Investors need not subscribe to the initial public offer of House of Pearl Fashions (HOPF). At the upper end of the price band, the offer values the company at about 20 times its annualised consolidated FY-07 per share earnings on an expanded equity base.
There are no exact comparables in the Indian space as the business model is unique vis-à-vis traditional textile players — a significant proportion of revenues is derived from distribution and sourcing of apparel.
Garment export major Gokaldas Exports can, however, serve as some kind of a reference point from a valuation perspective. The latter trades at a 25 per cent discount to HOPF.
We believe that the valuation is stiff considering the risks involved. Our recommendation reflects the scaling up challenges of HOPF's sourcing business, execution risks of its proposed foray into retail, and the long gestation period of its expansion project.
HOPF is a holding company and operates completely through its subsidiaries. In India, it operates through its 60 per cent subsidiary Pearl Global. It holds 12 subsidiaries directly and indirectly that operate in the US, the UK, Hong Kong, Indonesia, and Bangladesh, besides India.
Its international operations were only recently integrated into the company after a restructuring. On an annualised basis, the newly consolidated entity would boast a revenue of close to Rs 900 crore (financials are available only for the first half).
HOPF has 10 manufacturing facilities — seven in India, two in Bangladesh and one in Indonesia. But manufacturing contributes only about 30 per cent of its revenues, with the rest comes from third-party outsourcing. HOPF sources apparel from 150 third-party vendors from China, Bangladesh and India. It counts names such as JC Penny and ASDA Wal-Mart among its customers.
Objects of the offer
HOPF will raise about Rs 290 crore at the upper end of the price band. About Rs 60 crore of the offer proceeds will partly fund a Rs 100 crore capex plan that would double its annual garment capacity to about 40 million pieces.
About Rs 50 crore of the proceeds will also go towards payment to promoters as consideration for the transfer of assets (at book value) from group companies as part of the restructuring initiative. An equal amount will go towards pre-payment of loans.
HOPF is also planning to foray into the retail business in India as well as in the UK. It plans to invest Rs 73 crore in setting up a chain of stores in India; Rs 55 crore will come from the proceeds of this offer.
It has also earmarked Rs 40 crore of the proceeds for the acquisition of a brand in the UK or US for its operations outside India. A small portion of the proceeds will fund setting up of a design centre in Gurgaon and an integrated technology system. The impact of these initiatives is, however, unlikely to be realised in the near term. The new manufacturing capacities are likely to come on stream in a staggered manner, beginning September 2008 and stretching to March 2010. The full benefits of the expansion are likely to be realised only in FY-11.
The current production facilities operate at about 65 per cent capacity (as of June 2006), which offers some headroom for further ramp up in volumes; but it may not make a very significant overall contribution. For the near term, the company would have to count on its other businesses to drive revenue growth.
Sourcing challenges
HOPF sourced apparel worth over Rs 300 crore in the first half of FY-07. Its strengths in this business lie in its relationship with over a hundred small- and medium-size vendors in China, Bangladesh and India.
It is also looking at Vietnam, which is emerging as a hot sourcing destination.
The company sees its sourcing business as a way of scaling up revenues with limited investment, lending it a higher return on capital versus traditional garment players such as Gokaldas Exports. However, the focus on sourcing does lead to lower profit margins.
Margins in the sourcing business were at about 9.5 per cent in H1-07, while that of manufacturing was higher at 11.5 per cent. Therefore, HOPF's earnings prospects hinge to a great extent on a significant ramp up in business volume, unlike in the case of a pure garment manufacturer.
We see scaling up from these levels as a challenge for the distribution and sourcing operations. While there are no comparables in India, there are several sourcing outfits at the international level.
HOPF does not appear to have any marked competitive advantage over these outfits. Trading giants such as Li & Fung operate at a scale that is likely to help it deliver products at far lower prices. They also acquire brands across product categories to increase their bargaining power with retailers.
For a significant improvement in earnings from current levels, HOPF will have to continually forge relationships with more vendors across different countries.
To sum up, though the business model is quite different from pure manufacturers, the company's success in scaling up its sourcing base over the next few years will hold the key to its stock commanding a premium valuation.
Other risks
HOPF's proposed foray into retail may not yield the desired results. The company plans to open a chain of 10 pilot stores in a year's time. Given the planned investment amount, we do not expect this operation to contribute significantly to revenues in the near term. The timeline for its proposed acquisition of an overseas brand is fluid; integration of any such acquired brand will be an additional risk.
Offer details: About 60 lakh shares are on offer, of which about 12 lakh shares are on offer for sale by the promoters.
The stake of the Seth family (the promoters) post offer will be about 65 per cent. The lead manager is JM Morgan Stanley. The offer closes on January 23.