not assign any value to subsidiaries or
joint ventures and charge Rs5bn pa cash outgo to fund
subsidiaries in the DCF. Following poor 2Q results we now
apply a 25% probability for this outcome. Consequently, our target price declines 35%, to Rs421, vs. our revised base case
intrinsic value of Rs495 per share.
Key Triggers for the Stock
a) SSG remains robust: With a recovery in consumer
confidence levels, we believe average SSG trends will remain
in the high teens across PRIL formats. PRIL’s stronger SSG
(vs. its competitors) reflects its better consumer connection
and store location advantages. We expect revenue CAGR of
25% over F2010-14e in the core retail business for PRIL.
b) Improvement in working capital management: The
recent improvement in working capital management will likely
be sustained, in our view, and this could be the most important
driver of stock performance.
c) Monetization of investments in subsidiaries: According
to management, the board of directors approved, subject to
shareholder approval, the creation of a wholly-owned
company to manage and build the electronics business in a
manner that is less cost-intensive. We believe this would also
facilitate monetization of PRIL's investment in the electronics
retailing business. The management is now laser-focused on
reducing its debt burden – this can be achieved through a
combination of efficient capital management and monetization
of investments in some of its subsidiaries (such as Future
Capital, Future Ventures, Electronics retailing venture E-zone,
online retailing portal Futurebazaar etc). In our base case we
value these investments at 50% of book value.
We maintain our Overweight rating with a new target
price of Rs421 – 70% upside from current levels: We
expect the company (core retail) to deliver strong top-line
CAGR of 25% over the next four years (F2010-14e). We
believe that PRIL’s core retail space can post a CAGR of 13%
over the next four years and reach 21.4mn sq feet by F2014.
We assume operating margin for the core business will
improve steadily from 8.6% in F2011e to 9.2% in F2014. An
earnings CAGR of 49% for F2010-14e should arise from
better cost management, efficiencies from scale and financial
leverage.
Valuation: Price Target Revised to Rs421 from Rs644
Scenario Analysis
Price target (Rs421): We are reducing our price target to
Rs421 from Rs644. Our base case DCF model factors in
operating efficiencies driven by working capital improvement
and operating leverage. Although management has put in
requisite measures to improve efficiencies, successful
execution will be critical in driving these numbers. Following
poor 2Q results we now apply a 25% probability for our bear
case outcome and 75% to our base case.
Base Case (Rs495, down from Rs644): We have slightly
lowered our revenue estimates, mainly driven by lower than
expected new space addition. In our base case, we now expect
the home business to break even only by F14 vs. F12
previously. We assume the operating efficiencies achieved in
F2010 to sustain, driving an overall EBITDA margin expansion
of ~20 bps pa. & strong positive operating cash flow generation
to provide financial leverage. We have also raised our
estimates of debt servicing charges up by 50bps across
F11-14e and factor in a 100bps higher tax rate.
We value the core retail business (Value + Life – including
Home retailing) at Rs495 per share and assign a 50% discount
factor to book value of investments in subsidiaries and joint
ventures to derive our price target. We expect operating profit
CAGR of 24% between F2010 and F2014.
In our base case, for the core retail business we have assumed
that inventory less payables as a percentage of sales falls to
~6% by F2014 from existing levels of ~13%. We also assume
that EBITDA margin rises to 9.2% in F14 similar to F10 margin.
Exhibit 13
PRIL: Assumptions Underlying Our Base Case DCF
Model
Particulars Value
Nominal Growth rate during C2010E-20E (%) 15
Nominal Growth rate post 2020E (%) 6
Return on Incremental Capital employed during C2010E-20E (%) 13
Return on Incremental Capital employed during C2020E (%) 13
WACC (%) 10.5
Value (Rs. per share) 495
Source: Company data, Morgan Stanley Research
Bull Case (Rs647, down from Rs911): In our bull case, we
have assumed a significant improvement in overall working
capital management (compared to our base case). We value
Future Capital Holdings Ltd (listed subsidiary) on the basis of
market capitalization and other investments in subsidiaries and
joint ventures at book values.
In our bull case, we assume that inventory less payables is flat
by F2014 (we previously expected it to be negative). We also
assume an EBITDA margin of 10% in F2014 (previously we
assumed 12%) against the current 8.6% in F2011e.
Bear Case (Rs200, down from Rs332): PRIL is currently
trading close to our bear case value (Rs 200), which factors in
significant deterioration in overall working capital management,
increase in debt servicing cost and consequent slowdown in
long term growth for the company. Also, we do not assign any
value to subsidiaries or joint ventures and charge Rs5bn pa
cash outgo to fund subsidiaries in the DCF.
In our bear case, we assume that inventory less payables as a
percentage of sales increases to 16% by F2014 (we previously
expected 12%) from ~13% currently. We also assume an
EBITDA margin of 8.1% in F2014 against the current 8.6% in
F2011e.
Key Downside Risks to Rating and Price Target
An unfavorable macro and political environment might hamper
Pantaloon’s SSG. At the company-specific level, we cite:
1) Execution risk in terms of store rollouts
2) Sharp deterioration of working capital management
3) Company increases discounts to liquidate inventory
4) Increased funding requirement of its subsidiaries
Investment Thesis: Why OW?
• Despite recent severe weakness in
the stock, we think the long-term story
is intact, led by signs of strength in the
core retail business.
• Large operating cash flow (and free
cash flow) for the first time ever in
F2010, driven largely by much
improved working capital management.
• Our base case factors in operating
efficiencies, driven by working capital
improvement and operation leverage.
• However, if Pantaloon is not able to
improve working capital management
and benefit from operating leverage,
then we believe it would continue to
trade closer to our revised bear case
value of Rs200 per share, rather than
our current base case of Rs495.
Key Value Drivers
• Successful rollout of new stores.
• Margin expansion/contraction
because of scale benefits and
improving profitability of older stores.
• Improvement in working capital
management by managing
inventories more efficiently; SSG
showing gains.
Potential Catalysts
• Improvement in SSG.
• Margin expansion led by cost savings
and improvement in inventory
management.
• The unlocking of value in subsidiaries
• Further improvement in cash flow from
operations
• Better-than-expected new space
rollout.
Downside Risks
• Inability to fund growth plans
• Increased discounts to liquidate
inventory, squeezing gross margin
• Execution risk in terms of store
rollouts.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
Pantaloon Retail
Near-Term Headwinds; Execution Key Stock Driver
What's Changed
Price Target Rs644.00 to Rs421.00
EPS FY11e, FY12e, FY13e -34%, -31%, -27%
We have cut earnings estimates by ~30% through
our investment horizon: This reflects 1) continuing
losses in the electronics business; 2) cost inflation-led
margin compression; and 3) higher interest costs. PRIL
is the worst performing stock in our coverage over the
past three months (down 46%). Our base case factors in
operating efficiencies from working capital improvement
and operating leverage. Management has put in
requisite measures to improve efficiencies, but
successful execution will be critical. It is difficult to judge
overall progress on a quarterly basis, but improvement
in inventory management in 1H is encouraging, in our
view. We retain our Overweight rating on PRIL and
continue to watch for 1) SSG across formats; 2)
improvement in working capital management; and 3)
potential monetization of investments.
PRIL reported disappointing 2QF11 numbers…
Revenues, operating profit and net profit were 7%, 10%
and 37% below our estimates. Key negatives for the
quarter: 1) 150bps decline in operating margins for the
company, driven by continuing losses in electronics
retailing; 2) Rs4.5bn increase in standalone debt for
1HF11 – investments in subsidiaries and higher working
capital. Key positives: 1) strong SSG and 2) continuing
improvement in inventory management.
…and following these results, we now apply a 25%
probability to our Rs200 bear case value: PRIL is
currently trading closer to this value, which factors in
significant deterioration in overall working capital
management, increased debt servicing cost, and
consequent slowdown in long-term growth. We do not
assign any value to subsidiaries or JVs and charge
Rs5bn pa cash outgo to fund subsidiaries. Our new
target price is Rs421 (a 35% cut); our base case intrinsic
value is Rs495 per share.
Pantaloon: Execution Is Key Stock Driver
We have cut our earnings estimates in F2011, F2012 and
F2013 by 34%, 31%, 27% respectively, driven by three key
reasons:
1) Continuing losses in the electronics retailing
business: According to management, competitive pressures
and operational issues in the electronics business are driving
lower realizations and affecting Pantaloon’s overall home
retailing business performance. With a view to managing it
more efficiently, management plans to transfer the electronic
business to a wholly-owned subsidiary. In our view, margins
may continue to suffer from losses in this business but we
believe the current stock price already discounts this. We now
expect the home business to break even only in F2014 vs.
F2012 previously.
2) Cost inflation led margin compression in F11: EBITDA
Margins for the core retail business are down 150bps yoy in
Q2F11. We believe lifestyle margins would have been
hampered by inflation in prices of both cotton as well as
agricultural commodities. Notwithstanding a cyclical reduction
in inflation, and re-pricing of stock (especially in the apparel
segment) due to depletion of lower-priced store level
inventory and stock at warehouse, we are now assuming flat
margins in lifestyle retailing business – assumptions that may
prove to be conservative unless inflationary pressures
intensify
3) Higher interest costs: Interest costs are up 12% yoy
driven by Rs 4.5bn increase in debt in 1HF11. In our view, this
debt is being used to fund increase in investments in
subsidiaries (~Rs 2bn) and higher working capital (~Rs2.7bn).
We now estimate a higher debt servicing cost for the company,
and have raised it by 50bps to 13% for F11-14e. We have also
raised our debt estimates to Rs 35bn as at June 2011 from Rs
29bn previously as we factor in slower improvement in overall
working capital efficiency.
What’s changed in our estimates for Core Retail
Business? Revenues estimates are slightly lower, mainly
driven by lower than expected new space addition. We have
significantly lowered our EBITDA margin estimates adjusting
for 1) continuing losses in home retailing – we now expect the
business to break-even only by F14 vs. previous expectation
of F12 and 2) cost inflation. Our net profit estimates having
been driven lower by higher interest costs (debt servicing
charges up 50bps across F11-14e) and a 100bps higher tax
rate.
We Think the Long-Term Story Is Intact
Based on our analysis of the pro-forma core retail financials,
we estimate that PRIL generated a large operating cash flow
(and indeed free cash flow) for the first time ever in F2010.
This improvement in operating performance was driven
largely by a sharp improvement in working capital
management, in our view. If this trend is sustained it will likely
be the most important driver of stock performance.
PRIL has been the worst performing stock in our coverage
universe over the past three months (down 46% vs. the 12%
decline in the Sensex). Our base case factors in operating
efficiencies driven by working capital improvement and
operation leverage. Although management has put in
requisite measures to improve operating efficiencies,
successful execution will be critical in driving these numbers.
However, if the management is not able to improve working
capital management and benefit from operating leverage,
then we believe the stock would continue to trade closer to our
revised bear case value of Rs200 per share, rather than our
current base case of Rs495. It is difficult to judge working
capital management on a quarterly basis, but improvement in
inventory management in 1H is encouraging, in our view. We
retain our Overweight rating on PRIL.
The strength of its core retail business: PRIL’s underlying
retail business is continuing to show signs of strength, with
continuous improvement in same-store growth and improving
cash flow from operations. Pantaloon has demonstrated its
ability to develop appropriate business models to capture a
dominant share of consumer spending in India. PRIL has built
strong ecosystems in fashion, food, home products, general
merchandise, and consumer durables over the last few years.
We believe that the outlook for PRIL’s business fundamentals
is improving, driven by positive free cash flow from operations,
rising same-store sales growth (SSG) due to gains in
consumer confidence and recovery in IIP growth, a decline in
store rentals, and relatively benign competitive activity.
We continue to track:
1) SSG across formats
2) Further improvements in overall working capital
management
3) Investment in subsidiaries and
4) Potential monetization of investments.
PRIL is currently trading closer to our bear case value (Rs
200), which factors in significant deterioration in overall
working capital management, increase in debt servicing cost
and consequent slowdown in long-term growth for the
company. Also, we do not assign any value to subsidiaries or
joint ventures and charge Rs5bn pa cash outgo to fund
subsidiaries in the DCF. Following poor 2Q results we now
apply a 25% probability for this outcome. Consequently, our target price declines 35%, to Rs421, vs. our revised base case
intrinsic value of Rs495 per share.
Key Triggers for the Stock
a) SSG remains robust: With a recovery in consumer
confidence levels, we believe average SSG trends will remain
in the high teens across PRIL formats. PRIL’s stronger SSG
(vs. its competitors) reflects its better consumer connection
and store location advantages. We expect revenue CAGR of
25% over F2010-14e in the core retail business for PRIL.
b) Improvement in working capital management: The
recent improvement in working capital management will likely
be sustained, in our view, and this could be the most important
driver of stock performance.
c) Monetization of investments in subsidiaries: According
to management, the board of directors approved, subject to
shareholder approval, the creation of a wholly-owned
company to manage and build the electronics business in a
manner that is less cost-intensive. We believe this would also
facilitate monetization of PRIL's investment in the electronics
retailing business. The management is now laser-focused on
reducing its debt burden – this can be achieved through a
combination of efficient capital management and monetization
of investments in some of its subsidiaries (such as Future
Capital, Future Ventures, Electronics retailing venture E-zone,
online retailing portal Futurebazaar etc). In our base case we
value these investments at 50% of book value.
We maintain our Overweight rating with a new target
price of Rs421 – 70% upside from current levels: We
expect the company (core retail) to deliver strong top-line
CAGR of 25% over the next four years (F2010-14e). We
believe that PRIL’s core retail space can post a CAGR of 13%
over the next four years and reach 21.4mn sq feet by F2014.
We assume operating margin for the core business will
improve steadily from 8.6% in F2011e to 9.2% in F2014. An
earnings CAGR of 49% for F2010-14e should arise from
better cost management, efficiencies from scale and financial
leverage.
Valuation: Price Target Revised to Rs421 from Rs644
Scenario Analysis
Price target (Rs421): We are reducing our price target to
Rs421 from Rs644. Our base case DCF model factors in
operating efficiencies driven by working capital improvement
and operating leverage. Although management has put in
requisite measures to improve efficiencies, successful
execution will be critical in driving these numbers. Following
poor 2Q results we now apply a 25% probability for our bear
case outcome and 75% to our base case.
Base Case (Rs495, down from Rs644): We have slightly
lowered our revenue estimates, mainly driven by lower than
expected new space addition. In our base case, we now expect
the home business to break even only by F14 vs. F12
previously. We assume the operating efficiencies achieved in
F2010 to sustain, driving an overall EBITDA margin expansion
of ~20 bps pa. & strong positive operating cash flow generation
to provide financial leverage. We have also raised our
estimates of debt servicing charges up by 50bps across
F11-14e and factor in a 100bps higher tax rate.
We value the core retail business (Value + Life – including
Home retailing) at Rs495 per share and assign a 50% discount
factor to book value of investments in subsidiaries and joint
ventures to derive our price target. We expect operating profit
CAGR of 24% between F2010 and F2014.
In our base case, for the core retail business we have assumed
that inventory less payables as a percentage of sales falls to
~6% by F2014 from existing levels of ~13%. We also assume
that EBITDA margin rises to 9.2% in F14 similar to F10 margin.
Exhibit 13
PRIL: Assumptions Underlying Our Base Case DCF
Model
Particulars Value
Nominal Growth rate during C2010E-20E (%) 15
Nominal Growth rate post 2020E (%) 6
Return on Incremental Capital employed during C2010E-20E (%) 13
Return on Incremental Capital employed during C2020E (%) 13
WACC (%) 10.5
Value (Rs. per share) 495
Source: Company data, Morgan Stanley Research
Bull Case (Rs647, down from Rs911): In our bull case, we
have assumed a significant improvement in overall working
capital management (compared to our base case). We value
Future Capital Holdings Ltd (listed subsidiary) on the basis of
market capitalization and other investments in subsidiaries and
joint ventures at book values.
In our bull case, we assume that inventory less payables is flat
by F2014 (we previously expected it to be negative). We also
assume an EBITDA margin of 10% in F2014 (previously we
assumed 12%) against the current 8.6% in F2011e.
Bear Case (Rs200, down from Rs332): PRIL is currently
trading close to our bear case value (Rs 200), which factors in
significant deterioration in overall working capital management,
increase in debt servicing cost and consequent slowdown in
long term growth for the company. Also, we do not assign any
value to subsidiaries or joint ventures and charge Rs5bn pa
cash outgo to fund subsidiaries in the DCF.
In our bear case, we assume that inventory less payables as a
percentage of sales increases to 16% by F2014 (we previously
expected 12%) from ~13% currently. We also assume an
EBITDA margin of 8.1% in F2014 against the current 8.6% in
F2011e.
Key Downside Risks to Rating and Price Target
An unfavorable macro and political environment might hamper
Pantaloon’s SSG. At the company-specific level, we cite:
1) Execution risk in terms of store rollouts
2) Sharp deterioration of working capital management
3) Company increases discounts to liquidate inventory
4) Increased funding requirement of its subsidiaries
Investment Thesis: Why OW?
• Despite recent severe weakness in
the stock, we think the long-term story
is intact, led by signs of strength in the
core retail business.
• Large operating cash flow (and free
cash flow) for the first time ever in
F2010, driven largely by much
improved working capital management.
• Our base case factors in operating
efficiencies, driven by working capital
improvement and operation leverage.
• However, if Pantaloon is not able to
improve working capital management
and benefit from operating leverage,
then we believe it would continue to
trade closer to our revised bear case
value of Rs200 per share, rather than
our current base case of Rs495.
Key Value Drivers
• Successful rollout of new stores.
• Margin expansion/contraction
because of scale benefits and
improving profitability of older stores.
• Improvement in working capital
management by managing
inventories more efficiently; SSG
showing gains.
Potential Catalysts
• Improvement in SSG.
• Margin expansion led by cost savings
and improvement in inventory
management.
• The unlocking of value in subsidiaries
• Further improvement in cash flow from
operations
• Better-than-expected new space
rollout.
Downside Risks
• Inability to fund growth plans
• Increased discounts to liquidate
inventory, squeezing gross margin
• Execution risk in terms of store
rollouts.
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