Re-rating in recent months reason to be selective; FLFL, ABFRL and SHOP top picks
Macro and micro factors are turning favourable for India’s organised retail sector. We believe grocery and value apparel segments are best positioned, but valuations are factoring in several positives post sharp re-rating. We initiate on ABFRL, FLFL and SHOP as our top picks on favourable risk-reward, while rich valuations keep us on the sidelines on DMART and TRENT at Hold. We initiate on FRETAIL and VMART at Hold as competition and complexity increases.
Macro: Demonetisation and implementation of GST have been tailwinds for organised retail in India, allowing them to gain share from unorganised trade. Yet, they still account for only 7% of the market. They are still in the midst of a secular growth journey with several segments on the cusp of strong growth as per capita income rises past the crucial $2,000 threshold that has heralded strong growth in most other markets.
Micro: Most retailers have also retooled their business models after a decade of learning; instead of reckless expansion, e.g., most are more agile with increased focus on improving store economics and lifting SSSG, while staying focused on costs, return ratios and balance sheets. They are shutting loss-making stores, e.g., exiting non-core segments, increasing private label mix and using data analytics and omni channels better.
Framework: Even so, we find some business models stack up better than others. On the macro, grocery (~3% organised) and apparel (20% organised) segments should do well for several years, e.g., while some firms have done better on the micro when we assess unit economics based on productivity, working capital management and capex, or competition, execution track record, innovation and scalability. V-Mart stands out in apparel, e.g., as does D-Mart in grocery while macro tailwinds bode well for ABFRL and FLFL.
Valuations: The strong re-rating in the sector in the past 15 months that has driven valuations from 20x 12M forward EV/Ebitda to 32x EV/Ebitda prompts us to be more selective. The near-term EPS growth and long-term opportunity in grocery and value retail (40x EV/Ebitda) appear priced in, with greater margin of safety in department stores and apparel and brands at 20x EV/Ebitda.
BUYs: ABFRL is better placed to face competition. This leaves us with a 27% Ebitda CAGR in FY18-20e. Its 23x EV/Ebitda seem reasonable, as it does for FLFL (17x EV/Ebitda) where we expect 22% Ebitda CAGR in FY18-20e. SHOP post its non core asset exit and renewed focus to drive private label is a potential turnaround contender; we expect Ebitda CAGR of 28.6% over FY18-20e.