Street takes grim view of Avenue Supermarts' falling profitability

Anticipation of rise in operating costs and further pressure on margins may drag sentiment around the stock

Despite most analysts having a ‘buy’ rating on the Avenue Supermarts stock, the Street is increasingly turning less optimistic on the retail major. After the recent ‘underperform’ rating initiated by Morgan Stanley and ‘reduce/sector underperformer’ rating of Edelweiss, nearly 60 per cent of analysts tracking the stock have a ‘sell’ rating on it.

In an industry where cost structures are hard to curb and attractive operating margin is elusive, Avenue Supermarts, which operates the DMart chain of supermarkets, found acceptance among investors for its promise not to compromise on both.

Of late with competition heating up from brick-and-mortar and online platforms, Avenue Supermarts has had to diversify into new channels — mainly beefing up its online delivery model. While the operating highlights of its e-commerce vertical is likely to be published along with March quarter results, analysts at Morgan Stanley believe the operating margins of Avenue Supermarts, which fell to 8.3 per cent in December quarter (Q3), from 10.3 per cent a year-ago, may largely be due to this factor.

“Margin dilution from DMart Ready (e-commerce platform) may be higher than the market estimates, on account of cannibalisation of in-store sales. Investors may also be underestimating the disruption from digitisation — grocers will be forced to invest in technology, assortment, and fulfilment, driving costs higher,” say analysts at Morgan Stanley.

In addition, the recent move to slash selling prices in a bid to bump up sales, preloading of certain expenses relating to capability building, and overspending to manage festive season better through longer operating hours have also affected its profitability, the company said in its Q3 presentation. However, analysts at JM Financial add this hasn’t resulted in desired sales growth acceleration, compared to September 2018 quarter (Q2), despite festivals falling entirely in Q3 of 2018-19 (FY19).

Consequently, FY19’s gross and operating margins at 14.9 per cent and 8.5 per cent, respectively, have shrunk by 110 basis points (bps) and 80 bps each year-on-year. The brokerage, in fact, believes that FY19 may be a year of margin-reset for the company.

Those at Edelweiss echo a similar view. “With heightening competition, DMart’s gross margin has come under pressure (180/170 bps dip in Q2/Q3 FY19). Further, we believe, the company has optimised its cost items and hence, we see limited scope for margin expansion,” the analysts say.

There’s trouble with the pace of store additions as well. With only nine new stores added till Q3, it needs to be seen if Avenue Supermarts’ management keeps pace with its FY19 guidance of adding 16 stores.

For now, Morgan Stanley points out the positive factor for the retail major is its ability to sustain its average revenue per square foot at $530, which is higher than that of Walmart ($450). 

Nonetheless, with competition heating up, it needs to be seen if FY19’s margin compression is just a one-off. For now, trading at 78x FY20 earnings, stock valuations richly capture the near-term upsides.