HDFC Sec reiterates SELL on Trent on ‘heady valuations’ despite strong growth

Mumbai-based brokerage HDFC Securities has reiterated a SELL rating on retail giant Trent Ltd with a target price of Rs 1,370 — 33% below the current price — even as it acknowledged the company’s strong growth in recent years.

Trent has been one of the most exciting retail growth stories in India, growing at a CAGR of 30% over FY18-23, noted analysts Jay Gandhi and Tanuj Pandia.

“Trent continues to run circles around peers in terms of growth. Its disciplined working capital management and well-capitalised balance sheet remain best-in-class. However, its heady valuation (77x two-year forward EV/EBITDA) restrains us from becoming constructive on the stock,” they said.

Trent’s stock price has seen significant growth over the past 3 years, rising from around Rs 500 in April 2020 to current levels of over Rs 2,000. The stock tripled from under Rs 700 in April 2021 to around Rs 2,200 by October 2022 on the back of strong earnings.

Trent Ltd has been one of the remarkable retail growth stories in India in recent years. From just Rs 25,317 crore revenues in FY19, the company grew rapidly to reach Rs 77,152 crore revenues in FY23 – reflecting a strong CAGR of 30% over the past 5 years.

A key driver of this growth was Trent’s value fashion format Zudio, which follows an asset-light franchise model. Zudio stores jumped 5x from just 40 in FY19 to over 200 currently. Its revenues grew even faster from just Rs 92 crore in FY19 to Rs 5,600 crore in FY23, clocking a whopping 138% CAGR.

Zudio was also instrumental in driving significant improvement in Trent’s profitability metrics over FY18-23. While Zudio reported an EBIT margin of ~7% in FY23, HDFC Sec estimates half of this is contributed by profits from sale of fixed assets to franchisees. Sustainability of such high asset sale margins seems doubtful amid rising competition.

The company’s gross block tripled from Rs 3,600 crore to Rs 9,300 crore over this period. Return on capital employed surged from just 2.8% in FY18 to 23.1% in FY23 while return on equity soared from 5.1% to 19.1%.

HDFC Sec’s analysis shows Zudio already commands a 15% share of addressable market spend in most of the top districts like Mumbai, Delhi, Bangalore, Chennai etc. Further expansion here would lower sales productivity and unit economics.

The analysts said their proprietary store mapping analysis suggests Zudio can potentially open 291 stores in the top 12 districts over the next 2 years, assuming 15% share of the addressable market. But expansion beyond that would likely be at lower sales densities and unit economics, they noted.

HDFC Sec highlighted that Zudio’s sales density of ~Rs 18,000 per sq ft seems stretched and its blitzscaling approach may have only a 2-year runway before sales density starts to taper.

The key concern, in other words, is around the sustainability of Zudio’s blitzscaling model once it moves beyond the top districts where it faces lower competition currently, it noted.

Trent’s flagship format Westside also posted steady growth in revenues and profitability, with its EBITDA margin expanding 200 bps to 17.2% despite a 500 bps contraction in gross margins. This was achieved by passing on sourcing benefits to consumers to drive footfalls and volumes.

The company’s grocery retail chain Starbazaar also improved its EBITDA margin from -11% in FY18 to -4% in FY23 despite lower gross margins, highlighting the cost efficiency drive across formats.

The analysts also noted that dividends from Zara brand owner Inditex and profits from sale of fixed assets to franchisees accounted for 58% of Trent’s PAT in FY22 and FY23. These earnings streams are unlikely to sustain at the same quantum over the medium to long term, presenting headwinds to profit growth. HDFC Sec believes Inditex is looking for measured growth.

Because of this, HDFC Securities expects a deceleration in Trent’s earnings growth from 111% PAT growth in FY23 to just 5% growth in FY24 and 14.6% in FY25.