VIP Industries – Packed off by the Rupee

While domestic consumption oriented stocks have generally been having a party of their own in the past 2-3 years, one tribe member they clearly forgot to invite is VIP Industries, the largest seller of branded luggage in the country.
To illustrate, as of the 18^th of July, while the CNX Consumption Index has given a return of 33.7% over the last 1 year as against Nifty returns of 13%, the stock of VIP Industries (CMP 49, Mcap ~ 700 cr, EV ~ 750 cr) has lost nearly 40% over the same period.

When it rains it pours!!

In the 6 years till FY12 VIP’s topline grew at a CAGR of nearly 18% to a level of about Rs 850 cr on the back of rising consumerism and increasing travel by Indians. On a year on year basis, revenue grew at between 15% and 30% barring 2009, the year of the global financial crisis, in which it contracted 5%.

FY13 topline (broadly split as:  10% - exports, 25% - CSD , 65% - domestic retail) growth however slowed to less than 2%. Infact even this anaemic growth was a result of pricing while volumes shrunk YoY.

VIPs management explained this as a result of slowdown on all the three segments. Exports slowed due to weak demand in developed markets, while domestic sales were sluggish due to a cut back in discretionary spends on the back of rising inflation also evidenced by the slowdown in air traffic growth. Also, due to some political/ministerial issues, canteen stores were seen destocking during most of the year. A cut back in CSD sales was not specific to VIP but across all product categories but given that it is a meaningful segment for VIP, sales took a larger knock as compared to other consumer names.

Profit margins on the other hand were severely dented largely on account of the free fall in the rupee. The fast growing segment of VIP’s sales is the soft luggage segment (65-70% of revenues) which is almost entirely imported from China. This is not unique to VIP since China is supposedly the sourcing hub for much of the world’s soft luggage requirements. So, Gross profit margins (Gross profit as measured by Net Sales – Raw Material costs) in FY13 fell nearly 300 bps from the previous year to 49% (ranged between 52% and 56% in the previous 4-5 years). While the company took price hikes to offset this margin pressure, they were insufficient due to the extent of the fall in the rupee in FY13 (Average of 13.5% for the year).Inflation in freight, rentals and rebates led to a further fall at the EBIDTA level with margins coming in at 8% a contraction of nearly 600 bps over FY12 (EBIDTA margins between 11-15% in the past 4-5 years other than FY09 wherein it was at 7.5%)

Consequently, PAT for VIP in FY13 was down more than 50% at 31 cr.    

All in all FY13 was a deadly concoction of all the things that shouldn’t happen to any business.

A bit more about the business

VIP claims near 60% share in the branded luggage market (through multiple brands at every price point) where it enjoys a near duopoly with Samsonite. The unbranded market is estimated to be roughly the same size as the branded, pegging the total luggage industry size at 3000-3500 cr. This of course does not include segments like ladies hand bags etc. into which VIP is a recent entrant.

When you look at the demand drivers, the industry enjoys the same tailwinds of the India consumption story as other consumer plays viz. Low penetration, rising per capita incomes, favourable demographics etc... However, since per unit costs are high at between Rs 2000-4000 and spends discretionary, the industry is prone to some cyclicality. While that undeniably weakens the case for VIP as against some consumer staple names, for us it still does not take away from the moats that consumer facing businesses selling brands enjoy. Barring a blip once in a while, we would not be surprised to see sustainable periods of double digit industry growth driven by increasing travel by Indians and additionally helped by replacement demand and the shift to branded luggage as people become more quality and fashion conscious.

Another factor of appeal to us is the simplicity of the business. Unlike many other consumer facing businesses, the luggage industry is not meaningfully exposed to the threat of substitutes (remember the challenge faced by scooters from motorcycles) or any technology led product change (mobiles handsets, Televisions etc.). Shifts in consumer preferences, for eg. from hard to soft luggage, are more likely to be gradual than abrupt. All of which add up as natural moats for incumbents, leaving challengers with little scope for disruptive innovation. With manufacturing increasingly outsourced, pricing, brand building and distribution remain as the primary strategy levers.

Unlike some consumer businesses however, the business does not enjoy a float provided by negative working capital. VIP has been able to maintain its net working capital needs at between 2.5-3 months. With the fast growing soft luggage segment almost entirely sourced from China, there has however been relatively small allocation of capital to new capacity expansion. Consequently, dividends have been at between 30-50% of profits for the year (It remains to be seen if this will improve as the company is likely to become debt free by the end of this year). Due to poor profits, while ROEs have been around 12-13% in the last financial FY13, the average 3 year prior ROEs have been 30%. With the business not thirsty for capital, ROEs can thus show consistent improvement if growth and margins were to return to levels as seen in previous years.

Coming to management, whilst being a promoter led concern (part of Dilip Piramal group of cos) we have not seen any glaring instances of capital misallocation. While some may point fingers towards management judgement, on integrity there seem to be no major red flags to our notice. We also draw comfort in the simplicity of the business since the halo effect invariably has a large role in influencing our judgements of management’s decision making abilities.

To sum up while not a VVIP, VIP does look to us as good as its name.

A cyclical low or the new normal??

Given that the rupee has depreciated by nearly 10% already this financial year, FY14 has also started on a challenging note for the company. While Q1 results are not out yet, it is quite likely that the numbers will be muted in spite of a beginning of the year price hike of 5% or so. Infact, given that the first quarter contributes to roughly a third of annual sales, it would probably make it all the more difficult for full year numbers to improve meaningfully, even if things on the rupee front were to stabilise/get better hereon. So is this the new normal or only a cyclical low??

On a near term P/E (FY13/14e) the stock still trades at between 20-25 times, not extraordinarily cheap. But when you start considering the 50-70 cr of PAT that the company managed to achieve between FY10-FY12  the P/E drops to between 10-15 times. The verdict is thus clear. Markets do not seem to be pricing in a return to earnings in the near future. For Mr. Market this is probably the new normal.

While we believe that return to revenue growth is but a matter of time, expectation of margin reversion is not so easily justified. Given VIPs import dependence, any discussion on margins without a discussion on the rupee is fruitless. For starters, we are not about to make a case for Rupee appreciation, what with the continuous challenge the economy faces to fund the unmanageable CAD. The only point of view we have on this subject is that the rupee is unlikely to be allowed to depreciate annually at the same frantic pace as we have seen in the past couple of years. The belief is that the rupee’s behaviour in the last couple of years would likely seem more of an aberration when seen over the longer term. If however, this thesis not be true, then of course we have a lot more to worry about in our portfolios than only VIP Industries J. A more benign 5-6% kind of annual rupee depreciation should not be difficult to pass through to consumers in our view.

The other thing going for reversion in margins is that apparently the entire luggage industry imports from China and thus is equally exposed to the fickleness of the rupee. While we are not certain if the whole industry will have the stomach for a one time price hike given the near term demand challenges, we think VIP should be able to claw back margins in future years. In any case, if the rupee does not fall further, a ~5% price hike should be able to take back VIP to the gross margin levels seen in the past 4-5 years.

The primary risk with mean reversion themes however remains  in the judgement of where the mean lies and the time taken for such reversion. 

Net, Net we think the market is giving us an opportunity to buy a quality business temporarily displaced due to external factors, at interesting valuations. Maybe not in FY14, but we are willing to bet on VIP returning to its earlier levels of profitability in a year of two and growing thereon with healthy ROEs.

Best of Manufactured Luck!!