Future Retail gets HyperCity at a festive discount

Future Retail Ltd’s market capitalization has more than trebled this year, thanks largely to competitor Avenue Supermarts Ltd’s stellar listing, which has led to a rerating of the sector. The two companies trade at around 40 times and 90 times estimated fiscal year 2018 (FY18) earnings, respectively.

But the sky-high valuation of retail firms hasn’t cost Future Retail much in its purchase of Shoppers Stop Ltd’s subsidiary, HyperCity Retail (India) Ltd. The enterprise value of Rs911 crore ($140 million) amounts to 0.76 times HyperCity’s revenue of Rs1,191 crore in FY17.

This is far lower than Future Retail’s valuation of 1.6 times revenues and Avenue Supermarts’ valuation of well over five times revenues.

What’s more, since Future Retail is funding over three-fourths of its equity contribution through the issue of its stock, it has been able to take advantage of its own high valuations. In other words, it can have its cake and eat it too. Well, almost—it is yet to digest the acquisition, of course.

In March 2014, when Tesco Plc had acquired a 50% stake in Trent Hypermarket Ltd—a similar store format as HyperCity—it had paid over two times revenues. Of course, given the various hurdles overseas firms have faced in entering India’s retail market, Tesco paid a higher-than-usual premium.

On the other hand, HyperCity had been a drag on Shoppers Stop’s consolidated performance and the latter was desperately looking for a way out.

HyperCity had accumulated losses worth Rs712 crore at the end of March 2017, and it seemed like there was no respite in sight. The regular cash burn at the company also meant that its owners had to infuse capital at periodic intervals. As such, Future Retail has its task cut out; although, analysts seem gung-ho about the company’s prospects under the new owners.

“With its asset light strategy, Future Retail would be able to expand the footprint of HyperCity, something which current management has apparently been unable to do,” analysts at Nomura Financial Advisory and Securities (India) Pvt. Ltd said in an 11 September report.

According to Himanshu Nayyar, research analyst at Systematix Shares and Stocks (India) Ltd, the HyperCity platform will also help Future Retail push its private label brands, which typically fetch higher margins.

Of course, the 140-million-dollar question is if Future Retail can quickly turn around things on the profitability front. As the chart alongside shows, HyperCity’s Ebit (earnings before interest and tax) margins are far lower compared to Future Retail’s.

“The strength of the (Future) group lies in a strong back end and supply chain; with the front end of HyperCity and the back end of Future Retail, this could be a winning combination,” Nomura’s analysts said in the note.

In the near term, HyperCity will drag Future Retail’s earnings per share, thanks to the equity dilution as well as its lower margins. But considering that it accounts for less than 7% of the acquirer’s revenues, the extent to which it can drag performance is limited.

Besides, the deal may not cause much of a dent on Future Retail’s balance sheet. It had a comfortable debt-to- equity ratio of 0.34 times as on 31 March. Post this deal, it will increase to 0.42 times.

From Shoppers Stop’s point of view, while the HyperCity sale is good riddance of a loss-making operation, the consideration is a bit of a dampener. The cash that flows in is only Rs79 crore initially, and the value of the stock—Rs252 crore at present peak valuations—depends ultimately on market conditions