D-Mart IPO: Business Quality Premium or Smart Timing?

This post is not buy/sell/hold advice. Please see the disclaimer at the end before reading further

With all the hype around it, the D-Mart IPO sounds like a noisy baarat plodding through Dalal Street. The promoter of D-Mart is R. K Damani, who is a stock market heavyweight. The legend goes on to say that back in 1992, R.K Damani was shorting the stocks that Harshad Mehta was buying.

R.K Damani has since done the unthinkable: quit the stocks markets and entered the gritty world of retail business. Today Damani’s Avenue Supermarts, the parent of D-Mart, runs brick and mortal retail stores selling mostly Food and Beverage categories that generates 23% ROE.

The IPO has a marquee list of anchor investors and all of the big market names – including All Brokerage Houses – have a BUY reccomendation on it. Irrespective of the quality of D-Mart’s business, in the times of Amazon – such unequivocal bullishness for a sector like brick and mortar retail begs belief.

The retail model has changed from the box stores to internet purchasing. Amazon and Flipkart are also growing in Maharashtra and Gujarat, where D-Mart has concentration.

D-Mart is a zero frills retailer that competes on offering 6-7% cheaper prices than competitors and making higher operational savings. D-Mart saves on rentals by owning the real-estate of the stores it operates. It also saves on labor by hiring on contract, and has no advertising expenses. It is well positioned.

There are two larger questions on its current position:

  1. Can D-Mart defend its position in Western India from competition?
  2. Can D-Mart scale to other parts of India, while defending its position?

Experts have been commenting how D-Mart is cheaply priced vis-a-vis its competitors, of the likes of Future Retail, Trent, Reliance etc.

I contend that at an IPO PE ratio of 52 based on FY2016 EPS it is not cheap. Walmart’s PE ratio is 13. Is the operational efficiency of D-Mart so far superior to Walmart? I doubt it. What is possible is that the small size of its equity or the growth highway in front of it justifies its valuation.

Growth Highway

For scaling outside of Western India, D-Mart will need to buy properties (need for capex), or change its past strategy and rent them – which in turn will make its cost focus hard to sustain.

The company is cash-flow negative unlike Future Retail, the market leader with a larger geographical reach.

2017-03-05_17-09-34
Cash Flow Negative – Source: SEBI IPO Prospectus

I have no doubt it is a decent business. I have zero doubt it will give lottery like listing gains (Grey Market premium is 50% of IPO price).

What I doubt is the long term sustainability of the valuations and the timing of the IPO.

The IPO issue is expected to provide a partial exit to its biggest current shareholders, the Damani family. Trust Dalal Street to have the chops to come out with the IPO at a time of peak bull markets. They know how to sell, and when to sell it (both to retail and anchor investors)

The euphoria is hiding some misinformation about it being debt-free. A debt to equity ratio of 0.7 is not debt free.

One thing I really like about D-Mart is that 80% of its revenues come from Food and Beverage + home care, personal care and toiletries categories.

These are not segments that Flipkart and Amazon focus on. At least not until Amazon Go stores – with their self-checkouts – hits India in a major way.

Can the Return on Equity be Sustained?

The ROEs of 20+ are impressive for a retail business, but the average for Food and Beverage Retail is 23.

The brokerages seem to be evangelizing the high ROEs as a quality of the business, when it may be a quality of the F&B Retail sector itself.

The net margins may increase from 3 to 5% as targetted, as most of the IPO proceeds will be used to pay off debt. 5% still is a thin margin and this is a working capital and capex intensive business.

Does it deserve a PE of 50 ?

2017-03-05_17-14-49
The IPO proceeds will be used to pay off debts

Increased debt favors ROE during boom times but hurts ROE during recessions. So are we in boomtimes?

Future Retail has turned around in the second half of 2016 from net losses to net gains. Maybe, yes – it is boomtime.

The IPO prospectus also lists a handful of pending litigations on food quality and interparty transactions that may be worth noting.

2017-03-05_17-31-44

Do your research. And good luck with the listing.

Disclaimer: I am not a SEBI Registered analyst. I am a hobbyist investor writing to organize my thoughts. I do not offer Buy or Sell advice and none of my writing should be construed as a reccomendation. This is NOT advice for or against subscription to the IPO. My views may be biased. Always seek professional advice for making Buy/Sell/Hold decisions as stock markets are risky and can cause a permanent loss of capital.

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