Retail Sector - Dec 2007

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Retail Sector Report Company

December 13, 2007 Rohit Ledwani [email protected] +91 22 6634 1507

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RETAIL - Time to get organized With only about 3% share in an estimated $320-bn Indian retail industry, we see significant growth potential in the organized retail segment in India. The expected growth in income levels, easy availability of credit, increasing urbanization and favorable demographic conditions are expected to put the Indian organized retail industry on a rapid growth path. We expect a CAGR of 26% for this industry over the next four years and have a positive view on the sector. We initiate coverage on Vishal Retail with a BUY rating and a price target of Rs.861. We also initiate coverage on Shoppers Stop with a REDUCE recommendation with a target price of Rs.490, due to valuations.

Key investment rationale q Low penetration provides growth potential. According to Crisil, the total size of the retail industry in India is about US$320 bn, of which only 3-4% is organized. This provides significant potential for growth, in our opinion. Over the next few years, penetration levels of organized retail are expected to double and reach approximately 9% of the total retail industry by 2011. Companies covered n

Vishal Retail

n

Shoppers Stop

x

q Favorable Demographics. India has the youngest population in the world, with more than 50% of the population under the age of 25 according to E&Y. This population is the consuming population and is the one with demanding lifestyles. Thus, this is one of the key markets for retailers. We expect this to support growth of the organized retailing industry in India in the years to come. Also, growth in urbanization is key for retailers to succeed as currently nearly 85% of the organized retail market is concentrated in India's eight largest cities. The population of urban areas is expected to touch 550 mn in 2021 as compared to 376 mn currently. (Source: Government of India) q Rising income & consumption patterns to spur growth. With the economy on an upswing, income levels and consumption patterns of the Indian consumer are changing. The number of high income households has been growing at 20% year on year since 1995-96 and by 2010, 35% of socio economic classes A&B are expected to be double income homes, hence increasing their spending capacity. Spending by Indian consumers is already 12% higher in the current year as compared to the whole of the last year. They are expected to spend 42% more in the current year as compared to what they spent last year. Also, with increase in income levels the spending on lifestyle products increases, which is expected to fuel the growth of these formats in the retail industry. We initiate coverage on Vishal Retail with a BUY rating and a price target of Rs.861. We also initiate coverage on Shoppers Stop with a REDUCE recommendation with a target price of Rs.490.

Risks & concerns q Opposition from the unorganized sector and change in Government regulations. q Slowdown in the economy and change in consumption patterns of the population Peer Comparison based on FY09 earnings Company Shoppers' Stop Vishal

Price (Rs) 492

EPS (Rs) 7.7

P/E (x) 63.9

EV/ EBITDA 19.0

ROE (%) 8.5

EBITDA mgn (%) 6.0

NPM (%) 1.6

Target (Rs) 490

740

34.3

21.6

11.1

25.0

10.7

4.3

861

Source: Kotak Securities - Private Client Research

Registered Office: Kotak Securities Limited, Bakhtawar, 1st floor, 229 Nariman Point, Mumbai 400021 India.

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December 13, 2007

Investment argument Low penetration The current penetration levels of organized retail are the lowest in the world. With a massive population, the potential of the industry in India, going forward, is tremendous. Companies have announced big plans to enter into various segments in the industry. The penetration levels are as low as 3-4% overall and as low as 1% in segments such as food and grocery retail. Clearly, the potential of the sector going forward is enormous.

Favorable demographics provide enough potential for organized retail Out of India's population of about 1 bn, the overall target market for modern retail is estimated at about 50 mn people. With more than 50% of the population being under the age of 25, the market looks extremely attractive for organized retail players as this population has demanding lifestyles. This segment forms a major portion of any retailer's plan. Growth in urbanization is a key driver for the organized retail industry

Growth in urbanization is a key driver for the organized retail industry. This is because, currently 85% of the organized retail market is concentrated in India's eight largest cities. In India, the top six cities currently account for about 6% of the population but contribute to 14% of GDP. The population of urban areas is expected to touch 550 mn by 2021 as against 376(E) currently.

Rising incomes & consumption patterns to spur growth Out of an estimated 209 mn households in India, nearly 6 mn are classified as 'rich' as compared to 3 mn in 1999-2000 (Source: E&Y). Also, about 91 mn households are classified as 'consuming' as compared to 55 mn in 1999-2000. While rich households have income levels of greater than US$4700, the consuming class enjoys average income of US$ 1000-4000. Also, the average income level of high-income households has been growing at 20% YoY since 1995-96. This growth in income brings along with it a higher disposable income, willingness to spend and demand for better lifestyle. As income levels rise, one tends to spend more on lifestyle related activities and products, which is a key driver for these segments of the retail industry. These can be clearly observed from the statistic that discretionary spending has been seeing a 16% rise for upper and middle classes over the past three years. The private final consumption expenditure (PFCE) which is basically what a consumer spends on food and grocery, apparel, medical services, savings, entertainment etc, is estimated to grow from Rs.18.9 trillion in 2005 to Rs.53.62 trillion in 2015 and is expected to constitute 57.5% of India's GDP.

Easy availability of credit The number of credit cards issued in India has been witnessing a strong growth over the past few years. Currently, there are 22.6 mn cards in circulation as compared to 7.1 mn in 2003. This number is expected to grow by over 30% over the next few years. Easy availability of credit and also easy EMI schemes being offered by the bank as well as companies do provide a boost to retail companies as this directly has an impact in consumption patterns of people. In India, less than 1% of personal consumption happens through credit cards as compared to the global average of 5%. With a significant increase in the expected usage of credit cards, the spending patterns of consumers are expected to change further, in turn, benefiting organized retailers.

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Increased acceptance of "mall culture" to help growth The organized retail boom was given a boost with the concept of shopping malls. Currently, India has 179 operational malls and is expected to have 412 malls by 2010. These malls attract footfalls in ten of thousands everyday and have become family destinations to shop, eat and for entertainment. While further details are not available, we believe the expected growth in shopping malls and increased acceptance of the "Mall culture" should provide further boost to the organized retail sector. We initiate coverage on Shoppers' Stop with a REDUCE rating and Vishal Retail with a BUY rating.

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Brief synopsis of companies covered SHOPPERS' STOP Shoppers' Stop is a leading player in the lifestyle apparel segment. Shoppers' Stop operates 1.17 mn sq ft of space across formats such as Shoppers' Stop, Home Stop, Crossword, Café Brio, MAC and Mothercare. The company is on an expansion mode. We estimate that an increase in capacity by 89% should result in revenues growing at a CAGR of 36% between FY07 and FY09. Profits are expected to be stagnant at Rs.268 mn in FY09 viz-a-viz F07. EBIDTA margins are seen moving downwards from 7.5% to 6.0% between FY07 and FY09. Consequently, EPS is expected to be Rs.5.7 and Rs.7.7 in FY08 and FY09, respectively. The main reason for the contracting margins and stagnant profit is that the company is on an expansion mode and is setting up new stores and new formats. These new stores take about three to five quarters to break even. Since some of the formats are new, they will be biting into the margins until they gain some scale. Financials (Standalone) (Rs mn) Sales

FY07 8,995

FY08E 12,772

FY09E 16,674

Operating Profit

674

715

1,004

Operating Margin (%)

7.5

5.6

6.0

PAT

261

197

268

EPS (Rs)

7.6

5.7

7.7

Source: Company

Our sum-of-the-parts valuation gives us a 12month target price of Rs.490 for Shoppers’ Stop

We value the standalone business at Rs.440 using the DCF methodology. We have valued the Hypercity stake at Rs.50 (0.72x Sales), giving it a discount to Pantaloons, India's largest player in the value retail segment. Thus, our sum-of-the-parts valuation gives us a 12-month target price of Rs.490.

VISHAL RETAIL Vishal Retail is a leading player in the value retailing segment in Tier-II and Tier-III cities. Vishal retail operates 1.26 mn square feet of space with majority of its stores located in Tier-II and Tier-III cities. Vishal plans to expand its retail space to 2.1 mn sq ft in FY08 and to 3.1 mn sq ft in FY09. We are positive on the prospects of Vishal Retail as it has a strong foothold in the cities that it is present in. Its margins are also high as most of the products sold are in-house brands. We expect the revenues to grow at a CAGR of 72% between FY07 and FY09 and PAT to grow at a CAGR of 76% over the same period. Financials FY07 6,027

FY08 10,589

FY09 17,853

Operating Profit

670

1,240

1,916

Operating Margin (%)

11.1

11.7

10.7

PAT

250

465

768

EPS (Rs)

11.2

20.7

34.3

Sales

Source: Company

We recommend a BUY on Vishal Retail with a 12month price target of Rs.861

We value the company on a P/E multiple basis. We accord a PE multiple of 25x to our FY09E earnings. This is at a discount to Pantaloons which is India's largest retailer and leader in the hypermarket segment. We recommend a BUY on Vishal Retail with a 12-month price target of Rs.861. This 10% discount to Pantaloon is because Pantaloon is the leader in the hyper market segment and due to the relatively smaller size of Vishal Retail.

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Organized retail in India In India, retail is the largest industry, with a size of approximately US$320 bn and is growing at a fast pace of 26% (Source: Cris Infac). With over 12 mn retail outlets, India probably has the highest density of retail outlets in the world, with one for approximately every 90 people. However, a majority of this is unorganized, consisting mainly of small convenience stores, also known as kirana stores. Among major developed as well as emerging economies, India is one of the most under penetrated markets in terms of organized retailing. The current size of the industry is at $320 bn, according to Crisil. Cris Infac expects the Indian organized retail industry to grow at a CAGR of 26% over the next four years

KSA-Technopak, a retail consulting and research agency, predicts that by 2010, organised retailing in India will cross the $21.5-bn mark. Cris Infac expects the Indian organized retail industry to grow at a CAGR of 26% over the next four years. In contrast, the unorganized retail industry, on the whole, is expected to grow at 6%. With the economy on an upswing and with favorable demographics, the retail industry is at an inflection point. Large investments are being announced by players such as Reliance, Bharti-Wal-Mart, Aditya Birla Group and others. PricewaterhouseCoopers estimates that $412 bn is expected to be invested in retail over the next five years. This clearly indicates that there is a lot of growth to be witnessed in this sector. With a population of 1 bn people there is an expectation of phenomenal growth over the next few years. Over the past few years, we have witnessed a rise in income of people, increase in consumption and changing lifestyle patterns of the Indian society. Even smaller Tier II and Tier III cities have witnessed tremendous growth over the past few years. The retail market is no longer confined to bigger towns and cities. The real estate boom introduced the concept of malls. This took the shopping experience and entertainment levels to a new standard. Organized retail has, to a large extent, been kick started by this concept of malls.

Growth

Journey of organized retail: The India story M&A,

Supply chain Management,

Shakeout, Consolidation,

Range, Portfolio,

Entry, Growth,

Format

Expansion, Top Line

Options

Back-end

High

opeation, Technology,

Investments

Processes

ita cap r e P

Focus

First Phase 2000

End-to-End

Second Phase

2005

2008

e pac il S a t Re

Third Phase

Fourth Phase

2011

Source: E&Y The great Indian retail story

A study conducted by AT Kearney indicates that India is the top retail destination in the world

Retail Sector Report

A study conducted by AT Kearney indicates that India is the top retail destination in the world. The study ranks 30 emerging countries based on a set of 25 variables including economic and political risk, retail market attractiveness and retail saturation levels. It has retained India's position at the top for the third successive year.

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Global retail development index Rank Country

Country Market Risk attractiveness 0 = high 0 = high 100 = low 100 = low 67 42

Market saturation 0 = high 100 = low 80

Time Pressure 0 = high 100 = low 74

GRDI Score 0 = high 100 = low 92

1

India

2

Russia

62

52

53

90

89

3

China

75

46

46

84

86

4

Vietnam

57

34

76

59

74

5

Ukraine

41

43

44

88

69

6

Chile

80

51

42

43

69

7

Latvia

77

32

21

86

68

8

Malaysia

70

44

46

54

68

9

Mexico

83

58

33

33

64

10

Saudi Arabia

65

40

35

35

64

Source: AT Kearney

The study also indicates that India is at the peaking stage in retail as the strategy being currently employed by the retailers in India is a clear indication of this stage. Stages in retail OPENING

PEAKING

DECLINING

CLOSING

Strategy

Monitor market; consider sending research team

Open sourcing office or step up retail stores; test the market

Scale up openings to capture market share

Determine marker position; re evaluate strategy as needed

Formats

Not applicable

Consider supermarkets and hypermarkets, cash and carry, and convinence stores over other formats as they have higher success rates

Consider discount models

No pattern identified

Labor

Identify skilled labor pool for market

Hire and train local talent; create balance with expatiate employees

Switch balance from expatriate to local staff

No pattern identified

Source: AT Kearney

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Key growth drivers The current upswing in the economy, favorable demographics, availability of credit and growth in infrastructure are all expected to propel the retail story forward. Apart from this, the low penetration levels of organized retail have set the stage perfectly for exponential growth in the sector over the next few years.

Favorable demographics India, with a population of about 1 bn, is definitely a huge market waiting to be tapped. Estimates suggest that the potential market for modern retail is at about 50 mn people, which is a sizeable number. This estimate is based on the fact that this population of 50 mn is the consuming class. India has the youngest population in the world

With 50% of the population being under 25 years old, the market looks extremely attractive. These segments of the population have demanding lifestyles and contribute to the overall consumption. Hence, they form a major portion of any retailer's plan. India has the youngest population in the world. In 2020, the average Indian will be only 29 years old, compared with 37 in China and the US, 45 in West Europe and 48 in Japan. (Business Line) Urban markets are major markets for organized retailers. With increasing urbanization, the retail market is witnessing a high growth rate. As of now, 85% of India's retail market is concentrated in its eight largest cities. The top six cities of Delhi, Mumbai, Bangalore, Chennai, Kolkata and Hyderabad form 6% of the population but contribute to 14% of India's GDP. Urbanization has been increasing at a rate of 2.7% in the last 10 years. It is expected to increase at 2.4% between 2000 and 2015. The population in urban areas is expected to touch 550 mn, from an estimated 379 mn in 2007, by 2021 (Source: Ficci). Population of India by age and sex - 1997 and 2020

Source: US Bureau of census

Also, a study by international consultant, Deloitte Touché Tohmatsu titled '2007 Global Powers of Retailing' rates China, India and Russia as preferred retail destinations. The study identifies 250 global retailers operating on an average in 5.9 countries and increasing their international reach. While as many as 30 of these retailers are present in China, only five - Metro, PPR, Marks & Spencer's, Shop Rite, Dairy Farm - are in India. Further investments in India are expected to come in with relaxations in Government rules and regulations.

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Rising income & consumption patterns In 2006, India had approximately 209 mn households, of which the 6 mn were 'rich' households having annual incomes of over US$4700 and 75 mn were 'consuming' class having annual incomes between US$1000-4700. (Source: E&Y). The rising household incomes have led to a substantial change in the profile of the Indian consumer. Demand for better lifestyles and willingness to spend is increasing consumption. This is leading to the growth of modern retail formats. The number of high income households has grown by 20% YoY since 1995-96 (Source: E&Y)

Discretionary spending has seen a 16% rise for the urban upper and middle classes and the number of high income households has grown by 20% YoY since 1995-96 (Source: E&Y). In the table provided below, the profile of the 'Climbers', 'Consuming' and 'Very Rich' consumers class is biased towards self-indulgent consumption patterns. It is projected that by 2007, these segments will be over 170 mn households as compared to 124 mn in 2000. This will constitute about 86% of the population against about 69% in 2000. Classification of households Mn households Very Rich

1994-1995 1

1999-2000 3

2006-2007 6

Consuming

29

55

91

Climbers

48

66

74

Aspirants

48

32

15

Destitute

35

24

13

Source: E&Y the great Indian retail story

In the above table, the "Very rich" class has annual income exceeding US$4700 and is classified as Benefit Maximizers, owning cars and PCs. The "Consuming" class has annual income of US$ 1000-4700 and is classified as Cost-benefit optimizers. They consume bulk of branded consumer goods, 70% of two-wheelers, refrigerators and washing machines. The "Climbers" have annual income of US$500-1000, are classified as Cash-constrained benefit seekers and have at least one major durable (mixer, sewing machine/television). "Aspirants" have annual income of US$350-500 and are classified as new entrants into consumption. They consume bicycles, radios and fans. "Destitutes" have annual income of less than US$500 and have a Handto-mouth existence. According to E&Y, with the present population of 1.07 bn, the target consumer base for most retailers currently stands at about 405 mn. Of this, about 30 mn have a combined purchasing capacity of $230 bn. India's 6 mn strong 'rich' population shops annually worth $28.36 bn. Going forward, the growth in income and urbanization is expected to expand the market for retailers. The total aggregate household disposable income is estimated to be growing at a CAGR of 5.9% (NCAER)

As income levels rise, it is expected to lead to higher spending and consumption which will provide a boost to the retail sector. The total aggregate household disposable income is estimated to be growing at a CAGR of 5.9% (NCAER)

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Studies have shown that as income levels rise the share spent on food and groceries in the total household income declines, despite an increase in absolute spends towards these. Also, the proportion of income spent on lifestyle-related activities increases. India is no exception. With increasing income levels and spending the retail lifestyle segments and others are all set to witness tremendous growth.

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Changing trends of Indian consumers n For CY07, spending has gone up 12% in the last year n Indian consumers have saved lesser by 45% in the last three years n Indian consumers are expected to spend 42% more this year n Consumers have increased purchases using credit cards by 30% in the last two years n Also, 35% of all social-economic classes (SEC) A & B households are expected to be double income homes by 2010. Source: Economic Times, NCAER 2006;

Note: Data pertains to CY07

Private final consumption expenditure (PFCE) is basically what a consumer spends on food and grocery, apparel, medical services, savings, entertainment, catering services etc. PFCE is estimated to grow from Rs.18.91 trillion in 2005 to 53.62 trillion in 2015. It is expected to constitute 57.5% of India's GDP.

Consumers want quality product The new Indian consumer is now up to date with the latest developments in other parts of the world and is now looking for quality products. Organized retail with its corporate background will be able to provide the customer with quality as well as accountability. Hence, the consumer is slowly shifting to organized retail. Also, the cost savings that organized retailers will be able to provide will be a factor in consumers shifting to organized retail as India is known to be a highly price sensitive market.

Easy availability of credit Cards in circulation (in mn)

25 20

Bankers expect the credit card business to grow by over 30% in 2007-08. Over the years, credit cards have seen a growth from 7.1 mn in 2003 to 22.6 mn in 2007. As compared to the number of cards in 2006, which stood at 17.5 mn, the number has already grown by 30% this year. However, the penetration levels of credit cards stands at only 2% in India compared to a healthy 10-12% in developed economies. The current trend of growth in credit cards is clearly a good sign for retail as this will directly impact consumption patterns of consumers.

15 10 5

Source: Business Line

2007

2006

2005

2004

2003

0

According to industry data, about 65% of the credit card customers are from Tier-I cities, 20-22% from Tier-II cities and the balance from Tier-III cities. Another positive indicator is that less than 1% of the personal consumption expenditure is happening on cards. The global average stands at 5%. In some developed nations, it is as high as 15%. This growth in credit will have a direct impact on the consumption patterns, which will result in growth of the retail industry.

Mall culture in vogue There has been a sudden spurt in the number of malls coming up all over the country and are attracting daily footfalls in millions. This is attracting retailers to open stores in them. Malls provide not only a great shopping experience but are turning out to be places for family outings, entertainment etc. This coupled with the rise in incomes and willingness to spend is only boosting the growth of the industry. As of today, India has 179 operational malls with 47.4 mn sq ft of retail space, and is expected to have 412 malls offering 205 million sq ft of retail space in 2010, and by 2015 there would be more than 715 operational malls offering 350 mn sq ft of retail space and a very large chunk of these developments would be in India's TierII and Tier-III cities. (Source: Images F&R Research)

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Mall space growth in india

Source: Images F&R Research Distribution of Mall space across zones 2007 Total supply: 47.4 mn sq.ft

YEAR-END Delhi, NCR Jaipur

East 7%

2004 9

2006 28

2008* 64

2010* 79

3

7

12

14

1

8

15

1

4

5

3

7

Ludhiana South 14%

West 44%

NUMBER OF OPERATIONAL MALLS IN INDIA 2004 - 2010*

North 35% Source: Images F&R Research

Lucknow

1

Sonepat Kolkata

3

4

19

25

Bangalore

2

5

13

20

Hyderabad

1

5

12

16

Chennai

1

2

6

11

1

3

5

Kochi Mysore

3

6

30

56

68

Pune

2

7

10

Greater Mumbai

5

Ahmedabad

2

5

6

Distribution of Mall space 2011 across zones 2007

Nagpur

3

6

8

Indore

2

5

7

Total supply: 236 mn sq.ft East 9% West

Other Tier-II & III Cities

4

12

63

111

29

105

289

412

28% South 24%

North 39%

Source: Images F&R Research

In India's retail industry, food, beverages and tobacco form a substantial portion, comprising 76% of the total industry. However, it is in this sector where organized retail penetration is the lowest, that is, 1%. According to a McKinsey report, the share of an Indian household's spending on food is one of the highest in the world, with 48% of income being spent on food and beverages.

Source: Images F&R Research

The penetration of organized retail is highest in the footwear category at 31% followed by apparel, books, music/gifts, consumer durables, home décor and furnishings.

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Organized retail penetration 80

35

Share of total retail (LHS-%)

30

Share of organized retail (% - LHS)

60

25

Organized retail penetration (%-RHS)

20

40

15 10

20

5 Food and beverage

Beautycare products

Jewellery & watches

Home decor and furnishing

Books, Music & gifts

0 Clothing and textile

Footwear

Consumer durable

0

Source: Crisil

Category-wise spend The Indian consumer is spending most of his income on food, groceries and beverages. Taking into account that penetration levels in this sector are the lowest we can see this segment grow at a fast pace. Also, big players such as Reliance, Bharti and RPG are all betting big on this sector. They are focused on back-end logistics. These players are aiming to provide groceries at a low cost compared to small neighborhood shops, street vendors etc, who, as of today, account for most of the sales in groceries, vegetables etc. Even segments such as jewelry, beauty care, books are seeing good growth, mainly propelled by the growth in malls. Organized retail: Category-wise share (2006)

Food and beverage

Total retail (Rs bn) 9,510

Organised retail (Rs bn) 93

Clothing and textile

1,190

195

Consumer durable

622

106

Home décor and furnishing

388

34

Jewelry and watches

549

34

Beauty care (products)

281

10

Footwear

134

44

Books, music and gifts

107

14

12,781

530

Total Source: CrisInfac

Segment wise share in organized retail (2006) Beauty care (products) 2% Home décor and furnishing 6% Jewellery and watches 6% Consumer durable 20%

Footwear 8%

Books, music and gifts 3% Food and beverage 18%

Clothing and textile 37%

Source: CrisInfac

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Major retail formats Within organized retail, several formats have been introduced by players to cater to varied segments. Different formats are characterized by variations in size, location, product mix, target consumer, investment. For example, a food and grocery store requires a location in a residential area compared to a high street mall for a lifestyle apparel retailer. The store sizes are generally 2000-4000 sq ft. Investment in terms of fixed costs is lower than that required for a lifestyle store. There will also be faster turnover of inventory in such stores and the average ticket sizes will be small but sales/sq ft are high and the target consumer will be different from that of a lifestyle retailer. In our opinion, the four major retail formats are:

Food & grocery In 2003-04, private consumption expenditure in India amounted to Rs.16.9 trillion (US$375 bn) of which, retail sales constitute about 61% (US$ 230 bn). In that fiscal, food and grocery (US$154 bn) contributed to 41% of private consumption expenditure and about 77% of total retail sales. The food business in India is largely unorganized. Most food is sold in the local 'wet' market, by vendors, roadside push cart sellers or tiny kirana stores. The all-India food consumption is close to Rs.9 trillion, with the total urban consumption being around Rs.3.3 trillion, whereas the aggregate revenues of large food companies and retailers are estimated to be only 5% of the total Indian market, and around 1520% of total urban food consumption. The penetration of organized retail is only about 1% in this segment

The penetration of organized retail is only about 1% in this segment. The sector has low gross margins, but there is a tremendous growth potential for the organized sector in the form of hypermarkets, supermarkets and hard discount chains. Generally, stores are opened in residential areas and also part of hypermarkets. Although few are located in malls, a vast majority of these stores are located in residential areas. Generally, these stores are 2000-4000 sq ft in size and have high sales/sq ft. Organized retailers are generally able to sell products at prices cheaper than the ones offered by 'kirana' stores, due to their sourcing capabilities. Established players in this segment are Pantaloons Food Bazaar, Subhiksha, and Hypercity (Shoppers' Stop has a 19% stake). Players like Reliance with their 'Reliance Fresh' stores, Spencer's Retail and Aditya Birla Group with the stores under the brand name 'More' have recently entered into the market. There are also several regional players such as 'Fabmall' in south India. Stores such as Pantaloons' Food Bazaar are of sizes between 2000-20000 sq ft and clock sales/sq ft of Rs.12000-14000. The average ticket size per customer is Rs.200. The gross margins for Food Bazaar are in the range of 17-19% and net margins at 3-4%.

Apparels The organized retail penetration in the apparel segment is close to 16%

Apparels contribute close to 37% of total retail sales (according to Crisil). The organized retail penetration in this segment is close to 16%. We can further subdivide the clothing retail business into lifestyle and value. In lifestyle retailing, the leading players in this segment are Shoppers' Stop, Trent, Pantaloons, Central and Lifestyle (not listed). The margins in this business are higher as compared to those in food and grocery retailing as these products have a smaller market compared to that of food and grocery, purchases are made occasionally and also because of lower presence of unorganized segments. For Pantaloons, the gross margins are as high as 45%. Players such as Shoppers' Stop stock goods from various manufacturers and only 20% of its sales are of private labels. However, Trent has 100% private labels. Hence, its margins are even higher at over 10% EBITDA margins. Own brands (private labels) generally have higher margins than products of other manufacturers.

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In value retailing, Pantaloons operates stores under the name 'Brand Factory'. The gross margins for this format stands at about 35%. In lifestyle retailing, Pantaloon Fashion stores clock sales/sq ft of Rs.8500 and operates 31 stores as of today. Shoppers' Stop had 22 stores as on March 2007 and clocked sales/sq ft of close to Rs.8000. These sales are primarily of lifestyle apparels In value retailing, Brand Factory clocks higher sales/sq ft of Rs.14000. Vishal Retail is also a value retailer. It clocks a relatively lower sales/sq ft of Rs.7000. We note that Vishal Retail also sells other products such as FMCG products, with apparels constituting 60% of its revenue. According to Cris Infac, margins between private labels and other labels are dependent on several factors such as: Margins Private labels (%) 55 to 60

National brands (%) 28 to 35

Brand building costs

8 to 10

Nil

Markdown liabilities

7 to 10

Nil

3 to 5

Nil

Gross margin

Others Net margin

30 to 42

28 to 35

Stock turns

2.5 to 5.0

3.0 to 4.5

Source: CRIS INFAC

Consumer durables According to Crisil, the organized retail penetration in the consumer durables segment is 17%

According to Crisil, the organized retail penetration in this segment is 17%. However, this segment is dominated by regional players such as 'Viveks' in south India. The pan-India players are E-zone and Electronics bazaar. The recently launched "Croma" chain is also aiming to have a pan-India presence. Reliance has entered into this segment and recently launched its 'Reliance Digital' stores in New Delhi. According to industry data, stores such as Electronics Bazaar and E-zone have been clocking sales/sq ft in the range of Rs.13000-14000. We believe the gross margins in this business are between 10-13%.

Hypermarkets This format has seen unprecedented growth over the last few years. A hypermarket generally sells products ranging from food and grocery to consumer durables. These stores are fairly large in size. Hypermarkets have clicked well with the price sensitive and value conscious consumer

The stores generally sell products at lower prices compared to the unorganized retailers and have high sales/sq ft. We believe this is due to the sourcing capabilities of these companies. Hypermarkets have clicked well with the price sensitive and value conscious consumer. Players such as Big Bazaar, Vishal Retail, and Hypercity are leaders in this format. New entrants such as Reliance are betting big on this format. Stores such as Big Bazaar work with EBITDA margin of 6.5-7% and clock sales/sq feet of Rs.8000. \Vishal Retail has sales/sq ft of Rs.7000. A majority of the stores of Vishal Retail are located in Tier-II and Tier-III cities. Hypercity has only one store as of today located in Mumbai. It is a very large store of 125,000 sq ft and clocked a sales/sq ft of Rs.10400 in FY07. The concept of hypermarket has been a success in India. Ever since Pantaloons launched Big Bazaar in 2001 they now have 2.86 mn sq ft of Big Bazaar area.

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Other formats The other formats which have seen growth in the organized retail segment are home décor, books and music retailing and jewelry. The organized retail penetration in home décor and furnishings is 9%, 14% in books and music and 6% in jewelry. The established player in the organized jewelry retailing segment is Tanishq. In the books and music category the well established players are Crossword (owned by Shoppers' Stop), Landmark (74% owned by Trent) and Music world. The home décor segment is also fragmented. Players such as Home Town, Furniture bazaar and collection I (85% owned by Pantaloon) are now ramping up stores to get a pan-India presence. Stores such as Home Town clock sales/sq ft of Rs.12000 and formats such as Furniture bazaar and Collection I clock sales/sq ft of Rs.6000, in our estimate.

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Benefits of retail In our opinion, the growth in the retail sector can have a multiplier effect on the economy. Some of the benefits which can accrue are: n Farm income in India can increase if organized retail enhances farmer's realizations on food items from the currently estimated low level of 30-35% of retail price to the international norm of over 60% of retail price. n This would come from cost savings that will result from improving the underdeveloped supply chain for unprocessed food items. Higher farm incomes will benefit the vast majority of the nation's population that is dependent on agricultural income. n The supply chain for unprocessed food items is fairly under-developed in India. It has many layers leading to high wastages and a high cost of distribution. Increased penetration of organized retail into the food and grocery (F&G) segment can improve the supply chain and boost farm incomes. The growth in the retail sector can have a multiplier effect on the economy

n The current farm realizations for unprocessed items are estimated at around Rs.1.2 trillion. If this segment shifts entirely to organized retailing and the realizations of farmers are at levels comparable to developed countries (around 60-65%) n Higher farm income can boost the purchasing power of 60% of the population adding to GDP growth through higher economic activity. For instance, if the farmers spend 80% (given the lower propensity to save at low income levels) of their incremental income, the economy will witness an incremental spending of around Rs.1 trillion. This is equivalent to nearly 3% of India's GDP, even if the economic multiplier effect is excluded. n Companies are spending heavily on marketing, hence improving the growth of the marketing sector as well. Intense competition will only further increase the advertisement and marketing expenditure. Pantaloon has doubled its ad budget from Rs.1 bn to Rs.2 bn this year. Even Shoppers' Stop has increased its spending by 35% and will continue to keep its ad budget at 4% of its revenues. n Also, logistics and supply chain companies are set to benefit from the retail boom. Thus, growth in retail can have a multiplier effect on the economy.

Indian consumers: Largest beneficiaries India's middle class as well as lower income consumers will be the ultimate gainers with multiple benefits: n Reduction of prices in typical monthly basic needs. Shopping bills may reduce by at least 10% within the next 24-30 months, leading to generation of an equivalent amount of surplus disposable income n Improvement in quality of fresh/perishable products in the market n Improved assortment and reliable availability of products

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FDI in retail Currently, foreign direct investment in retail chain stores is restricted in India. Prior to 1997, there were no FDI restrictions in the domestic retail sector. Players who entered were McDonalds, which opened in India in 1996 and Foodworld, which was hived off as a 51:49 joint venture between Spencer & Company (RPG Group) and Dairy Farm International. Companies that entered prior to 1997 have been allowed to continue with their existing foreign equity components. Currently, a foreign company can conduct business through the following channels:

Franchising This entails the granting of rights by one party, the franchiser, to another, the franchisee, in return for a sum of money. The franchisee is then allowed to exercise those rights under the guidance of the franchiser. The franchiser owns the concept and the brand name. The franchisee is allowed to conduct business using the franchiser's know-how and brand name. (for example, Marks and Spencer's).

Cash and carry wholesale FDI has been allowed to the extent of 100% in cash and carry wholesale business. This business essentially means that a large distribution network is established to aid local manufacturers in reducing the supply chain. This model has been designed in such a manner that the wholesaler deals with small retailers and not directly with consumers. (for example, Metro AG, Bharti-Wal-Mart)

Joint venture Currently, FDI in retail is restricted in India and companies can operate only through select channels

In this case, the international brand provides equity and support to an Indian entity. However the share of the MNC is restricted to 49%. (for example, Reebok)

Distribution The international company has to set up a distribution office in India and supply products for sale to local retailers. (for example, Swarovski)

Manufacturing Under this route, the international company has to set up an Indian company to manufacture its products and then can it get the right to retail its products in India. (for example, Bata, Benetton)

Single brand retail FDI up to 51% has been allowed in retail trade of 'single brand' products with prior government approval and under certain conditions: n Products to be sold should be of a 'single brand' only. n Products should be sold under the same brand internationally. n 'Single brand' product retailing would cover only products that are branded during manufacturing

Benefits of FDI in retail n Inflow of investment and funds. n Improvement in the quality of employment and generating more employment. n Increased local sourcing, better value to end consumers, Investments and improvement in the supply chains and warehousing. n Growth of infrastructure.Increased efficiency which can lead to further cost reduction. n Stimulate infant industries and other supporting industries.

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Drawbacks of FDI in retail n Would give rise to cut-throat competition n Promoting cartels and creating monopoly n Increase in real estate prices n Marginalize small domestic entrepreneurs. n Displacement of unorganized players because of financial strength of foreign companies n Unfair trade practices like predatory pricing in case of absence of proper regulatory guidelines

Steps being taken to protect margins Retail is a low margin, high volume business. With the retail boom being witnessed in the country, all companies are on an expansion mode and adding stores at a fast pace. This expansion is leading to cost pressures and biting into the margins of the retailers. In order to protect its margins and also with the aim to counter competition in the industry, companies are taking several measures to stay competitive and also expand margins, as well as offer best prices to the customer. Companies such as Reliance Retail have announced a plan to set up a massive supply chain which will involve sourcing products directly from farmers/manufacturers, hence avoiding all middle men and resulting in significant low costs of sourcing. In case of apparel retailing, companies are now concentrating towards developing their own private labels in order to expand margins. Players such as Shoppers' Stop and Reliance Retail are altering their product mix in order to include more private labels as the margins in these are higher than other brands. Lifestyle retailers are also looking at options such as becoming anchor tenants in malls so as to reduce lease costs

Lifestyle retailers are also looking at options such as becoming anchor tenants in malls so as to reduce lease costs, which are a very significant proportion of their costs. Players such as Shoppers' Stop and Trent have already tied up with mall developers and have agreed to be their anchor tenants for several of their projects. This provides a win-win situation to both developers and retailers, as developers are aware that such stores can attract footfalls to the malls. Companies also get into revenue sharing agreements with mall developers and thereby reduce their lease costs. Companies are concentrating on their back-end by setting up warehouses at different locations so as to ensure sourcing costs are low as well as stocks reach stores on time. Players such as Vishal Retail and Pantaloons have several distribution centers located all over India to take care of their supply chain. Pantaloon has set up a company called Future Logistics, which provides all the back end support to all its businesses.

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Risks & concerns Delays in mall construction may delay launch plans of retailers A survey by ICICI Property and Technopak suggested that malls would account for half of the total organized sector retail space demand in the next five years. However, the rising cost of retail space in India is affecting the growth plans of retailers. Real estate costs are hampering their margins, which are already not very high. Retailers, in order to get prime real estate, have even started to look at residential properties located at prime locations to convert them into retail outlets/malls. They are also entering into long-term lease arrangements with mall developers as anchor tenants in order to reduce lease costs and also entering into revenue sharing agreements.

High employee costs Companies are now looking at innovative retention schemes in order to reduce attrition and reduce employee costs

Another major concern is staff costs. Owing to increasing competition and new entrants in the retail business, attrition levels for the industry have gone up drastically resulting in high expenses to retain and hire new people. Staff costs have gone up by 35% since 2006. Companies are now focusing on retaining their employees and are forced to offer them higher salaries and bonuses, which in turn have an impact on the profitability of the companies. Companies are now looking at innovative retention schemes in order to reduce attrition and reduce employee costs.

Opposition to organized retail Opposition from the unorganized sector and any consequent political opposition can hamper growth plans of retailers. Also, delays in opening up the retail sector to FDI may impact growth rates of the sector, going forward.

Pressure on margins Another important fact is the pressure on margins, which the retailers will face once competition enters. Retailing as such is a low margin business. EBITDA margins for food and groceries are wafer thin at 3-3.5%. Margins in the apparel business are in the range of 8-16%. Retailers are concentrating more and more on private labels where margins are higher

Retail Sector Report

Given the big expansion plans of retailers, net profits may have to take a hit in order to increase volumes. Retailers are concentrating more and more on private labels where margins are higher. However, we still feel that, going forward, this is a key risk in this business. The company that is able to properly understand the consumer and his needs would be the one that will survive in the long run.

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Conclusion We are positive on the sector and believe current players such as Pantaloon, Shoppers' Stop, Vishal Retail and Trent are well positioned to take full advantage of the growth in the sector. With the growth in consumerism, urbanization and a young population the retail sector is clearly on an upswing. To protect margins, retailers have now started to concentrate on their supply chain and logistics so as to ensure low cost of procurement. As such retail is a high volume, low margin business and one which requires sizeable investments in working capital. Average margins across major formats are as under: Table Format Apparel: Lifestyle

Gross margins (%) 35-45

EBITDA margins (%) 8-16

Value

32-37

10-12

Hypermarkets

25-30

6-7

Food and Grocery

15-20

3-4

Source: Kotak Securities Private Client Research

We feel that looking at the size of the market and the potential, there is a market large enough for several large players to co-exist

With organized retail penetration levels of 3-3.5% of the total industry, and as low as 1% in segments such as food and grocery the scope for growth is tremendous. Players such as Reliance Retail, Aditya Birla group are all expected to do well, going forward. Although there may be questions about the cutthroat competition we feel that looking at the size of the market and the potential, there is a market large enough for several large players to co-exist. Even in case of other segments such as apparel and value retailing, the penetration levels are low and with growth in number of malls and hypermarkets, established players such as Shoppers' Stop, Trent, Pantaloon are expected to benefit as they have a strong foothold and pan-India presence already. Our preferred pick in the sector is Vishal Retail.

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SHOPPERS' STOP

Rohit Ledwani [email protected] +91 22 6634 1507

Price : Rs.492 Target Price : Rs.490

Shoppers' Stop is one of the leading players in lifestyle apparel retailing and has a strong foothold in metro cities. In FY07, the company had 1.17 mn sq ft of space and reported sales of Rs.8.99 bn. The company is on an expansion mode and wants to rapidly increase its presence across the country. With this rapid expansion, we estimate margins will come under pressure going forward for the next two years. We are initiating coverage with a REDUCE recommendation.

Stock details BSE code NSE code Market cap (Rsm)

: 532638 : SHOPERSTOP : 17146

Free float (%) 52-wk Hi/Lo (Rs) Avg. daily volume (m)

: 33.84 : 777/441 : 3487

Shares o/s (m)

: 34.85

Summary table - Standalone Rs mn

FY07

FY08E

FY09E

Sales

8,995

12,772

16,674

32.8

42.0

30.6

Growth % EBITDA EBITDA margin % Net profit Net cash (debt) EPS (Rs)

674

715

1,004

7.49

5.60

6.02

261

197

268

(137)

(488)

(1,698)

7.6

5.7

7.7

Growth %

(3.5)

(24.5)

35.9

CEPS

15.0

16.9

23.2

DPS (Rs)

1.5

1.1

1.5

ROE %

9.2

6.6

8.5

11.9

9.8

11.8

ROCE % EV/Sales (x)

2.0

1.4

1.1

EV/EBITDA (x)

26.9

25.6

19.0

P/E (x)

64.9

86.9

63.9

P/Cash Earnings

32.8

29.2

21.2

5.8

5.6

5.3

P/BV (x)

Source: Company, Kotak Securities - Private Client Research

Shareholding pattern (Q1FY08)

Banks, Fis, Ins cos 0.4%

Corportae Bodies 4.7% Public 4.4%

MFs UTI 9.0% FIIs 15.3%

Promoters 66.2%

One-year performance (Rel to nifty) Sensex

SSL

Source: Capitaline

Retail Sector Report

Recommendation : REDUCE FY09E PE : 63.9x

We estimate that the company will operate 1.62 mn sq ft in FY08 and 2.21 mn sq ft in FY09. The company has also introduced new specialty formats such as Arcelia, MAC and Mothercare in order to diversify its portfolio. However, since these are new formats and will take three to four quarters to break even, they will significantly impact the overall results of the company. For standalone Shopper's Stop stores high operating costs particularly that of lease rentals and energy costs are impacting margins. The company also has the option of increasing its stake in Hypercity from the current 19% to 51% by December 31 2008. The 51% stake in hypercity gives us a value of Rs.50 per share of Shoppers Stop and we feel that the current market price clearly discounts the potential of this format as well. We estimate the company's revenue will grow at a CAGR of 36% between FY07 and FY09. However, we estimate EPS will stagnant and Rs.7.7 in FY09 as compared to Rs.7.6 in FY07. Based on our DCF valuation, we value the standalone business at Rs.440 per share and Rs.50 per share for the Hypercity stake. Given the pressure on earnings, going forward, we recommend a REDUCE.

Key disinvestment rationale Expansion plans to impact earnings Shoppers' Stop is currently present in 12 cities. The expansion plans of the company have been slow over the past two years primarily due to delay by mall developers in handling over stores. Over the next three years, we expect that the company will open 18 new stores. We also believe the company will be expanding its specialty stores such as Mothercare and Café Brio and new formats such as Arcelia. As the stores that had got delayed are now ready to open, this sudden bunch up of stores could impact margins significantly, going forward. Consequently, the total area is expected to go up to 1.62 mn sq ft in FY08 and to 2.21 mn sq feet in FY09 from 1.17 mn sq feet in FY07. Although this expansion is expected to contribute to the sales, EBITDA and net level we estimate the company's earnings will be impacted negatively in the medium term. This is primarily because these stores operate on a negative EBITDA initially and will take three to five quarters to break even. With lot of stores expected to open over the next two years we estimate earnings will take a hit. These costs pressures bite into the margins earned by the older matured stores and hence impact the results of the company.

Hypercity stake Shoppers' Stop has the option of taking a 51% stake in Hypercity, which currently operates one hypermarket in Mumbai and is 125,000 sq ft in size. Currently, Shoppers' Stop has about 19% stake in Hypercity. Hypercity has been very successful. In FY07, the first year of operation, it clocked a turnover of Rs.1.3 bn. However, the expansion plans of Hypercity have been delayed. With the slow expansion of the format we feel the valuation of Rs.50 per share of Shoppers' Stop fully reflects the potential. The additional stake will be acquired by Shoppers' Stop at cost plus 10%. We assume Shoppers' Stop will operate seven Hypercity stores at end of FY09.

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High lease rentals & operating costs Shoppers' Stop being a lifestyle retailer operates most of its stores in malls or high streets. With a boom in the real estate space the lease costs have risen significantly and these have a direct impact on margins. Recently, Shoppers' Stop opened two new stores in Delhi with lease costs of Rs.100/sq ft, which we feel are very high. These can have significant impact particularly in the initial stages of a store and impact overall earnings. Other operating costs such as energy costs have also risen significantly in areas such as Mumbai and are straining the earnings of the company.

New formats to take time to break even and mature Shoppers' Stop launched the Mothercare and MAC formats over the last two years and the latest format Arcelia in Q2FY08. These are intended to drive growth, going forward. As competition sets into the apparel retailing, companies that can differentiate themselves are expected to do well. With precisely this motive, Shoppers' Stop is now building on these formats. However, in the near future we see these stores reporting operating losses until the format matures and expansion plans are complete. We do not see this happening for the next two years and estimate margins of the total business will come under pressure.

Competition With increased competition in the lifestyle retail space we do not see Shoppers' Stop like to like growth growing at the pace of 21% that it achieved in FY07. This could slow down sales going forward.

Valuation & recommendations We recommend investors REDUCE with a 12 month target price of Rs.490

We estimate the company’s revenues to grow at a CAGR of 36% between FY07 and FY09 and EPS to be Rs.5.7 in FY08 and Rs.7.7 in FY09. Based on DCF methodology we value the standalone business at Rs.440 per share and the Hypercity stake at Rs.50 per share. Hence we recommend investors REDUCE with a 12 month target price of Rs.490.

Risks and Concerns n Better performance on the margin front could impact our estimates and could result in better earnings for the company which is an upside risk to our recommendation. n A fall in lease rentals could also improve operating margin and hence be an upside risk to our estimates. n Faster opening of new stores would also result in better sales and could impact our estimates of slow expansion. n On the down side: Further delay in opening of stores could further impact earnings negatively.

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BUSINESS OVERVIEW Shoppers' Stop, promoted by the Raheja group, is India's oldest organized retailer. It commenced operations in 1991 with a store in Andheri, a suburb in Mumbai. The store sold apparel, perfumes and lifestyle products. Over the past 15 years, Shoppers' Stop has become a well known brand in apparel retailing and operates 23 stores with over 1 mn sq ft as on March 31 2007. Shoppers' Stop went public in 2003 and raised over Rs.1 bn to fund its future expansion plans. The company aims to operate close to 45 stores over the next few years. Shoppers' Stop also owns the Crossword chain of book stores. It recently formed a JV with Nuance and won bids to operate duty free stores at the international airports of Bangalore and Hyderabad. Shoppers' Stop also operates a store at the Mumbai airport under the name 'Stop & Go'. Currently, it is India's largest airport retailer. Shoppers' Stop also has two stores called Home Stop in Mumbai and Bangalore, which are one-stop shops for all home needs ranging furniture to bedroom furnishings, kitchen appliances, health equipment etc. They are also promoters of a hypermarket called Hypercity. Hypercity, currently, has one store in Malad in Mumbai. Shoppers' Stop has an option to pick up a 51% stake in Hypercity before December 31 2008 at a premium of 10% compared to cost. During FY07, Shoppers' Stop acquired a 19% stake in Hypercity. Shoppers' Stop also formed a JV with Argos of UK, which is primarily into catalog retailing. Shoppers' Stop plans to set up and expand this format of retailing within the next year. As on March 31 2007 Shoppers' Stop along with its specialty stores has 1.17 mn sq ft in operation

Shoppers' Stop has also tied up with cosmetics giant Estee Lauder to open MAC stores in India. The first store was started in Mumbai in 2005. They have also forayed into the food and beverages segment. They own cafes under the brand name 'Café Brio', which currently operates 16 outlets and another fast food joint called 'Desi Café' in Mumbai. Apart from this, Shoppers' Stop also acquired a 45% stake in Time Zone entertainment. The latter is in the business of operating family entertainment centers in five outlets in four cities. As on March 31 2007 Shoppers' Stop along with its specialty stores has 1.17 mn sq ft in operation, with employee strength of 3071.

KEY DISINVESTMENT ARGUMENT Delayed expansion plans Shoppers' Stop's expansion plans have not been a high growth track as compared to its peers in the retail business. Its plans have been delayed primarily due to delay in handing over of stores by mall developers. In FY07, the company managed to open only one Shoppers' Stop store and one Home Stop store. These delays considerably impact the growth of earnings. However, many stores that were delayed are now getting ready to open over the next two years. However these new stores have very high operating costs and put a significant pressure on the overall margins of the Company. The stores generally take about four quarters to break even. In this period, they are loss making and impact the profitability of the company significantly. Shoppers' Stop is currently present in 12 cities. Over the next three years, we believe the company will open 18 new stores. We also expect it to extend the reach of its specialty stores such as Mothercare and Café Brio and other specialty formats such as MAC and Arcelia. We estimate that the company will increase total area to 1.62 mn sq feet in FY08 and to 2.21 mn sq feet in FY09. This would result in an increase in area by over 89% as compared to FY07.

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Area as on 30th June 2007 (Sq feet) Shoppers' Stop Home Stop Mothercare Mac F&B Outlets Crossword

22.00 2.00 13.00* 2.00 22.00 23.00*

Source: Company, * - including 7 shop in shops, ** - including 9 shop in shops

Also, since the company would be on an expansion mode over the next few years, we estimate margins will be under pressure for the next three to four years. With operating expenses such as lease and energy costs also rising significantly, the new stores will be draining resources until they mature. Even the new formats will take time to mature and we see the margins under pressure over the next two years. This capex will be financed by IPO proceeds that were raised and partly by debt. Also, the company said they could be raising further funds via a rights issue. However, we have not considered the dilution arising out of the rights issue and have considered that the company would finance the capex through debt and internal accruals.

Hypercity stake Area (mn sq. feet)

Shoppers' Stop has the option of taking a 51% stake in Hypercity, which currently operates one standalone hypermarket in Mumbai and is 125,000 sq ft in size. In the first year of operation, Hypercity clocked a turnover of Rs.1.3 bn. Hypercity is also expected to expand its reach over the next few years.

3.0 2.5 2.0

However, the expansion plans of Hypercity have also not taken off as expected. Although the store has done well in the past year, we feel the current price fully discounts the potential of the business, going forward. The operating margins of the business are close to 6%.

1.5 1.0 0.5 FY11E

FY10E

FY09E

FY08E

0.0

Source: Kotak Securities - Private Client Research

Hypercity Sales Growth (Rs mn)

5000

Shoppers' Stop currently holds 19% stake in Hypercity and has an option to buy 51% stake at cost plus 10% by December 2008. We value Hypercity at 0.72x Market Cap/Sales (FY09E) giving it a 20% discount to Pantaloon, which is the leading player in the hypermarket segment. This gives us a value of Rs.50 per share of Shoppers' Stop for the 51% stake. The total cost of acquiring this additional stake is expected to be Rs.3.5 mn. Going forward, we have assumed the Hypercity area will expand to 0.7 mn sq ft from the current 0.12 mn sq ft between FY08-FY10.

High operating costs

4000

Being a lifestyle retailer, Shoppers' Stop opens most of its stores in malls or high streets. With a boom in real estate market, lease costs have shot up significantly. Lease costs form a major part of the operating expense of a retailer. With this cost rising, margins are expected to come under significant pressure.

3000 2000 1000 FY09E

FY08E

FY07

0

Source: Company, Kotak Securities - Private Client Research

Also costs such as energy costs have been on the rise. In locations such as Mumbai the electricity costs have almost tripled for retailers and have put earnings under pressure. The service tax on rentals may further increase operating costs. The company has made a provision of 9 mn for service tax on rentals this year. With the company on an expansion mode, the new stores and new formats will have high operating costs and are expected to keep margins under pressure over the next few years.

Conservative accounting policies In FY07, Shoppers' Stop changed its accounting method of depreciation, by reducing the life of assets. This resulted in a loss in the last quarter of the year. This added depreciation will impact the net earnings of the company. Hence the company reported a flat growth in profits over FY06-FY07. In the long run this is a good move as Shoppers' Stop renovates its stores every five years and this change in depreciation better reflects the asset life, which otherwise was overstated. However, this added depreciation could impact the net profits of the company over the next two years and hence keep the net margins low.

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Competition With the retail sector on a strong growth track the apparel retailing segment is expected to get crowded with players such as Reliance Retail, AV Birla group all expected to make their entry into the segment. Players such as Trent are also expected to significantly increase their space over the next few years. The increase in competition could slow down earnings of the company going forward.

New formats to take time to break even and mature Shoppers' Stop runs a variety of specialty formats such as MAC, Mothercare, and F&B outlets Café Brio and Arcelia. These are new stores and are reporting losses. The management expects stores to break even within three to five quarters after opening of a new store. With the company in an expansion mode on these formats also, we expect margins to be under pressure until they formats gain some scale and so that new store openings do not result in losses.

Financials Growth in net Sales of the company 8000 6000

For the year, ended March 31 2007 Shoppers' Stop clocked a turnover of Rs.8.99 bn, a jump of 33% from the previous year. EBITDA margins were at 7.5% as compared to 7.2% in FY06. The company reported a PAT of Rs.261 mn, as compared to 271 mn in FY06. The main reason for this de growth was that due to the change in the method of depreciation by the company in Q4FY07, the company posted a loss at the PAT level of Rs.22.7 mn. However, for the year ended FY07, the company had shown an increase in sales/sq ft from Rs.7576 in FY06 to 7973 in FY07.

4000 2000

Financial Summary Q2FY08 FY07

FY06

FY05

FY04

0

Source: Company Annual Report

(Rs mn) Revenue

Shoppers' Stop 2660.20

New initiatives 347.00

Total 3007.20

45.30

8.80

54.10

Operating expenses

725.40

147.40

872.80

EBITDA

157.40

-23.80

133.60

8.40

3.60

12.00

Depreciation

87.80

11.70

99.50

PBT

61.20

-39.10

22.10

Operating income

Finance charges

Source: Company

Financial summary Q2FY08 (Rs mn) Retail turnover

Q2FY08 3042.80

Q2FY07 2201.90

Retail Sales (Before VAT)

3007.20

2174.20

Sales Net of VAT

2870.60

2086.90

Margin on Sales

952.20

667.60

Margin on sales %

31.70

30.70

Other retail operating income

35.70

27.70

Other income Operating expenses Operating expenses % EBITDA EBITDA %

18.50

3.20

872.80

544.30

29.00

25.00

133.60

154.20

4.40

7.10

Finance income

16.60

23.90

Finance charges

28.60

9.90

Depreciation

99.50

48.30

PBT

22.10

119.80

Tax

17.90

45.80

PAT

4.20

74.00

Source: Company

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n For Q2FY08, Shoppers' Stop revenues grew at 38% as compared to the corresponding quarter last year. n EBITDA margins are down from 7% to 4.1% this year. Higher employee costs, energy costs were the main reason for the margins moving downwards. Also, the new stores have been reporting negative EBITDA thus eating into the profitability. New initiatives reported losses of Rs.23.8 mn at the EBITDA level. n PAT was down 94% to Rs.4.2 mn for the quarter. We expect EPS to stagnate at Rs.7.7 in FY09 vis-a-vis Rs.7.6 in FY07

n The H1FY08 of the company showed a revenue growth of 35% and same store sales growth of 20%. Sales/sq ft for the quarter stood at Rs.3961 as compared to Rs.3919 last year. n However, EBITDA margins were down at 5.1% as compared to 7.2% last year. n PBT also declined 69% from Rs.230 mn last year to Rs.70.9 mn this year. n PAT declined 76% from Rs.144 mn to Rs.34.4 mn this year. PAT margins were at 0.6%. n The operating costs rose from 26% of sales to 29.3% primarily due to higher employee, lease and other operating expenses. n Going forward, we see the same trend continuing in terms of revenues and EBITDA. The new stores will still take another three to four quarters before reporting profits and until then we see the margins subdued on the operating as well as PAT levels. Shoppers Stop financials (Standalone) (Rs mn) Income

2007 8,995

2008E 12,772

2009E 16,674

Cost of Goods Sold

8,321

12,057

15,670

Operating Profit (EBDIT)

674

715

1,004

Depreciation & Amortisation

256

390

540

Gross profit(EBIT)

418

325

464

Interest

(47)

113

153

22

83

90

PBT

487

295

400

Tax

225

97

132

PAT

261

197

268

Other Income

Source: Kotak Securities Private Client Research

Going forward, we see the company's revenue growing at a CAGR of 36% over FY07FY09 and space increasing from 1.17 mn sq ft to 2.21 mn sq ft in FY09. This would mean an additional 11 stores. However, we see margins contracting significantly in this period as the company is on an expansion mode. We estimate there would be costs pressures going forward. We have assumed that in FY09 the EBITDA margins to be at 6%.

Valuation and Recommendation Going forward, we expect the company's revenues to grow at a CAGR of 36% between FY07 and FY09 and EPS to de grow to Rs.5.7 in FY08 and Rs.7.7 in FY09 as compared to Rs.7.6 in FY07. We value the standalone business at Rs.440 per share, based on DCF methodology and the Hypercity stake at Rs.50 per share. This gives us a valuation of Rs.490 per share. We therefore recommend investors REDUCE the stock with a price target of Rs.490.

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Concerns n Better performance on the margin front could impact our estimates and result in better earnings for the company which is an upside risk to our recommendation. n A fall in lease rentals could also improve operating margin and hence be an upside risk to our estimates. n Faster opening of new stores would also result in better sales and could impact our estimates of slow expansion. n On the down side: Further delay in opening of stores could further impact earnings negatively.

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Financials: Shoppers Stop Ltd. (Standalone) Profit and loss statement (Rs mn) Year end March Revenues % change yoy EBITDA % change yoy Depreciation EBIT % change yoy Net Interest Other Income Earnings Before Tax % change yoy Tax as % of EBT Net Income adj % change yoy Shares outstanding (m) EPS (Rs) DPS (Rs) CEPS

Balance sheet (Rs mn)

FY07

FY08E

FY09E

8,995 32.8 674 37.6 256 418 19.2 (47) 22 487 20.9 225 46.3 261 (3.5) 34.5 7.6 1.5 15.0

12,772 42.0 715 6.1 390 325 (22.2) 113 83 295 (39.5) 97 33.0 197 (24.5) 34.9 5.7 1.1 16.9

16,674 30.6 1,004 40.4 540 464 42.8 153 90 400 35.9 132 33.0 268 35.9 34.9 7.7 1.5 23.2

FY07

FY08E

FY09E

418 256 504 170 (47) 225 (9) 540 138 (679) (12) 44 32 (61) 22 4 546 41 553 (103) 1,098 995

325 390 419 296 113 97 86 877 (489) (388) (46) (46) (45) 83 (0) (41) (4) (352) 995 643

464 540 721 283 153 132 (2) 1,236 (1,236) (61) 90 800 828 (410) 643 233

Cash flow statement (Rs mn) Year end March EBIT Depreciation Change in working capital Operating cash flow Interest Tax Cash flow from operations Capex (Inc)/dec in investments Cash flow from investing Adjustment for depreciation adjustment for reserves Total adjustments Dividend paid Other income Proceeds from equity issue Increase/(decrease) in debt Deferred tax credit Cash flow from financing Change in cash Opening cash Closing cash

Year end March

FY07

FY08E

FY09E

Cash and cash equivalents Accounts receivable Others Current Assets Inventories LT investments Net fixed assets Total Assets

995 73 1,245 2,312 1,152 489 1,522 5,475

643 178 1,450 2,271 1,600 2,008 5,880

233 232 2,112 2,577 2,250 2,704 7,531

Payables Others Current liabilities

1,223 128 1,351

1,550 140 1,690

2,145 190 2,335

LT debt Other liabilities(deferred tax)

1,131 41

1,131 -

1,931 -

Equity & reserves Total Liabilities BVPS (Rs)

2,952 5,475 85.6

3,058 5,880 87.8

3,265 7,531 93.7

Ratio analysis Year end March

FY07

FY08E

FY09E

EBITDA margin (%) EBIT margin (%) Net profit margin (%) Adjusted EPS growth (%)

7.5 4.6 2.9 -3.5

5.6 2.5 1.5 -24.5

6.0 2.8 1.6 35.9

Receivables (days) Inventory (days) Sales / Net Fixed Assets (%) Interest coverage (x)

3.0 46.8 6.9 0.0

5.1 45.7 6.5 1.0

5.1 49.3 6.2 2.0

0.4

0.4

0.6

ROE (%) ROCE (%)

9.2 11.9

6.6 9.8

8.5 11.8

EV/ Sales (x) EV/EBITDA (x) Price to earnings (x) Price to book value (x) Price to cash earnings (x)

2.0 26.9 64.9 5.8 32.8

1.4 25.6 86.9 5.6 29.2

1.1 19.0 63.9 5.3 21.2

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Debt/ equity ratio

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VISHAL RETAIL

Rohit Ledwani [email protected] +91 22 6634 1507

Price : Rs.740 Target Price : Rs.861

Vishal Retail is one of the leading players in the value retail segment. It operates 50 stores in 18 states spread over 1.26 mn sq ft. The company recently went public and raised Rs.1.1 bn to fund its future expansion plans. It operates mainly in the hypermarket segment and most of it sales are of apparel.

Stock details BSE code NSE code Market cap (Rsm)

: 532867 : VISHALRET : 16569

Free float (%) 52-wk Hi/Lo (Rs) Avg. daily volume (m)

: 36.07 : 815/423 : 29802

Shares o/s (m)

: 22.39

Summary table Rs mn

FY08E

FY09E

Sales 6,027 10,589 Growth % 108.9 75.7 EBITDA 670 1,240 EBITDA margin % 11.1 11.7 PBT 393 693 Growth (%) 110.0 76.5 Net profit 250 465 Growth (%) 100.3 85.9 EPS (Rs) 11.2 20.7 Net cash (debt) (2,281) (2,954) ROE % 25.0 23.1 ROCE % 21.6 19.8 Operating Cash Flow (1,008) 140 Net W Capital (Days) 150.5 123.6 P/E (x) 66.3 35.7 P/BV (x) 13.1 6.0 DPS (Rs) 0.0 3.1 EV/Sales (x) 3.2 1.9 EV/EBITDA (x) 28.4 16.2

FY07

17,853 68.6 1,916 10.7 1,147 65.4 768 65.4 34.3 (4,347) 25.0 21.8 736 97.4 21.6 4.9 5.1 1.2 11.1

Source: Company, Kotak Securities - Private Client Research

Shareholding pattern (Q1FY08) Corporate Bodies 17.8%

The company's revenue has grown at a CAGR of 86% between FY03FY07 and net profit at a CAGR of 160% over the same period. Going forward, we estimate the high growth to continue. We are positive on the prospects of the company given its strong foothold in Tier-II and Tier-III cities. The company's operating margins are higher at 11.1% mainly due to lower costs of rentals and share of private and quasi private labels. The company plans to aggressively expand in Tier-II and III cities. We estimate the company will operate 2.1 mn sq ft of space by FY08. We feel this expansion will further strengthen the presence of the company in smaller cities and will significantly add to its revenues and profits. It has a strong supply chain. With further expansion and economies of scale we do not see the margins coming under too much pressure, going forward. We estimate the revenues to grow at a CAGR of 72% between FY07 and FY09 and PAT to grow at a CAGR of 76% in the same period. At the current price of Rs.740, the stock discounts FY08 and FY09 earnings by 36x and 22x, respectively. We are positive on the company, and recommend investors BUY the stock with a price target of Rs.861.

Key investment rationale First mover advantage in Tier-II and Tier-III cities Vishal Retail's stores are located primarily in small towns and its concept is to provide quality at low costs. It has been able to develop a strong connect with the middle and lower income groups and has a strong foothold in small towns. As none of the big retailers have ventured into small cities as yet Vishal Retail has a first mover advantage and has built a strong reputation.

Low real estate costs

Public 8.2%

Banks, Fis, Ins cos 0.2% MFs UTI 3.0%

Recommendation : BUY FY09E PE : 21.6x

Promoters 63.9% FIIs 6.8%

Source: Capitaline One-year performance (Rel to nifty) Sensex

Since Vishal Retail's stores are located in Tier-II and Tier-III cities, it has lower real estate costs compared to other retailers who are primarily present in metro and Tier-I cities. The average rental per sq ft is only Rs.32 for Vishal Retail as compared to Rs.70 for Shoppers' Stop and Rs.50 for Pantaloons. This allows the company to achieve a higher level of profitability.

In-house brands / private labels expected to prevent margin erosion The overall company's sales currently consist of only 10% of in-house brands and 20% of its apparel sales are of private labels. Going forward, the company wants to further increase its sales of private labels as these have higher margins. Its EBITDA margins in FY07 were 11.1% and net margins at 4.2%. With economies of scale kicking in further, we do not see these margins reducing significantly even though the company is on an expansion mode and this increase in sales of private labels will help protect its margins.

Vishal

Source: Capitaline

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Procurement from low-cost production centers and efficient logistics In order to keep margins stable Vishal Retail has a strong distribution network with warehouses spread across the country and has a fleet of its own trucks. The company also sources products from low cost centers such as China and has also set up an office there for sourcing.

Increasing sales of FMCG and other private labels Sales of private labels accounted for only 10% of the total revenues in FY07, and more than 60% of revenues of the company come from apparels. However, with a view to reduce seasonality, Vishal is now focused on increasing the proportion of FMCG products sales. This is also expected to help in attracting more footfalls. As competition sets in, such measures to increase footfalls will be helpful in increasing its same store growth. In order to nullify the dip in margins due to sales of FMCG products, Vishal has its own private labels for products such as toothbrushes etc.

Valuation and recommendation We recommend investors BUY with a price target of Rs.861

The current price discounts FY08 earnings by 36x and FY09 earnings by 22x. We estimate sales to grow at a CAGR of 72% between FY07 and FY09 and PAT to grow at a CAGR 76% in the same period. We value the stock on a P/E multiple of 25(x) based on FY09 earnings giving it a discount to Pantaloon, owing to the fact that it is the leader in the hyper market segment and Vishal being relatively smaller. We recommend investors BUY with a price target of Rs.861.

Risks and Concerns n High inventory level: Last year the inventory days of Vishal Retail shot up to 151 days. Such high levels of inventory block up working capital and also will have to be sold at low prices or written off on a later date. We have assumed the inventory days to decline going forward as in FY07 the inventory was higher due to SAP implementation and piling of inventory for new stores. n Competition: As other companies expand their presence in Tier-II and Tier-III cities Vishal may have to face competition, going forward. n Staff costs: With growth in the sector, the company will now have to spend more on retaining its employees and high staff costs can impact margins, going forward.

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COMPANY BACKGROUND AND MANAGEMENT Promoted by Ram Chandra Agarwal. Vishal Retail is one of the leading players in the value retail segment. It operates 50 stores in 18 states spread over 1.26 mn sq ft. The company started off as a retailer of readymade apparel in Kolkata in 2001. Vishal has a diversified portfolio of offerings ranging from readymade garments to FMCG products, household products, groceries, toys, footwear etc. The company either manufactures products in-house or procures them directly from manufacturers to reduce costs and achieve economies of scale. Vishal Retail has got a manufacturing plant in Gurgaon and seven distribution centers across the country. The company has a fleet of owned trucks in order to maintain an efficient logistics system. Out of its 50 stores, 43 are located in Tier-II and Tier-III cities. The company operates its stores under the brand name 'Vishal Mega Mart'. Vishal Retail plans to further expand its base of 50 stores covering 1.26 mn sq ft to 2.1 mn sq ft in FY08

Vishal Retail plans to further expand its base of 50 stores covering 1.26 mn sq ft to 2.1 mn sq ft in FY08. A total of 22 new stores will be funded from the money raised in the IPO and the balance from internal accruals. Out of these 22 new stores, 18 will be opened in Tier-III cities, one in a Tier-II city and the remaining three in TierI cities. The company wants to strengthen sales from its private labels by expanding its manufacturing and importing products from low-cost locations like China, thereby achieving superior profitability, going forward.

INVESTMENT ARGUMENT Tremendous growth opportunities in organized retail in small cities With most retail companies focusing on metro and Tier-I cities, Vishal has decided to concentrate on smaller towns and cities. It is a strategy that has benefited the company immensely. With hardly any presence of organized retailers in these cities, we believe Vishal will stand to benefit immensely as the population of these cities are becoming more aspirational and are willing to spend in such stores. Vishal will have a first movers advantage in these cities and will help it get a strong foothold in these cities before any competition sets in and will become a dominant retailer in these cities This strategy has also helped the company to have strong margins as the capex costs as well as lease costs are significantly lower as compared to metro and Tier I cities. With its first mover advantage Vishal has built a successful model and in just five years created a strong brand for itself.

Strong player in value retail segment Vishal's retail business works on the 'value retailing' concept - providing quality products at low prices. Vishal has been able to develop a strong customer connect with its target segment of middle and lower middle class consumers. In our opinion, the company has been able to provide these because of its relatively lower costs in the form of lower rents and also it's sourcing capabilities. The company has a strong back end supported by distribution centers and transport facilities spread across the country. It has close to 0.8 mn of warehousing space. The company's focus on private and quasi private labels has ensured higher margins for the company and low prices for the consumer. Focus on all aspects such as manufacturing, private/quasi private labels, supply chain, low cost of rentals has ensured that Vishal Retail always provided consumers with quality at low costs and has built a strong reputation in this segment.

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Procurement from low-cost production centers and efficient logistics In order to obtain cost efficiencies, Vishal Retail already procures and intends to increasingly procure products from low-cost production centers across the globe. In India, for example, it sources shirts from locations such as Tirupur and uses its strong distribution network to obtain cost savings. Rather than focusing on national private labels, Vishal stocks quasi private labels. This gives Vishal Retail more bargaining power as such brands are localized, are directly procured from the manufacturers, in turn have higher margins. In FY07, these labels contributed to 72% of sales. It also sources a few products from low cost locations like China. It has set up a sourcing office in China, which is helping in overall sourcing for the company. Efficient sourcing, along with a strong distribution network is one of the key strengths of Vishal Retail. Approximately 5% of the products of the company are imported. This figure however will increase as Vishal increases scale. Sales of products that are imported from destinations like China have higher margins. This will also prevent margins from coming under pressure as the company expands its presence. The company also set up SAP for better inventory management. This will ensure working capital is not locked up in inventory as well as stocks are replenished just in time to ensure shelves are always stocked and costs are kept to the minimum.

Presence in Tier-II and Tier-III cities, low real estate costs Vishal Retail operates and aims to expand, primarily in Tier II and Tier III cities where the penetration of organized retail is very low. This strategy reduces the cost of running a store as rentals in these towns are relatively low compared to a Tier I city. On an average, Vishal Retail has been paying a rental of Rs.32 per sq ft

Also, big retailers like Pantaloon and Shoppers' Stop do not have any significant presence in these Tier-II and Tier-III cities. Hence, this reduces the risk arising from competition. On an average, Vishal Retail has been paying a rental of Rs.32 per sq ft for all its stores. This compares favorably with competition, which pays average rentals of Rs.50-75 per sq feet. Out of the 1.84 mn sq ft it plans to add by FY09, Vishal Retail has already tied up for 1 mn sq ft and the remaining is in the pipeline.

Aggressive store openings - strong execution skills Over the past four years, Vishal has expanded its stores from seven (in 2003) to 49 (in 2007). With this, Vishal has shown strong execution skills which are very essential in the retail business. As the stores need not be located in malls, Vishal Retail is not dependent on mall developers, who generally cause delay in handing over properties. Since its stores can be stand-alone stores and real estate costs are lower in cities that it aims to operate, we feel that Vishal will be able to get real estate without any delay. It further plans to expand its space to 2.1 mn sq ft in FY08 and to 3.1 mn sq feet in FY09. The total number of stores is expected to go up to 124 by FY09, with average store sizes being 25,000 sq ft. With strong execution skills and low real estate costs, we expect the company to perform well over the next two years. It has shown over 100% CAGR in sales over past few years and this strong growth is expected to continue going forward.

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Area at the end of the year (mn sq ft)

New stores opened between FY03-FY07 Year end 31st-March No. of stores at the beginning of the year

3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0

2007 26

2006 16

2005 14

2004 9

2003 7

Stores opened during the year

27

11

4

5

7

Total stores at the end of the year

49

26

16

14

7

FY09

FY08

FY06

FY05

FY04

FY03

Source: Company

Source: Company

We have assumed the space will expand to 2.1 mn sq ft in FY08 and to 3.1 mn sq ft in FY09.

High margins Because of low cost of sourcing and manufacturing, Vishal Retail's operating and net profit margins are higher than any of its peers. We do not see margins coming under too much pressure going forward.

Focusing on increasing sales of private labels & FMCG products In order to increase footfalls and reduce the risk of seasonality of its products such as apparel, Vishal Retail is increasing the mix of FMCG products in its stores. This will ensure footfalls throughout the year. This, in turn, may lead to higher sales of its apparel. However, other than private labels the company has been able to report high margins also due to the fact that most of its apparel other than the private labels are quasi brands, which have higher margins as compared to national brands. It aims to keep national brands in very low quantities going forward. The company wants to continue its focus on quasi brands to protect margins. Vishal Retail also aims to manufacture at least 25% of its apparel requirements inhouse. As of FY07, the contribution of private labels was 9.7% overall. The rise in sales of private labels could help in improving margins as well as reducing dependencies on few suppliers. This is expected to keep overall margins intact as the company is on an expansion mode

Financials HY1FY08 Result Summary (Rs mn)

HY1FY08

Income 3851.6 Cost of Goods Sold 3409.5 Operating Profit (EBDIT) 442.2 Depreciation & Amortisation 108.2 Gross profit(EBIT) 334.0 Interest 134.1 Other Income 32.7 PBT 232.6 Tax 85.3 PAT 147.3 Source: Company

In FY07, Vishal Retail reported sales of Rs.6.03 bn, EBITDA of Rs.670 mn and PAT of Rs.249 mn. The company's revenues have grown at a CAGR of 90% between FY04 and FY07 and PAT has grown at a CAGR of 302% in the same period. EBITDA margins have improved significantly from 3.3% in FY04 to 11.1% in FY07. For the half year ended September 30 2007 Vishal Retail posted sales of Rs.3.85 bn and net profit of Rs.147.2 mn. EBITDA margins were at 11.5%, which are higher than the margins recorded for FY07 which stood at 11.1%. The sales/sq ft stood at Rs.2872 for the half year. During the period under review Vishal Retail added 2509 employees, seven new warehouses spread over 0.4 mn sq ft, taking the warehouse space to 0.89 mn sq ft. During the period under review, they also commenced operations of their garment manufacturing plant located in Dehradun, which has a capacity of 5000 units/day. Imports as a percentage of sales also increased to 7% as compared to 5% for the full FY07. The improvement in operating margins, we feel, is primarily due to savings accrued from low cost sourcing and improved margins on products. It is also because only one store was opened, hence there was no significant cost pressure. The share of non apparel sales increased to over 40% during this period. Only one new store was opened during the first half of the year. However, Vishal Retail has signed MoUs for 45 new stores spanning an area of 0.99 mn sq ft.

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Going forward we estimate the company's revenues will grow at a CAGR of 72% between FY07 and FY09 and net profit at CAGR of 76% during the same period. However, on the Operating margin front we estimate the margins to be 11.7% in FY08 and 10.7% in FY09, primarily because of increased competition in the retail space that it operates in, and cost pressures that could be faced during expansion going forward with increased competition.

Sales break up HY1FY08

FMCG 20%

Others 1%

Non Apparel 20%

Apparel 59%

Source: Company

Based on our estimates, we expect the company to report an EPS of Rs.34.3 in FY09 and we give Vishal Retail a 10% discount to Pantaloon, which is the leader in the hypermarket segment and also India' largest retailer. Based on this we value Vishal Retail at a P/E of 25(x) on FY09 earnings and recommend investors BUY with a target price of Rs.861.

Valuation & recommendation Going forward, we estimate the company's revenue will grow at a CAGR of 72% over FY07-FY09. Net profit will grow at 76% over the same period. We value Vishal Retail on P/E of 25x, based on FY09 earnings, giving it a discount to Pantaloon. Pantaloon is the leader in the Indian retail industry and also in the hypermarket segment with its store Big Bazaar and other value retailing formats such as Brand Factory and Food Bazaar.

We recommend investors BUY Vishal Retail with a price target of Rs.861.

Vishal has grown at a scorching pace over the last few years. We feel this growth will continue, going forward. We recommend investors BUY Vishal Retail with a price target of Rs.861.

Concerns n High level of inventory. Vishal Retails inventory days shot up from 99 to 151 days in FY07. This pile up of inventory locks up working capital and may result in the inventory having to be sold at low prices. The reason for the pile of inventory was due to implementation of SAP and for new stores. n Staff costs. Owing to the competition in the retail sector the company will have to spend more to retain its employees and factors like attrition etc will have to be countered owing to the demand for professionals in the sector. n Competition. Vishal had the first mover advantage in the Tier-II and III cities where it primarily operates. However, with these cities now coming under the radar of other players Vishal will have to face stiff competition

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Financials: Vishal Retail Profit and loss statement (Rs mn) Year end March Revenues % change yoy EBITDA % change yoy Depreciation EBIT % change yoy Net Interest Other Income Earnings Before Tax % change yoy Tax as % of EBT Net Income adj % change yoy Shares outstanding (m) EPS (Rs) DPS (Rs) CEPS

Balance sheet (Rs mn)

FY07

FY08E

FY09E

6,027 108.9 670 154.5 153 518 146.7 148 23 393 110.0 143 36.4 250 100.3 22.4 11.2 0.0 18.0

10,589 75.7 1,240 85.0 302 938 81.2 297 52 693 76.5 229 33.0 465 85.9 22.4 20.7 3.1 34.2

17,853 68.6 1,916 54.5 450 1,466 56.3 405 86 1,147 65.4 379 33.0 768 65.4 22.4 34.3 5.1 54.4

FY07

FY08E

FY09E

518 153 1,679 (1,008) 148 143 (1,299) 831 (831) (2) 328 326 23 (38) 1,882 6 1,873 69 83 152

938 302 1,100 140 297 229 (385) 1,349 (1,349) 1,066 1,066 (79) 52 41 1,068 (18) 1,063 395 152 546

1,466 450 1,180 736 405 379 (48) 1,300 (1,300) (131) 86 1,100 1,055 (293) 546 253

Cash flow statement (Rs mn) Year end March EBIT Depreciation Change in working capital Operating cash flow Interest Tax Cash flow from operations Capex Cash flow from investing Adjustment for depreciation Adjustment for reserves Total adjustments Dividend paid Other income Proceeds from equity issue Increase/(decrease) in debt Deferred tax credit Cash flow from financing Change in cash Opening cash Closing cash

Year end March

FY07

FY08E

FY09E

Cash and cash equivalents Accounts receivable Others Current Assets

152 1 3,154 3,307

546 2 4,668 5,217

253 3 6,403 6,659

1,082 4,389

2,128 7,345

2,978 9,637

671 671

1,086 1,086

1,641 1,641

2,432 18

3,500 -

4,600 -

1,268 4,389 56.6

2,759 7,345 123.2

3,397 9,637 151.6

Year end March

FY07

FY08E

FY09E

EBITDA margin (%) EBIT margin (%) Net profit margin (%) Adjusted EPS growth (%)

11.1 8.6 4.1 100.3

11.7 8.9 4.4 85.9

10.7 8.2 4.3 65.4

Receivables (days) Inventory (days) Sales / Net Fixed Assets (%) Interest coverage (x)

0.1 150.9 5.6 0.0

0.1 120.6 5.0 0.0

0.1 95.1 6.0 0.0

1.9

1.3

1.4

ROE (%) ROCE (%)

25.0 21.6

23.1 19.8

25.0 21.8

EV/ Sales (x) EV/EBITDA (x) Price to earnings (x) Price to book value (x) Price to cash earnings (x)

3.2 28.4 66.3 13.1 41.2

1.9 16.2 35.7 6.0 21.6

1.2 11.1 21.6 4.9 13.6

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LT investments Net fixed assets Total Assets Payables Others Current liabilities LT debt Other liabilities(deferred tax) Equity & reserves Total Liabilities BVPS (Rs)

Ratio analysis

Debt/ equity ratio

Source: Company, Kotak Securities - Private Client Research

Retail Sector Report

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Kotak Securities - Private Client Research

December 13, 2007

ANNEXURE Big ticket investments being made Around $22 bn are expected to be invested in retail over the next few years. Big players such as Reliance, Bharti (with its JV with Wal-Mart), and Dabur are all set to foray into the fast growing retail space. These companies have already announced their plans to grow aggressively in this space.

Reliance Retail Reliance is planning to invest $6 bn over the next five years

Reliance is planning to invest $6 bn over the next five years. Out of this, approximately 20-25% will be invested in developing a supply chain to support its retail activities, so as to derive sufficient cost savings. The company is planning complete backward integration right from contract farming to having its own air strips, warehouses and cold storage. Reliance has already opened stores in Delhi, Hyderabad and Bangalore and several other cities. The company has stated its goal to achieve a turnover of Rs.100 bn from its retail business in the future. The main strategy for Reliance is to open Reliance Fresh outlets within a radius of 3-4 km each in order to serve larger sections of the population. That means an average of at least 35 stores in all major metros. It is also launching mini-hypermarkets under the name 'Reliance Mini Mart' and is expected to open 65 outlets by March 2008. The company has also forayed in the consumer durables business under the brand name 'Reliance Digital'. According to the company, they plan to open 100 stores in the first year of its operation and earn revenues of Rs.15-20 bn. It has tied up with Videocon for the supply of color televisions and color picture tubes. Reliance will sell these under the Reliance brand. It is also looking at entering the after sales service segment. Demand for consumer durables rising rapidly Rs. In mn white goods

2009-2010 19923

2005-06 13062

2001-02 9030

1995-96 5827

CTVs regular

9957

6295

4580

1785

motorcycles

8369

4663

2599

760

Cars

3466

1560

788

276

Source: NCAER

Five year projected growth Product Cars & Utility vehicles

1 year growth 11%

5 years growth* 16%

Colour Television

12%

12%

Paints

11%

14%

Two Wheelers

11%

11.5%

5%

7%

Washing Machines

* five years growth is projected CAGR (2010-2011 over 2005-2006) One year growth is y-o-y growth (2006-07 over 2005-06) Source: Crisil Research

Reliance is also planning to enter the luxury goods market. The company is tying up with brands like Louis Vuitton. Reliance is also launching specialty formats such as health and wellness, jewelry, footwear, books and music, home solutions and cosmetic stores. These stores are expected to have a heavy mix of private labels.

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December 13, 2007

Roll out plan across formats: Category Health and Wellness

Size in square feet 5500-15000

No. of stores (over 3 years) 4000

6500-14000

150

Apple stores

2000-5500

37

Home Solutions

1-2.5 lakh

13

Jewellery

Books and Music

5000-15000

23

Reliance mini mart

11000-50000

200

Apparel

30000-50000

100

Source: Economic Times

In FY07, Reliance acquired Adani Retail, a retail chain in Gujarat, for a price of about Rs.1.1 bn. The buyout will give Reliance access to 54 retail locations (neighborhood stores, supermarkets and hypermarkets) across nine cities in Gujarat in one shot. Besides this, Reliance will get its infrastructure and sourcing facilities. With commercial real estate prices shooting up across India, the acquisition will help the company control costs substantially as 60% of Adani retail outlets are companyowned. Reliance is also entering the e-commerce business. The company has appointed a separate team to kick start this venture. It is planning to have depots at various locations that will serve as pick up points for products. With an increase in broadband penetration and rising real estate costs, Reliance believes this will contribute about 5-6% of its total revenues in the next two to three years. The company will use this format to link its front-end and back-end logistics. According to industry sources, in order to overcome the competition from local kirana' stores, Reliance Retail has come up with a strategy to bring these local kirana stores into its own network by taking their property on lease. The company is signing a non-competition agreement with them that bars them from conducting a similar business. Reliance is paying four to five times more than the prevailing market rent to these shops. This is much more than the sales of these stores. This is proving to be a win-win for both Reliance as well as these small shops. The latter would otherwise have been impacted by the presence of Reliance stores in their vicinity. Reliance will use these acquired outlets to sell fruits, vegetables and groceries under the 'Reliance Fresh' banner. Recently Reliance opened its apparel retailing store under the brand 'Reliance Trends'. These stores have a mix of both private labels and brands of other manufacturers.

Bharti-WalMart Bharti plans to invest $2.5 bn by 2011 and aims to earn revenues of $4.5 bn out of it by 2015

Bharti has tied up with Wal-Mart and will be investing in supply chain, logistics and wholesale cash and carry stores. Bharti is also planning to start neighborhood stores, which will be 100% owned by Bharti, since FDI is not allowed in multi-brand retail. Bharti's tie-up with Wal-Mart will be only for the back end. The company aims to have 10 mn sq ft of retail space and employ 60,000 employees. Bharti plans to invest $2.5 bn by 2011 and aims to earn revenues of $4.5 bn out of it by 2015.

Dabur Dabur is planning to invest Rs.1.4 bn by 2010 in the retail health and beauty business by opening 350 stores. They plan to open 1000 stores by the tenth year of their operation.

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Aditya Birla group The group plans to invest about Rs.150 bn in its retail foray. It plans to open supermarkets and hypermarkets and also use its company Madura Garments as a key in its retail plans. The group recently acquired a retain chain in south India called 'Trinethra'. 'Trinethra' has most of its stores in Karnataka and Andhra Pradesh under the brand name 'Fabmall' (in Karnataka) and 'Trinethra' (in Andhra Pradesh.) It has 172 stores and one hypermarket in Mysore called 'Fabcity'. Trinethra, which has adopted convenience and supermarket formats, is focused on selling food and groceries in residential areas. However, some of the stores also offer pharmaceutical products. Trinethra also offers value-added services like forex remittances and bill payments. A typical Trinethra store measures around 2500 sq ft. The chains of stores are serviced by an infrastructure of central warehouses in Andhra Pradesh, Karnataka, Tamil Nadu and Kerala, with a space of about 50,000 sq ft each.

Spencer’s Retail Currently, the group has 320 outlets, including Spencer's Hypermarkets, Spencer's Fresh Stores, Spencer's Express Stores and Spencer's Daily Stores

Spencer's Retail is part of the RPG Group. The company plans to open 2,000 retail stores covering 1 mn sq ft by 2009 with an investment of Rs.10 bn. Currently, the group has 320 outlets, including Spencer's Hypermarkets, Spencer's Fresh Stores, Spencer's Express Stores and Spencer's Daily Stores. It plans to close the current fiscal will 600 Spencer's Daily stores. The company also has plans to roll out a chain of consumer electronic stores. To start with the company plans to open five in South India and the stores are expected to be of a minimum area of 4000 sq ft.

Subhiksha Chennai-based Subhiksha is a retail chain, which has the format of local 'kirana' stores. However, Subhiksha sells products at a discounted price. The chain's target customers are those who spend about Rs.2000-3000 a month for their household expenses on food and toiletries. In India, this is a massive market owing to the sheer size of the country's population. The company sells products about 10% cheaper and also provides free home delivery. Hence, the chain provides the convenience of a 'kirana' store. In March 2006, Subhiksha had 120 outlets, mostly in Chennai. These have now grown to more than 650 outlets with 74 in Mumbai and over 100 in Delhi. The chain plans to have 1000 outlets by the end of the year and is eyeing 2000 in the next two years. The retailer is aiming for a turnover of Rs.10 bn from the present Rs.3.5 bn. The chain has seen an increase in profit margins as well, from 2% in 2003 to close to 3.5% in 2007.

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Trent Trent is a wholly-owned Tata company. The company has entered into an agreement with the Xander Group Inc, a global private equity firm. The Xander Group, through one or more of its fund vehicles, will invest in the development of an institutional retail real estate portfolio in India in partnership with high quality Indian developers. The company would have anchor tenancy rights and obligations and would participate with Xander in the management of such a portfolio and its growth. Trent also has strong growth plans in its current formats such as Westside, Landmark and Star India Bazaar. As per the management, Westside a fashion retailer and is expected to operate 37 stores by FY08 as against the current 24. Star India Bazaar is the company's hypermarket in Ahmedabad. The company is expanding to four stores this year. Five more Landmark stores will also be added this year. Trent has also raised money through a rights issue a few months ago to fund its expansion plans. Another Tata company Infinity Retail is expected to invest around Rs.4.5 bn to expand its chain of multi-brand outlets of consumer durables and electronics called 'Croma'. In fiscal 2007-08, 40 of these mega stores will be opened. The company has set a target of over 100 'Croma' stores by 2010. The Croma stores will feature over 180 brands of consumer durables and electronics. Spread across 15,000 to 20,000 sq ft, these stores will offer products across eight categories including home entertainment, home appliances, white goods, computers and peripherals, communication, music and gaming software.

Research Team Name

Sector

Tel No

Dipen Shah Sanjeev Zarbade Teena Virmani Awadhesh Garg Apurva Doshi Saurabh Gurnurkar Saurabh Agrawal Saday Sinha Rohit Ledwani Sarika Lohra Chetan Shet Shrikant Chouhan Kaustav Ray K. Kathirvelu

IT, Media, Telecom Capital Goods, Engineering Construction, Cement, Mid Cap Pharmaceuticals Logistics, Textiles, Mid Cap IT, Media, Telecom Metals, Mining Banking, Economy Retail NBFCs FMCG, Power Technical analyst Editor Production

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