Higher capex, competitive pricing key factors hurting DMart profitability

The Avenue Supermarts stock is down 18 per cent over the last year on worries that increasing competition, higher capex and volume-focussed lower pricing approach could aggravate margin pressures. These, coupled with worries on the pace of growth and hefty valuations, are expected to keep the stock under pressure.

A major worry for the Street is the intense competition from both offline and online retailers which could negate the advantage that Avenue’s DMart branded stores had hitherto enjoyed. The company indicated that the level of discounting from well-funded e-commerce players and store expansion by brick-and-mortar majors have risen significantly over the last year and the gap between Avenue and the second-largest player on pricing has narrowed considerably.

The management, however, believes that the retail pie is large enough to accommodate all players. While the online threat is significant in the food and grocery category, the cost structure of a well-run offline retailer is better than that of the online firm given the higher logistics and technology cost for the latter.

While revenue growth has been strong, the ability of the company to sustain it could be an issue given the slowing new-store additions. The firm added 21 stores in FY19, down from 24 in FY18, as there was a delay in regulatory permissions for construction. 

Despite lower store additions, capex in FY19 increased 45 per cent due to real-estate prices and bigger store size. The new stores are larger at 50,000 square feet; older stores are about 30,000 square feet. The pace of addition, however, is expected to increase with the company looking at opening 24 stores in the current financial year.

Though top-line growth, led by the volume and everyday low pricing model, is robust, the worry is that growth is coming at the cost of margins. Margins at the start of the last financial year (Q1FY19) were at 9.3 per cent, which came down to 7.5 per cent in the March quarter. Analysts at Motilal Oswal Securities believe that intensifying price competition, the increasing cost of adding new stores and the potential lease cost will continue to exert pressure on the Ebitda margin. Further, newer stores in north India may take longer to break even and investment in DMart Ready may pose a risk of increasing cost. Margins both at operating and net profit levels are expected to be flattish at 8.2 and 4.5 per cent over the next couple of years. 

While the company is looking at private labels in the non-food category, it will take time for these to become a significant contributor from the current 5 per cent. Food is the biggest segment for Avenue and accounts for 51.3 per cent of its revenues.
Though DMart’s pricing advantage would continue to stay, competitive pressures could force it to drop prices to maintain a gap with the competition. 

While revenue growth should be strong, operating and net profit growth is expected to be much lower due to margin pressures.

In fact, net profit growth in FY19 slowed to 12 per cent as against the peak of 55 per cent seen in the FY15-18 period. Analysts advise investors to reset their earnings expectation from DMart with average net profit growth in the 25 per cent-30 per cent range over the FY19-21 period.

While there are few peers who have been able to match DMart’s execution capability, given the headwinds, the price-to-earnings ratio over 50 times its FY21 estimates is on the higher side. Though most analysts have a sell rating on the stock due to high valuations, investors could get attractive entry points from equity dilution.