PC Jeweller FY2017 Results Review June 1, 2017
PC Jeweller reported FQ4 2017 & FY2017 results. The company continues to perform well in a difficult operating environment due to regulatory measures. FY2017 saw demonetization and a stricter regulatory environment including high value purchases require a pan card, and imposition of an excise duty. The company also issued preferred shares to DVI Mauritus and Fidelity investments with a guaranteed dividend yield of 13.0% along with a conversion option. Despite, the regulatory environment PC Jeweller grew by 15.7%. Gross profit grew by 0.3% while operating profit increased by 12.1%.
The company’s gross margin declined as exports were a larger portion of sales. The table below illustrates management’s estimates of gross margin by geography and product within the domestic market. Based on the midpoint of the assumptions below gross margin should be roughly 13.37%.
The company improved capital efficiency with inventory only growing by 8.3% in the year. The slight decline in the company’s NOPAT margin combined with the improved capital efficiency saw ROIC increase to 24.7% from 20.9%. A measure used commonly used in the retail industry is gross margin on inventory. Given the biggest investment within the Indian Jewelry industry is inventory, 57% of PC Jeweller’s 2017 assets was inventory. Since 2008, inventory has accounted for 58% of assets. The typical formula is gross profit divided by average inventory. We modify it slightly by subtracting interest expense from gross profit as the company purchases inventory using gold leases that comes with an interest component.
Unfortunately, the GMROI continues to decline. Compared to its peers, PC Jeweller is at the lower end of GMROI. This is particularly concerning when compared to Titan Company, whose GMROI is almost three times higher than PC Jeweller’s as the company generates a higher gross margin and pays less on interest.
The company’s declining and poor gross margin return on inventory points to a lack of pricing power.
PC Jeweller increased its showroom count to 75 from 60 in FY2017, while the square footage grew by 10% from 352,313 square feet to 386,923 square feet. The company’s average store size decreased to 5,159 square feet.
In FY2017, domestic sales per store and square foot decreased by 15.8% and 4.2%, respectively.
Since, the government took drastic measures in 2013 to stunt the growth of the gold industry, the primary growth driver for PC Jeweller is new showrooms.
The company trialed its first franchise operations and will continue to add additional franchises fueling growth with little additional investment requirements.
Overall, PC Jeweller continues to execute and is one of the most profitable and fastest growing companies in the Indian jewelry industry due to the strength of the company’s management and focus on efficiency. Management is one of the most innovative in the industry with many initiatives not seen in the industry. The company is trying to double its showroom footprint over the next five years. Despite the strengths of the company and management, government is continually bringing new regulation to the detriment of the industry. Additionally, the industry is fiercely competitive with evidence pointing to no barriers to entry. As discussed in a weekly commentary, the jewelry industry evolution in more developed countries points to no barriers to entry and a compression of profitability towards the cost of capital.
Given our research on industry evolution, our base case involves elimination of excess profits by the end of the terminal year as competition intensifies. PC Jeweller is able to grow by 10% over the next five years before fading to 0% terminal growth leading to an estimated annualized return of 2.6%.
The optimistic scenario assumes the company to grow its sales by 15.0% over the next five years inline with PC Jeweller’s target of doubling its store count over the same period. In the terminal assumptions, there is assumed to be continued grow of 2.5%. Also, the company is not impacted by competitive forces allowing the company to maintain its profitability leading to an estimated annualized return of 25.4%.
The pessimistic scenario assumes no growth and immediate decline in profitability as well as no excess profits in the terminal assumption as competition impacts the company. The estimated annualized return under the pessimistic scenario is -4.0%.
At current valuation levels, the risk rewards is no longer drastically in our favor and a sustained continuation of the company’s excess profits is needed to justify much higher valuations. We will cut our position size to 2.0% as long as the share price is above INR450.