Risk reward

Risk reward:

I am all for holding stocks for the longer term and taking an ownership approach to sitting on large winning positions. Or for that matter, waiting it out in tough market conditions by focussing on underlying business fundamentals and prospects. However, sometimes, valuations of even good businesses start to bake in simply too much. The problem is that from such heady levels, the margin for error for the stock price is razor thin – even a sliver of a disappointment in market’s anticipation of prospects will set off a sharp correction. You are in for years of consolidation even as earnings grow near about elevated expectations, as it was all well discounted.

You need not necessarily sell in such cases (or partially sell) – but it’s important to be aware that this disappointment is on the anvil and there is a decent chance that if the business misses a step, valuations may come off sharply. The risk reward equation is not on your side. The wise have usually ridden much of the rise as the business surprised and delivered while the ones chasing the stock price, often with superficial business understanding are most at risk.

One such example which come to mind is Trent Ltd. A Tata group company which has executed phenomenally well in scaling up a large private label apparel store chain, called Westside. This is a format priced as mid to premium, and run very efficiently with a robust backend, and has built a reputation with loyal consumers. The company hit another huge run when they successfully experimented with a smaller mass market format called Zudio – relative to Westside, Zudio appeals to a younger and more value conscious consumer, who is also more fast fashion focussed. Both the formats have proven unit economics – good operating margins with solid inventory mgmt. (high turns with decent share of close to full price sales). Zudio, as it turns out is way more scalable given lower store sizes and an ability to grab share from the low-end unorganised market. Retailing is a tough nut to crack, and what they have going is unique, hard to replicate, especially at this scale and pace.

Westside’s sales have grown ~5x in the last five years and NOPAT has grown ~7x. The stock is up 13x over the same period. It now trades at 12x sales and 105x earnings basis one year forward estimates. These kinds of sales multiples are unprecedented in the history of retailing – the 105x PE multiple is also elevated given the company is already doing 10-11% EBIT margin which is close to steady state for a retailer (this can certainly move up but 11% is not depressed either).

Here is what the current market cap of US$ 23bn seems to be baking in:

• Next five years revenue growth of 25% CAGR basis (FY29 sales would be 3x current sales). This bakes in a lot of success by the way – it assumes Westside store count is higher by 50% in five years while Zudio store count doubles to ~1000 stores. Zudio is still relatively new and not as well vintaged as Westside, so we do not really know. This forecast further assumes, that Westside’s sales per store compounds at 8-9% and Zudio’s at 13% (given higher share of new stores)
• EBIT margin expansion from the current 11% to 15% by FY29 (this is possible but a tall ask – few retailers make that kind of margins. Zara does those margins but not sure if any other retailer, including many good ones in India do 15% EBIT margin)
• An exit multiple of 40x on FY29 earnings forecasted using the above two assumptions (revenues up 3x and EBIT up 4.5x). Multiples will get rational over time – and 40x exit is a punchy multiple on fully flexed out margins and assumes a further growth high runway after FY29.

If all the above plays out to the T, the stock should remain flat over the next five years – as this all seems to be discounted in the current price. Note that this will be an excellent outcome for Trent and the Tata Group – US$5 in sales at a 10% post tax margin.

Now, let’s assume that – the company does very well but somewhat lower that our elevated expectations above – lets say, revenues grow at 20% instead of 25% and EBIT margins peak out at 13% from the current 10% (but don’t reach 15%). Assuming a similar 40x exit multiple, the stock may be actually 25-30% lower than where it is today. Below are some sensitivities around the revenue growth and margin as two key variables.  

Hmm…not liking the risk reward here. Also bear in mind, a 20% growth and a 300bps margin expansion is a fantastic outcome for the business and management – at the top tier of consumer franchises in India. But may not work for investors given currently baked in super elevated expectations.

Let’s now invert this whole thing and ask, what would the company need to deliver for us to make a 15% IRR from here on? If I play around with the above variables, here is what it seems like:

To generate a 15% IRR from here, Trent needs to:

• Grow revenues at a 30% CAGR and double EBIT margins to 20% over the next five years – this is possible but highly unlikely/ extremely low probability. I am putting this mildly, I think.
• Or let’s assume they somehow pull off 25% revenue CAGR and a 500bps margin expansion (10% to 15%) which is what the current price seems to be baking in. To a make a 15% IRR, the exit multiple assumption needs to be 65x and not 40x. Good luck with that. Can that happen, of course – but does not seem like a sensible assumption to base a mere 15% IRR on.

A poor risk reward in my view.

Note: This note is not meant to be an investment recommendation and reflects purely my personal views, and not those of my employer.