Value Investing Contest Winning Entry #2: V-Mart Retail

This report was prepared by JK, as part of the Safal Niveshak Value Investing Contest. None of the facts herein have been validated by Safal Niveshak. Also, please DO NOT treat this report as a “recommendation” from either the author or Safal Niveshak. Do your own homework.

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The Big Picture
Understanding the big picture, foreseeing the structural trends and sector tailwinds play a critical role in identifying and developing conviction on ideas that go on to become multi-baggers creating huge wealth for investors in the long run.

So what are the current structural trends going on in the Indian economy?

I can clearly identify two –

1. Switch from Unorganized players to Organized players: Organized players are gaining market share from the unorganized players. This structural shift is happening in every consumer facing sector, be it jewellery, bathroom solutions, plumbing solutions, kitchen appliances, shoes, apparels and inner-wears, restaurants, or retail.

Why this switch? Because of rising income levels, customers’ aspirations are increasing and organized players are considered to be providing higher quality products.

Social proof, advertisements, Pavlovian association (to associate ‘I have heard of this product’ to ‘I like this product’) are the psychological reasons which are making sure that this switch is here to stay.

2. Increase in Purchasing Power of Tier-II & III cities’ population: With high rental costs and space constraints, many organizations are moving out of Metro and Tier-I cities and launching operations in smaller cities. With some of the village population moving to smaller cities for want of better lifestyle, the target population is also growing in smaller cities and it makes all the more sense for organizations to expand in Tier-II and Tier-III cities. Consequently, these cities are growing and expected to grow much faster than metro and Tier-I cities.

This is precisely the reason why some of the Tier-II & III focussed companies are growing much faster than the industry. For example – Emami, Cera, Kewal Kiran, Atul Auto are growing faster than their industry.

Now, how about a company which allows an investor to play both these themes simultaneously?

A company focussed on Tier-II and III cities and where organized players’ share is not even 10% of the total market size?

V-Mart Retail is one such company.

Company Business & History
V-Mart is in the business of Organized Retail. It is one of the pioneers in setting up retail stores across various small Indian towns and cities. V-Mart primarily operates in Tier-II & III cities and offers –

• Apparels (Men, women and infants);
• General Merchandise (Non-apparels i.e., footwear, fashion jewellery, books, games, home furnishing, kitchenware, crockery and gifts); and
• Kirana (FMCG products, food items, personal care and home care).

As on date, the company has 88 stores across 12 Indian states with a total area of 7.1 lakh sq feet.

V-Mart was incorporated as Varin Commercial Pvt. Ltd. in 2002. It opened its first retail store in Gujarat in 2003. In 2006, the name was changed to V Mart Retail Pvt. Ltd. and in 2008, it was made a public limited company. V-Mart came with IPO in the beginning of 2013 and got listed on 20th Feb. 2013.

Financials
Over the past 6 years (2008 to 2014E), V-Mart’s revenues have grown at a CAGR (compounded annual growth rate) of 33% while EBIT (earnings before interest and tax) has grown at 34% and PAT (profit after tax) has grown at an impressive CAGR of 40%.

So what’s the reason for this high growth?

A big part of this growth (26%) has come from increase in stores. About 6% growth has come from same store sales growth, and a part of PAT growth can be attributed to margin expansion.

Management Quality
V-Mart has a return oriented management handling the company. What makes me conclude that?

• Management’s aim is not store expansion but Sales and Profits growth. They keep mentioning this in their con-calls and annual report. “At V-Mart, we would rather grow 30% compounded across ten years supported by revenue growth in every single year as opposed to 50% compounded with three down years in ten” writes the management in its annual report .
• Management evaluates each store on Profitability basis. And if any store fails to perform as per expectations, the management isn’t hesitant to close it. Recent closure of three stores including one in Delhi is a good example of this. Read here.
• Management follows a Regional cluster-based store expansion strategy. Every new store they open is within 150-200 kms from an existing store. This strategy helps the company in efficient brand spending, superior inventory turns and better human resource management.
• Management keeps a good check on costs. The company’s rental costs and selling & distribution expenses are the lowest in the industry. They have also stopped offering Kirana products (being lower margin products) in their new stores.
• Management has outlined a policy of keeping debt to equity ratio below 0.75.

As a result of all these measures, the ROE (return on equity) stands at around 18% now.

Competition
V-Mart faces competition from Pantaloon, Trent, and Future Lifestyle from the listed space. However, all these retail chains focus mainly on Metros and Tier- I cities, while V-Mart’s sole focus area is Tier-II and III cities. The company faces nil to minimum competition from listed players in these cities.

Major competition in V-Mart’s target cities comes from local and niche players. However, as the company’s brand image and value proposition grows, it is bound to snatch market share from the local players.

Bullish Viewpoints

• Low penetration: The Indian retail industry has grown from Rs 14,574 billion in FY07 to Rs 28,840 billion in FY12, at a CAGR of 14.3%. During the same period (FY07 to FY12), organized retail has grown from Rs 598 billion to Rs 1,932 billion, at a CAGR of 26.4%. As a result, share of organized retail has grown from 4.1% in FY07 to 6.7% in FY12. Compared to the US and the UK where organized retail share is 80-85%, Indian figure of not even 7% is very small and provides ample growth opportunities for India’s organized retailers.
• Tier-II & III focus: Tier-II and Tier-III cities are growing and expected to grow faster than Metros and Tier-I cities. The growth in Tier-II and Tier III cities is aided by increasing disposable income that has created immense opportunities for companies looking out for new markets to grow. More and more companies are moving to these cities due to availability of talent pool at a lower cost, more affordable real estate prices and stable business environment. As a result of this trend, players with focus on smaller cities are doing well. Out of a total of 88 stores, V-Mart has more than 85% of its stores in Tier-II and Tier-III cities.
• Big opportunity size: As on date, V-Mart has 88 stores in 76 cities across 12 states, out of a total 1,600 cities (all tiers) in India spread across 35 states and union Territories. So, there is huge opportunity size that V-Mart can potentially cater to.
• First mover advantage: The retail industry has low entry barriers. However, being a first mover will help V-Mart in not just gaining better knowledge on customer needs and supply chain management but will also deter potential competitors from entering in these small markets, some of which may not be profitable for two retail chains.

So, we can see that V-Mart has a huge opportunity to grow. But how will this growth be funded?

• Ability to fund growth: At the end of December 2013, V-Mart had a surplus cash of 36.5 crore from its IPO & pre-IPO placement. The company opens new store with a total area of approx 8,000 sq foot and incurs capex of about Rs 1,300/sq foot for opening a new store. So, V-Mart can open 35 new stores before this cash runs out. It has opened 20-25 stores in FY14. So, this cash is enough to fund capex plans for next 1.5 years. The company’s has a healthy debt to equity ratio of 0.32 (as on Dec 13 end). It has a policy to keep debt to equity ratio below 0.75. So, internal accruals and some debt will be able to fund growth beyond 1.5 years also. There will be no need for raising cash through fresh equity. The management has also guided on the same in the con-calls.
• Sensible return-focussed management: Already discussed.
• Same store growth and margin expansion: Over the past 6 years (2008 to 2014E), the company has been able to grow its income per store at a CAGR of 6%. The growth has been higher in the recent years. The company achieved same store sales (stores operating for more than 1 year) growth of 20% in FY13 and 9% in 9mFY14. As it gains more popularity, this growth is expected to continue in the future as well. Its net profit margins have expanded from 3.6% in FY08 to 4.7% in FY13 due to economies of scale, effective utilization of ads & promotions, better bargaining power with suppliers, better inventory management and focus on better margin products (apparel and general merchandise).
• Good & improving ROE: For a new store, IRR calculations are as under:

So, a new store has IRR of 17.4% once it achieves efficient sales level (which generally happens in about 3 months).

Then with same store growth and margin expansion, it will improve in next few years and with efficient use of debt, the company should be able to improve ROE to 20%+.

Risks

• E-retailing: There is an increasing trend among Indian buyers to buy online due to higher discounts. Substantial increase in e-retailing can provide a challenge to V-Mart’s business model and its growth prospects. However, low internet penetration in India especially among V-Mart’s target customers (i.e., customers residing in Tier-II & III cities with annual income range between Rs 1 lakh to Rs 10 lakh) and tendency among Indian buyers to see and feel the product before buying should act as a hindrance for the growth of e-retailing.
• Competition and low entry barriers: The company faces competition not just from organized players like Pantaloon and Trent but also local niche players. Competition can intensify from multi-brand FDI which may eat into V-Mart’s margins. The industry has low entry barriers. It’s not tough to open retail stores. However, understanding customer needs, managing supply chain, and learning curve should act as a source of competitive advantage for a retail company like V-Mart.
• Inability to understand and adjust with fashion trends: The company is in the business of apparel and general merchandise wherein customers’ demands change with fashion trends. In case the management fails to understand and adjust its inventory based on fashion trends, the company may be left with unsold inventories. Hence, it’s important to monitor the company’s inventory holding days. At FY13-end, its inventory holding days were 94 (decreased from 103 days in FY12).
• Institutional exit: Foreign shareholding (shareholding with FIIs & NRIs) reached its maximum allowed limit of 24% in V-Mart recently. See here. DIIs also hold 7.5% of total shares. Exit by some of them even due to non-fundamental reasons may cause volatility in the stock price.

Valuation
At the current market cap of Rs 500 crore, V-Mart is trading at about 19x FY14 PAT. So what is market expecting at this price?

Assuming opportunity cost of 12% per year and terminal growth rate of 2% per year, market is pricing in 18% growth rate for the next 5 years.

So can V-Mart achieve 18% growth for next 5 years?

Yes in my view, with 5% same store sales growth and 13% annual increase in stores. For this, the company will need to have 162 stores by 2019 end. With more than 1,600 cities, that should not be a problem.

For opening 74 new stores, V-Mart will need capital of Rs 148 crore at current costs (Rs 1 crore per store for capex and Rs 1 crore per store for working capital). This growth can easily be funded by current cash (Rs 32 crore) and internal accruals over the next 5 years (NPV of PAT for 2015-19 is Rs 152 crore).

Also, V-Mart’s high growth period has a probability to last more than 5 yrs due to big opportunity size and economies of scale.

So, in nutshell, V-Mart is a good and improving business with huge opportunity size and is priced attractively.

Disclosure: I, JK, am invested in the stock.