DMart and Reliance Retail: Food & Grocery | From a disruptor’s lens

Capital dumping is likely to take center-stage going forward. Global/domestic retailers Amazon, Walmart-backed Flipkart and Reliance Retail have significantly strengthened their war chests for investments in supply chain, fulfillment capabilities and pricing/selection. An inkling of this can already be seen in the reducing selection/pricing arbitrage of DMART over these biggies. Fulfilment/supply chain investments of Amazon’s F&G unit (adj. for scale) are already >6x that of DMART’s (Comparison: DMART Ready vs Amazon). Former remains aggressive on footprint expansion. HDFC Securities maintain SELL recommendation on DMART with a DCF-based target price of Rs 2160/sh.
 
The view from a disruptor’s lens is a salivating one as short of a few well-capitalised operators, the organised Food & Grocery ecosystem remains:

(1)  profitless
(2)  cash-strapped
(3)  supported by increasing crutches (high gross margins, inefficient cost structures and increasing vendor support)
 

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HDFC Securities read-through across the ecosystem suggests:

(1)  the phase of capital dumping by global/domestic biggies may soon be upon us
(2)  selection/pricing arbitrage vis-a-vis industry bellwether DMART continues to shrink
(3)  margin cracks are imminent
(4)    Reliance Retail – Future Retail combination could change the complexion of competition in top Indian districts..
 
Margin crack for ecosystem is imminent: 
 
Over FY15-20, despite low competitive intensity, most organised grocers’ sales velocity (1-4% CAGR) has undershot inflation, signaling a gradual but structural footfall reduction.
 
(1) Most continue to hide behind high gross margins as cost of retailing remains inefficient
(2) have bare-bone investments in online fulfilment capabilities. Moreover, as subsidised home delivery becomes table stakes, even the best (D-MART) may get arm-twisted into bringing a part of online fulfillment costs on their books (not factored in, remains a risk to estimates).
 
Thus, the imperative to remain competitive (reducing GMs) + rising cost of retailing is likely to crack operational margins for the ecosystem over FY21-25.This has played out globally too (Walmart’s CY15-20 margin crack).
 
Reliance + Future Retail > DMART in store density: 

Post integration and, if executed well, the Reliance Retail + Future Retail store network is likely to get nearly as dense as DMART’s in the latter’s key markets (HDFC Securities Estimate: 48% of DMART’s stores, 65-70% of revenue). These markets are the most populated/over-retailed districts in India with high PCI. Hence, the rise in competitive intensity/price action and near-zero sourcing margin arbitrage seems to be a foregone conclusion. The high population density in these districts could help fulfill JioMART orders within controlled costs too.
 
Survivors don’t offer any margin of safety: 
 
While consolidation in F&G is imminent, survivors (DMART) do not offer any margin of safety at 75x+ FY23 P/E. DMART’s growth is likely to be healthy (21/23/23% revenue/EBITDA/PAT CAGR), largely underpinned by network expansion. Alas, pressure on sales velocity and margins remains probabilistically high as deep-pocketed operators enter DMART’s key catchments.
 
HDFC Securities maintain SELL recommendation on DMART with a DCF-based target price of Rs 2160/sh – implying 34x FY23 EV/EBITDA + 2x FY23 sales for e-comm.
 
Note: HDFC Securities currently have an SOTP-based fair value of Rs 3743bn for Reliance Retail, implying 20x FY23 EV/EBITDA + 3x FY23 sales for its e-commerce business.