We maintain Neutral on Titan with a target price of Rs 240 per share. We believe regulatory storms need to subside for stock outperformance. The stock trades at 27.6x FY14e (estimates) and 24.2x FY15e EPS (earnings per share) . We are cutting our earnings estimates by 3% to factor in the soft underlying demand. We are now building in EPS growth of just 3% in FY14 and 14.2% in FY15. Our estimates are 8-10% lower than consensus.
Titan remains a core long-term play on rising lifestyle spending,underpinned by favourable demographics,and will be a key beneficiary on account of its dominant positioning in jewellery and watches,as also the Tata brand heritage. We remain believers in Titan’s long-term attractive franchise,which is supported by favorable demographics,shift towards the branded segment,its excellent execution track record and high quality management.
However,near-term stock performance will be a function of regulatory actions. While media articles suggest that the government/central bank are contemplating reversal of some of their regulatory actions,the timing and extent of these is unclear.
Demand for jewellery,watches sluggish: According to the management,underlying demand remains weak in both jewellery and watches. A weak macro environment,slowdown in discretionary consumption,sticky inflation and poor consumer sentiment are impacting footfalls. The management indicated that while the festive season was sub-par,wedding demand too appears weak. Despite higher number of wedding days,jewellery demand has not recovered.
Regulatory constraints stifling: Over the last six months,the government has introduced various measures to dampen gold consumption to stem a deterioration in the current account deficit. Amongst the key measures it has taken are: (i) increase in customs duty on gold to 10%,(ii) introduction of 20:80 scheme for gold imports,requiring 20% of imported gold to be used for exports,and (iii) ban on gold-on-lease. Media reports indicate that there has been a sharp increase in gold smuggling,given the attractive arbitrage of 10% customs duty.
Recent media reports suggest that the government is contemplating removal of some of its restrictions. Implementation of the 20:80 scheme has tightened gold supply,resulting in a widening of the premium on legitimate gold to 7-8%. This premium of nearly R2,000 per 10 gram puts Titan at a disadvantage,as smaller local players are able to procure gold illegally at lower prices.
Besides,the ban on gold-on-lease has impacted financing of gold inventory. Titan is now procuring gold on upfront payment as against 180 days credit it used to get under the gold-on-lease option. If this ban is continued,it will have wider implications for its balance sheet (leverage,return ratios) and cash flows (higher working capital,lower FCFfree cash flow).
Hedging could turnout far trickier: Gold-on-lease also served as a natural hedging mechanism for the company,as prices were fixed daily,depending on the days sale. However,Titan now hedges on the domestic commodity exchange. Challenges in hedging include lower limits.
Titan is currently allowed to hedge till four tonnes,while its inventory stands at nine tonnes. The company has been representing with regulatory authorities for an increase in the hedging limit or permission to hedge on overseas exchanges. However,it has not been granted the permission,yet.
Once the existing lease contracts expire (end of January 2014),half its gold inventory might be exposed to commodity price fluctuations,if the hedging limit is not raised by then. This could introduce an MTM (mark-to-market) component in Titans P&L (profit & loss account) and could impact its earnings multiple.
Titan is trying to mitigate the adverse impact of the above factors by improving its inventory turns,which currently stand at 2.2x. Assuming these restrictions are not lifted and given the managements guidance of going ahead with regular expansion plans (1 lakh square feet addition per annum in jewellery),Titan will look to manage new stores without increasing inventory.
Watch margins yet to bottom out: The slowdown in discretionary consumption continues to impact the watch segment. Footfalls in its stores have fallen as a consequence of weak macro and poor consumer sentiment. The division is witnessing slowdown across segments (Titan,Helios,Fastrack). However,Sonata (mass offering) is witnessing good demand.
We note that Titan reported volume decline in watches in Q2FY14. Volume decline is depriving the division of operating leverage,which may continue to hurt Ebit (earnings before interest and taxes) margins,notwithstanding the stable contribution margins. The management stated that expansion in watches will be calibrated now,after two consecutive years of aggressive expansion. The eyewear division is witnessing consistent demand and should deliver 20% growth. Titan will be adding 20-30 stores in the eyewear division in FY15.
Its entry into the fragrance category through a new brand,Skinn is well received and is seeing good traction. Currently,it is distributing Skinn through World of Titan outlets. Titan has also entered into helmets,which are being retailed through Fastrack outlets.