PC Jeweller is a leading Indian jewelry retailer with 41 showrooms across India. It is strong operator consistently generating above average margins, IC Turnover and Return on Invested Capital. The company will more than double its showroom over the next five years. It is managed by owner operators with a long-term outlook and incentives aligned with minority shareholders by virtue of owning over 70% of the company and total compensation less than 1.5% of operating income. The company is in a strong financial position with net debt to EV of 18%. Despite the company’s strengths, it is trading on a pre-tax operating income yield of 20% twice the local AAA corporate bond yield. It warrants a 10% position.
The following is a brief summary of the primary factors of evaluating a company discussed at greater length in the report.
The certainty with which the long-term economic characteristics of the business can be evaluated
The Indian Jewelry industry does not seem to have any barriers to entry given there are 4,500 jewelry retailers in the industry. Most of these competitors are traditional retailers. Modern retailers only account for about 20% of the total jewelry market in India but increasing their share. Although barriers to entry seem not to exist, PC Jeweller consistently generates ROIC significantly above its cost of capital and its competitors. This can be attributed to the strength of PC Jeweller’s designs, its focus on the wedding segment, its strength in selling diamonds and weak competition from the traditional sector.
PC Jeweller is not exposed to gold price fluctuations as the company purchases inventory through gold leasing programs allowing the company to price the inventory at the time of sale, assuming it is within 180 days.
PC Jeweller’s profitability should persist for some time given the growth expected in the market and the low penetration of the modern market will both competitive forces at bay.
Current earnings used in valuations are conservative given the PC Jeweller should double its showroom count over the next five years.
The certainty with which management can be evaluated, both as to its ability to realize the full potential of the business and to wisely employ its cash flows
Management has not allocated capital to anything other than store expansion, and a small cash dividend. This and management’s statements of future expansion provide evidence that the company will continue to allocate capital to showroom expansion. Management executes generating ROIC well above the industry average. As owner operators whose wealth is derived primarily from PC Jeweller, management ensures the company maintains a healthy financial position. The company continued expansion will be financed by cash flows and gold leasing programs for inventory requirements. Both ensure PC Jeweller will stay financially strong.
The certainty with which management can be counted on to channel the rewards from the business to the shareholders rather than to itself
There are no corporate governance issues, management owns 70% of the company’s shares and management has started paying a small dividend. Management’s wealth is directly tied to share ownership, as management’s base salary is less than a percent of the value of the shares outstanding, ensuring incentives are aligned with minority shareholders. The small dividend paid would be better allocated to expansion and brand building in new regions, but it seems to be a signal of management’s intention to pay dividends in the future as the business matures.
The purchase price of the business
A period of regulatory pressure created an environment where growth slowed and upfront investment requirements increased. Demand weakened due to cyclicality. Both regulatory pressures and demand cyclicality weakened share prices within the sector. PC Jeweller is trading at a 20% EBIT yield almost twice the AAA corporate bond yield. This yield is extremely attractive given the growth outlook for the industry and company. The company is also trading well below peers with stronger returns, financial health and corporate governance.
PC Jeweller started operations in April 2005 with one showroom at Karol Bagh Delhi. It is a first generation business promoted by two brothers Padam Chand Gupta and Balram Garg. Mr. Padam Chand Gupta, Chairman of the Company has three decades of jewelry experience. At the end of FY2014 (March 31, 2014), PC Jeweller had 41 showrooms with 238,000 total square feet. PC Jeweller is targeting 56 showrooms with 338,000 total square feet by the end of FY2015. PC Jeweller has yet to close any of its showrooms.
PC Jeweller has its origins in Delhi NCR. It builds operations and showrooms in the region and has expanded to other regions within India. With showrooms in Tier I, Tier II and metros, the company is disciplined to wait for locations on high streets.
The company’s business model consists of opening large format, stand-alone stores at high street locations. Its stores stock a wide range of jewelry across all price points, with an increasing focus on diamond jewelry. The company sells only hallmarked jewelry and certified diamond jewelry. This assurance on quality & purity along with transparent & customer friendly policies has enabled PCJ to become an established and trusted brand name in a short time span.
The managers of PC Jeweller are owner operators. At the end of FY2014, the promoters hold 70.55% of total shares outstanding up from 70.02% from the end of FQ3 2014. No shares are pledged.
The company has two business segments: domestic and export. The domestic division accounts for roughly 75% of sales and exports accounts for the remaining 25%.
INDIAN GEMS AND JEWELRY INDUSTRY
According to the World Gold Council, India is the largest consumer of gold jewelry in the world at 29% of total consumption. According to CARE, the Indian Gems and Jewelry Export Industry reached US$42.83 billion in 2012 and is expected to grow at 8-10% over the next few years. The Indian gems and jewelry industry has various segments: cut and polished diamonds, gemstones, gold and diamond jewelry, pearl and synthetic stones and others with the two major industry segments in India are gold and diamond jewelry. India also dominates the diamond processing trade with 11 out of 12 diamonds being cut and polished in India. The industry accounted for approximately 14.1% of India’s export revenue in fiscal 2012 and directly or indirectly provided employment to approximately 3.5 million people. The low cost of labor and highly skilled labor force are keys to India’s competitiveness in the Global Jewelry Industry.
The domestic jewelry retail industry reached US$45.3 billion (₹2,165.9 billion) in 2012, with gold sales account for 80-85% of the total sales. Government regulation stifled growth over 2013 and the beginning of 2014. Despite the government actions, AT Kearney believes the domestic jewelry retail industry can double over the next 6 years, with growth fuelled by the growing spending power of Indians (economic growth), the increased participation of the modern retail channel (increased advertising) and increased acceptance of wearing jewelry every day. Investment demand accounts for an estimated 45% of total jewelry demand. 57% of investment demand in India comes in the form of coins and bars. PC Jeweller does not sell bars or coins but many of the company’s largest competitors do.
The government took a number of actions to decrease the consumption of gold as gold prices slumped Indian consumers went on a gold buying spree creating a hole in India’s current account deficit. Gold has the second-highest share in imports, increasing from 6% in 2002-2003 to 11% in 2012-2013. The government’s focus was investment demand but the lack of investment infrastructure meant that from a regulatory it was difficult to differentiate between consumption and investment leading to consumption demand being stifled as well. The timeline of regulatory events is listed below.
The regulators increased the import duty to 10%, required 20% of all imports to be re-exported (80/20) and required domestic buyer to pay cash. This eliminated sales generated by credit programs created by many of the retailers. PC Jeweller’s credit program was less than 3% of sales but some competitors had significant amount of sales through credit programs. The requirement of domestic buyers to pay cash greatly increased the working capital requirements of the jewelry retailers, as the industry requires significant inventory. Prior to the requirement for cash purchases, retailers financed inventory through gold leases which allowed them to hold inventory for 180 days and price it at the time of sales. Only if inventory was held for more than 180 days did retailers take on gold price risk. Gold leasing also came at an interest rate of 3-4% compared to a working capital loan that had an interest rate over 10%. On May 22nd, 2014, the government allowed eased the regulation allowing retailers to lease gold decreasing upfront working capital requirements and financing costs.
The other regulations will be eased as the current account deficit comes under control. Given the importance of gold in the Indian culture, it is difficult to see the regulatory pressure being anything more than a cyclical measure meaning as Government regulations ease growth in the industry should continue.
The domestic jewelry retailing industry is fragmented with over 450,000 traditional neighborhood jewelers. Over last five years with share of national and regional modern retail chains increased from 3-5% and 7-17% respectively. The table below illustrates store counts of the largest players within the industry.
Given there are over 4,500 industry participants it would be hard to argue that any barriers to entry number of participants, there is clearly no barriers to entry in the industry. Fragmentation could also be a function of the diversity in cultures throughout India leading to diverse consumer preferences. The growth of Modern Retailers creates a potential for economies of scale on purchasing, advertising, and the design process. Many participants point to the modern retailers’ strength in design as a key selling point over traditional retailers.
Looking at the other four forces, there are a large number of diverse competitors and the customers has very low switching costs pointing to intensity of rivalry being a strong competitive force. The threat of substitute is a weak force.The bargaining power of suppliers of materials is a weak force particularly for the larger modern retailers as most modern retailers have manufacturing facilities and can easily fully backward integrate. The supply is also a commodity that is a sizeable portion of a retailers’ total cost, both factors point to significant price sensitivity. The bargaining power of suppliers of labor is a strong force as the industry has an apprenticeship model rather than formal institutional training creating both long training times and a lack of industry best practices and standardization. The industry is not attractive for younger workers so labor may extract higher value in the future. The bargaining power of customers is a strong force as there are low switching costs, many different competitors, the product is a high purchase price item creating an incentive for customers to shop around and customers are more sophisticated than one would think based on where the industry is in its life cycle given the cultural importance of gold. Overall, the five competitive forces point to an industry that should not earn economic profits. A few things ease competitive pressures. The industry growth rates and the traditional retailers are not strong competitors. Competition is predominantly between traditional and modern rather than between modern competitors allowing modern retailers to generate excess profits with more efficient operations. Titan Company and PC Jewellers are the stand out ROIC performers within the sector.
Titan generates the highest ROIC in the sector. Titan is the largest jewelry retailer with international operations and the largest domestic store count. Titan and PC Jewellers also has the best brand recognition of all companies within the sector with 100% percent of the respondents are aware of Tanishq (Titan) followed by PC Jewellers (84%), Mehrason (84%), Nakshatra (81%), Sanchi (77%) & Gitanjali (63%).
Strong margins, through superior design, and better than average IC Turnover drives PC Jeweller strong ROIC performance. In PC Jeweller’s export business, the company generates substantially higher margins than peers due to the company’s strength in design. In the domestic business, PC Jeweller’s strength in design and high share of diamond jewelry sales relative to the overall market drive the strong performance.
During the period of intense regulatory pressure, Titan Company and PC Jeweller were the only large retail companies able to maintain net margins above 5%, illustrating the strength of both companies.
PC Jeweller’s management team has done a good job of navigating the highly competitive Indian Jewelry industry in a profitable manner. As illustrated above, the company is generating a well above average ROIC. Cash flows are negative but this is associated with the company’s expansion. Owner’s earnings and owner’s earnings ROIC are very positive.
The company has not made any acquisitions and there are no significant related party transactions. The company is paying a dividend of $1.50 per share. Given the showroom expansion opportunities, strong ROIC and the nascent stage of the modern retail market, the insignificant dividend could be better used for brand building or showroom expansion. With that said, it sends a signal to the market of management’s intention to pay dividends in the future, which may alleviate concerns over future capital allocation.
Management is doing a good job of focusing on increasing long-term intrinsic value and their incentives are aligned with minority shareholder with key management wealth tied to share prices rather than salary.
PC Jeweller strategy is to continue to expand the number of large format showrooms (>3,500 sq. ft.) to create a pan-Indian presence focused on the wedding segment. The company expects to open 100,000 sq. ft. in 15 showrooms in FY 2015.
The company is trying to increase the amount of diamond jewelry sold as a percentage of total sales, as illustrated in the revenue breakdown chart above diamond jewelry has 30-35% gross margins compared to 10% gross margins for gold jewelry. Gold jewelry increased as a percentage of sales in FY2014 due to the fall in gold prices making the gold more attractive on a relative basis.
The company is trying to maintain exports as a consistent portion of revenues to help buffer against regulatory risk, particularly the 80:20 rule stating 20% of gold imported must be re-exported.
The company has been making strides at creating a national brand through advertising and sponsorships. From 2008 to 2013, the company only spent 81bps of sales on advertising. If branding creates significant value, the company should be spending more on advertising.
Who knows what the future holds or what growth PC Jeweller will see. The industry is highly regulated and macroeconomic concerns persist both globally and in India. Although the future growth rate is very uncertain the drivers of growth are in place. As illustrated below, India’s GDP per capita is low relative to the rest of the world allowing for ample room for economic growth. India’s debt levels are low relative to the rest of the world eliminating the burden of debt. India’s organized retail sector contribution is a small percentage of the overall market as India matures so should its organized retail sector.
PC Jeweller has a history of showroom growth and the company’s ambitions are for many more showrooms. The company has the ambition and the market has the room for PC Jeweller to reach at least 100 stores, which seems to be a target for the company although it has not officially stated such.
There is a high degree of confidence double digit growth will persist for at least the next five years and more likely ten years, with that stated, no growth is assumed in valuations.
PC Jeweller is trading on an EV/EBIT of 5 times. It seems irrational for a company with a franchise value of almost three and a long runway for growth to trade at a pre-tax income yield of 20% almost two times the AAA corporate bond yield in India. PC Jeweller has no corporate governance issues, no business quality issues, and no financial health issues, yet is offering a 100% return of capital in three and half years, assuming a full payout of EBIT.
Assuming the company can double its store count in the next five years and there are no operational improvements or changes to the competitive landscape, PC Jeweller will be on an EBIT yield of 40% in five years.
No Growth Valuation
Using the assumptions of key value drivers illustrated above, PC Jeweller has a blended valuation of ₹227 per share. Operating margin is higher than the financial ratios above as rent expense is capitalized and added to debt. Finance charges for working capital are moved below the operating line, removed from working capital and added to debt. Both reflect the underlying economics of the transactions.
The table and chart below show intrinsic value per share progression of PC Jewellers.
The table below shows the sensitivity of the Target Price to changes in key value drivers.
On an EV/EBIT basis, PC Jeweller trades at a significant discount to industry peers despite the strength of the PC Jeweller’s profitability, growth outlook and financial health. There are no corporate governance issues, which would warrant the valuation discount. Titan is the clear leader in the sector and warrants a premium but PC Jeweller should trade at a premium to all other players.
The company is trading at low valuation because of a lack of coverage, regulatory pressures on the industry and the cyclical nature of demand. Those with a short-term investment horizon shun the uncertainty of not knowing when regulatory pressures will be alleviated from the industry.
As illustrated over the past two years, the biggest risk for PC Jeweller and the jewelry industry is regulatory risk. As the industry matures, the infrastructure for investment demand and consumer demand for gold should mature and separate. Given the regulators were targeting investment demand, this maturation should lead to less regulatory risk going forward.
Growing competition from the modern and traditional retailers in the form of better product offering is always a concern.
Expansion outside of Delhi NCR could lead to weaker returns as the company moves outside of a region, where its brand is well known and it understands the design requirements of the local culture.
Tightness in supply of skilled labor could be an issue in the future as the industry is not attractive to younger workers and there is no formal training programs to create best practices for the industry.
Jewelry is a traditional investment vehicle for Indians as the financial system matures and confidence in the system grows there could potentially be disinvestment in gold in favor of modern savings platforms. If the Reserve Bank of India were to tame inflation for an extended period, investment in gold may decline as well.