PC Jeweller FQ2 FY2015 Results November 17, 2014
PC Jeweller reported FQ2 2015 results on November 12, 2014. The results point to a normalizing operating environment after regulations and economic weakness temporarily depressed showroom productivity and profitability.
PC Jeweller currently trades on EV/Operating Profit 8.5x below a no growth valuation. This is extremely cheap for a company that is run by owner operators with a franchise value of 3, has a target of tripling its showroom count over the next three years and has room for productivity increases as the regulatory pressures ease and the economy improves.
The graphic below gives a good overview of the top line breakdown.
Given the seasonality in the business, best way to look at the number is by focusing on year on year figures.
Overall Sales for Q2 FY 2015 was Rs. 11,836 mn (6.5% yoy) driven by domestic retail sales of Rs. 9,938.3 mn (44.8% yoy).
The growth of 44.8% exaggerates the strength of the quarter, as FQ2 2014 was a period of weakness in domestic retail operations. FQ1 2014 was a very, very strong quarter so demand was pulled forward out of FQ2 2014 weakening the quarter a bit. Additionally, FQ2 2014 was when regulatory conditions started to tighten significantly and supply side was squeezed. There was uncertainty over the new procurement rules (80:20, no gold leases) and import duties were increased to 10%. In the latest quarter (FQ2 2015), regulatory pressures have eased and gold prices fell by 11%. There is normalization after a very weak period associated with a higher gold price and regulatory pressures on the supply side.
Recent regulation declared PC Jeweller’s Jewellery for Less program as illegal. Under this program, customers pay in installments for jewelry. Many other retailers have similar programs; all are in the process of being discontinued. Forced redemptions of pre-payments from Jewellery for Less accounted for 4-5% of total sales. Growth without JFL redemptions was 37.5%. Almost 90% of deposits have been redeemed so forced redemptions should have minimal effect on sales going forward.
Over the past year, PC Jeweller has increased its showroom count to 46 from 36. It total square feet increased to 272,000 from 198,000. Looking at sales per sq ft to account for capacity growth, sales per sq ft grew by 5% yoy illustrating capacity growth was the main driver behind sales growth in the quarter. Sales per sq ft trended up until RBI regulations came into force creating the supply side restrictions. Demand was hampered by an increase of import tariffs to 10%. As regulation and the economic environment normalize, sales per sq ft should start trending upward again.
Export sales dropped by 55%. Management states revenues are order based and tend to be very lumpy.
Profitability increased by 12% yoy with Domestic Profit before interest and tax (PBIT) increasing by 109% and export PBIT decreasing by 73%. The strong profitability was due to weakness in FQ2 2014 and operating advantage in the business. PC Jeweller also increased its share of diamond sales in FQ2 2015 (32.5% vs. 30.3% in FQ2 2014). This profitability came with lower capital requirements leading to an improve ROCE (36% vs. 24%). Despite the weakness in sales per square foot the company has been able to maintain profitability per square foot, which speaks to potential for productivity gains.
Interest costs increased significantly yoy as working capital continues to be financed through loans rather than gold leases. Loan rates are roughly 10% compared to 3% gold lease rate. The Reserve Bank of India recently eased regulation banning gold leases and the industry is in the process of moving back to gold leases so finance costs should decrease.
As illustrated above, Interest Expense to Raw Material Costs have increased from an average of 3.8% between FY2008 to FY2014. In FQ4 2014, the RBI implemented the requirement for upfront payment purchases for gold. This shifted inventory financing from gold leases, which were not paid until the sale of gold and only carry an interest cost of 3-4%, to loans, which carry an interest rate of 8-12%. Interest Expense increased to 5.7% of Raw Material Costs in FQ2 2015. The RBI rolled back the regulation and gold leases are now permissible. Eliminating the excess Interest Expense associated with financing via loans Profit Before Tax would have increased by 9.7% rather than a decrease of 5%.
Taxes increased as tax subsidies have expired and the tax rate is at a normal rate.
PC Jeweller targets opening 20 new showrooms every year for the next five years. Total showroom count will triple greater than our initial aggressive estimates of a double showroom count over the next five years. PC Jeweller will open large showroom in Tier I and Tier II metros. The company will start franchising for Tier III cities. PC Jeweller’s growth story is strengthened by management’s showroom target. Franchising is a good strategy as it decrease investment costs and hopefully gets the company first in some Tier III cities to acquire the brand jewelry position in the mind of consumers. It will be very interesting to see if PC Jeweller can maintain its efficiency and profitability as franchising requires appropriate processes or the PC Jeweller name can be hurt.
The company also announced an exclusive deal with popular online shopping site Flipkart. The companies plan to revolutionize online jewelry sales. PC Jeweller could not have found a better partner and this gives the company a unique online proposition. It also shows the innovation and forward thinking of management.
Relative to peers, PC Jeweller continues to outperform with the exception of Titan. These two firms have proven to be the best two operators in the industry.
As illustrated above, PC Jeweller’s growth lagged only Titan on the top line and outperformed all peers on operating profit growth. In addition, PC Jeweller is the most profitable Jewelry retailer as measured by operating margin outperforming its closest domestic peer, Titan, by 7%. Only Titan outperforms PC Jeweller on efficiency of capital employed leading to Titan’s more efficient ROCE. All other jewelry retailers are well behind both PC Jeweller and Titan. Over the past five years including exports, PC Jeweller still outperforms domestic oriented Titan and all other jewelry retailers on operating margin. Titan outperforms PC Jeweller on capital employed efficiency and ROCE. All other jewelry retailers are well behind both Titan and PC Jeweller.
Titan outperforms PC Jeweller on Capital Turnover by employing very little debt and relying heavily on trade payables and advances from customers to finance operations. Over the past five years, 38% of Titan’s funding has been in the form of debt and equity while 51% of PC Jeweller’s funding has been in the form of debt and equity. Titan has relied much more heavily on installment schemes than PC Jeweller as illustrated by the advanced to customers to assets ratios averaging 20% at Titan compared to only 2% for PC Jeweller. These schemes have now been restricted by the RBI and Titan’s reliance on customer advances, as a source of financing will diminish as illustrated in FQ2 2015. The ROCE gap should close dramatically as illustrated by FQ2 2015 ROCE figures (PC Jeweller = 36% vs. Titan = 43%). However, Titan will continue outperform as PC Jeweller’s export business carries with it very high receivable dragging down PC Jeweller’s Receivables turnover. PC Jeweller also prides itself on its jewelry variety leading to a lower Inventory Turnover at PC Jeweller.
At 8.7 times EV/Operating Profit, PC Jeweller’s current valuation does not account for any growth despite the improving operating environment, the target to triple its store count over the next five years, further potential growth from online distribution and productivity increases. In addition, PC Jeweller has the ability to expand margins through a higher portion of diamond sales and productivity increases. If the company only doubles its retail area (sq ft) over the next five years and sees no increase in sales or profitability per sq ft, the company will be trading on just under a very conservative 4.5x operating profit or 23% yield. This valuation seems very cheap for a company run by owner operators that continually outperforms its peers on margins and ROCE that should have a long runway for growth after five years.
We will maintain our current weight of roughly 7.5% and if there is any pullback around Rs200, we will be looking to add to our position.