Kalyan Jewellers’ IPO – Should you invest?

Indians are the largest jewellery buyers in the world and the market is dominated by tiny unorganized retailers. Ordinarily, this should have made for a great stock market investing opportunity in listed companies selling branded jewellery. But companies from this sector have more often decimated wealth than created it, with Titan Company (a diversified consumer play with watches and eyewear in addition to jewellery) being the sole exception.

This is what makes the IPO from Kalyan Jewellers, a pan-India player backed by marquee private equity investors, an interesting proposition. Here’s our analysis of the IPO.

The offer

This Rs 1,175 crore IPO from Kalyan Jewellers consists of a fresh issue of Rs 800 crore (9.2 crore shares) and an offer for sale of Rs 375 crore (4.3 crore shares) by promoters and private equity investors. While the promoters are selling shares worth Rs 125 crore, the private equity investor HighDell Investment is selling Rs 250 crore. Both will retain a significant stake post-offer. HighDell is an associate of global private equity giant Warburg Pincus. It first invested in Kalyan in 2014 and enhanced its stake in 2017 at a weighted average price of Rs 56.6 per share. 

Post offer, the promoters’ stake in the company will dip from 67.99% to 60.53% while the public shareholding (which includes the private equity investor) will rise from 32.01% to 39.47%. Rs 600 crore of the offer proceeds will go towards meeting working capital requirements while Rs 200 crore is earmarked for ‘general corporate’ purposes.

The IPO is being made in the price band of Rs 86-87 with a 35% reservation for retail investors.

Kalyan Jewellers – The business

Established in 1993 as a sole proprietorship firm, Kalyan has grown fairly quickly to become one of India’s largest pan-India branded jewellery companies with a 5.9% share of the organized jewellery market in India. In FY20, 78% of Kalyan’s revenues originated from India and 22% from the Middle Eastern markets. In a business beset by governance issues, Kalyan was a rare family-owned jeweller to draw private equity investments.

The presence of HighDell, a Warburg Pincus associate as a shareholder since 2014, apart from toning up governance, has likely played a significant role in shaping its retail strategy, ushering transparency into its book keeping and transitioning Kalyan to a professionally-run entity.

Starting out with a single outlet in Kerala, Kalyan has managed to spread its wings pan-India, achieving greater success at geographical diversification than other North Indian or East Indian jewellery players (like TBZ and PC Jewellers) who have attempted this in the past. In FY20, operations outside South India brought in over 57% of sales.

In a market plagued by quality issues, Kalyan has established a reputation as a trusted family jeweller and pioneered good practices such as transparent billing (breaking down gold, stone and making charges in each bill) and selling only BIS-hallmarked jewellery.

Like other branded jewellers, Kalyan too is in the midst of an attempt to improve its profit margins by changing its product mix in favour of diamond and stone studded jewellery, rather than plain gold jewellery. Studded jewellery allows retailers to demand a premium for design and craftsmanship as opposed to the traditional practice of cost-plus pricing in vogue with plain gold jewellery.

It has had reasonable success at this. In FY20, 75% of its revenues were from plain gold jewellery, 23% from studded jewellery and 2% from other jewellery.  This is comparable to Titan’s studded jewellery share of about 26%.

Kalyan relies mainly on local contract manufacturing to keep its outlets supplied, and sources from local manufacturers and artisans on cost-plus contracts. This gives the company control over its raw material costs, supply chain and product quality, while allowing it to cater to localised tastes in design and grammage. Competitors such as Titan have run failed experiments with standardizing their showroom formats and designs across India, later waking up to the highly localized consumer preferences, especially in wedding jewellery. Kalyan, with its ‘hyper local’ strategy seems to have caught on to this trend early and reaped benefits.   

Kalyan Jewellers relies mainly on company-operated, large format retail stores (over 4000 sqft) to drive its sales. It leases retail space. At the time of the offer, it had 107 showrooms spread across 21 Indian states, 30 showrooms in the Middle East and 766 “My Kalyan” service centres designed to extend customer outreach and drive traffic into Kalyan’s main showrooms. This compares to Titan’s 351 retail showrooms across 214 towns. It also owns online platform www.candere.com but this makes a negligible contribution to revenues.

If the idea of owning a pan-India branded jeweller in your portfolio appeals to you, here’s a deeper dive into the offer’s pluses and minuses.

Pluses

#1 Demand growth

While one would expect discretionary purchases such as jewellery to take a big knock post-Covid, India’s branded jewellers are reporting a quick normalization and even growth of sales post Covid on three counts.

One, with Indian wedding traditions encompassing compulsory jewellery purchases, the resumptions of weddings post lockdown has helped drive a sharp demand recovery. Players such as Titan have reported a strong resurgence in wedding demand in Q3 and Q4 of FY21 which they expect to continue into Q1 of FY22.

Two, as has been observed in other discretionary categories, Covid-related hygiene fears have led to a sharp unorganized to branded shift in consumer preference, which is positive for branded national players like Titan and Kalyan.

Three, with curbs on the number of guests and scale of the Big Indian Wedding, traditional wedding budgets splurged on the event are being diverted to jewellery purchases. Kalyan is likely to have benefitted more from this trend than Titan, given the predominance of wedding sales in its portfolio.  

#2 Shift to organized players

A shift in market shares from unbranded players in any sector to formal branded players is a stock market theme that has created enormous wealth over the past decade, playing out in everything from pressure cookers to ceramic tiles. The Indian jewellery market is ripe for this shift, with organized players still at just 32% of the market, while tiny neighborhood jewellers and artisans rule the roost.

Apart from Covid, which has made Tier 2 and Tier 3 consumers more brand-conscious, tightening regulatory oversight of the bullion sector (there’s a proposal to set up a bullion spot exchange in India under SEBI) and more taxman scrutiny of the sourcing and sale of gold (to prevent money laundering et al) promise to speed up this transition.

Quality (caratage) issues plaguing most traditional jewellers are also likely to draw in younger buyers to branded players. India’s aggregate demand for gold jewellery is quite likely to register sluggish growth in volume terms, thanks to digital gold and a preference for lighter pieces. But players like Kalyan may see strong revenue growth piggybacking on this shift towards branded, large-format retailers.   

#3 Managed working capital

The high-value nature of jewellery retail makes for better per-store economics than other forms of retail. According to a Technopak study cited in the Kalyan offer document, with typical transaction values at Rs 5,000- Rs 1 lakh compared to Rs 5,000 in apparel retail and Rs 2,000-3,000 in footwear retail, jewellery stores rake in revenues of Rs 4-6 crore per month compared to Rs 20-30 lakh for the other forms of retail. This helps optimize both lease rentals and employee costs. But the significant amounts locked up in inventories (Rs 30-40 crore compared to Rs 1 crore) require sound working capital management. Kalyan doesn’t fare badly on this score.  

Kalyan’s old gold exchange programmes make up 27-32% of revenue. Next, purchase advance or the erstwhile ‘gold deposit’ schemes, where customers make monthly ‘deposits’ with jewellers and convert it into bulk jewellery purchases at the end, help finance working capital at low costs and contribute revenue visibility. Kalyan seems to have well-entrenched customers through this route, with 26-27% of India revenues originating from purchase advance schemes. This enables cheaper funding of working capital. Kalyan’s inventory turnover ratio for the last three years at 2-2.2 times is quite comparable to Titan’s.

Minuses

#1 Low margins

Despite the glamorous packaging, the branded jewellery retailing business in India isn’t an attractive one to be in, in terms of profit margins. With most traditional jewellery sold on cost-plus pricing pegged to daily gold rates, the business operates with low pricing power and wafer-thin operating profit margins. Even branded players are forced to peg their final product prices to prevailing gold rates for the day, with add-ons for stones and making charges.

Jewellers typically source their raw material needs through a combination of gold metal loans from banks (these loans are given out in the form of physical bullion with rates pegged to the value), market purchases and exchange of old jewellery by consumers. But large moves in gold prices can saddle jewellers with significant inventory losses that can wipe out the meagre margins. Over the years, Titan has evolved a sound sourcing strategy to mute the impact of gold price fluctuations (whether positive or negative) on its margins, by entering into back-to-back supply arrangements with producers/miners which minimizes price risk and inventory on its books.

While Kalyan’s offer document also talks of an active hedging strategy, its significantly lower operating profit margins compared to Titan’s jewellery business, despite a similar contribution from studded jewellery, suggests that it hasn’t insulated itself as effectively from gold price moves. The current quarter may be negative for jewellers on this score, as the customs duty cut on gold and the 12% dip in domestic gold prices may translate into inventory losses for Q4.  

#2 Regional risks

Despite its pan-India showroom presence, Kalyan does not seem have completely mitigated regional risks. In FY19, its revenues dropped 7%, precipitating a 21% drop in EBIDTA, after the floods in Kerala in August 2018 shut down operations for a month. While FY20 saw a revival from this setback, the imposition of Covid related lockdowns in the month of March put paid to growth, with revenues expanding just 4% year on year. FY21 again has been a troubled year with lock-downs impacting operations for much of the fiscal year with normalization only in the last quarter.

Looking at its showroom spread, Tamilnadu and Kerala still contribute a very significant share with nearly 37 of its 107 showrooms pan-India located in these two States. Natural calamities or a Covid spike in these states precipitating a second round of lock-downs can therefore pose a risk to the normalization expected from the company starting Q4 of FY21.

In fact, the offer document reveals that the company has seldom enjoyed a normal year of operations since FY18, with its earnings per share at Rs 1.5 in FY18, a negative Rs 0.04 in FY19, back to Rs 1.5 in FY20 and a negative Rs 0.96 in the first nine months of FY21.  

#3 Higher debt

The setback to operating performance left Kalyan’s debt-equity ratio at an elevated 2.1x and its interest cover at a not-too-comfortable 1.8x for FY20. In the first nine months of FY21 the debt-equity saw a moderation to 1.7x while interest cover narrowed to 1.3x.

With its investments over the last few years in new showrooms yet to pay off fully and Covid further depressing capital return ratios, the company has been utilizing over 90% of its working capital lines. It has also availed of a loan moratorium from banks using the RBI dispensation.

While the company enjoys strong relationships with lenders and expects the IPO to prune debt levels and meet working capital needs, its credit metrics may have some way to go before rating agencies grant a significant rating upgrade. ICRA’s last report in October 2020 rated Kalyan’s long term borrowing programme A minus and its short-term borrowings A2 plus, well below top notch ratings. (You can find the rationale here https://www.icra.in/Rationale/ShowRationaleReport?Id=98811).

#4 Market favour

The stock market perception of listed jewellery players has taken repeated battering over the years with governance issues cropping up with alarming regularity. While the 90s crop of diamond players were tainted by controversies over over-invoiced exports, off-book bullion imports and padded up revenues, along with bank loan defaults, recently listed players like TBZ or PC Jewellers have not kept out of trouble either.

While TBZ has been involved in a controversy on over-the-top pay to its family executives (https://www.bloombergquint.com/markets/tbzs-promoters-to-deliver-value-by-taking-fat-pay-hikes), PC Jewellers has had to withdraw a buyback offer on a pushback by banks. Given that both stocks have been wealth destroyers for investors, much will depend on Kalyan Jewellers being able to convince the market that it deserves a better valuation than most listed jewellery peers.

The backing of a renowned PE investor and a better record on governance may stand Kalyan in good stead, compared to some of its listed peers. But when compared to Titan Company, a significant wealth creator which has demonstrated secular earnings, Kalyan’s up-and-down financials in recent years and low shareholder return ratios (ROE of 6-8%) can prove a dampener to valuations.

Valuations and Recommendation