C Mahendra Exports IPO Analysis

Seeks high premium despite volatile operations

C Mahendra Exports (CMEL) is a flagship company of C Mahendra Group, promoted by Mahendra C. Shah and Champaklal K. Mehta. The group is an integrated diamond and diamond jewellery player sourcing rough diamond, trading rough and polished diamonds, processing diamonds and manufacturing diamond jewellery. C Mahendra Exports initially started in 1978 by trading in diamonds and precious stones. However, it expanded into cutting and polishing of diamonds since 1993, after setting up a processing facility in Surat. The company has manufacturing facilities for cutting and polishing of diamonds at Varachha and Udhana in Surat, each with capacity of 1,20,000 carats per annum.



CMEL has two 100% subsidiaries: C Mahendra International (CMIL) and C Mahendra DMCC. It also owns a 54% stake in C Mahendra BVBA, while the remaining 46% is owned by CMIL. CMIL in turn has three 100% subsidiaries: Ciemme Jewels Ltd, C Mahendra (USA), and C Mahendra Exports (HK). C Mahendra (USA) Inc has 99% stake in two of its subsidiaries, C Mahendra (NY) LLC and Ciemme (NY) LLC. C Mahendra Exports (HK) has a 100% subsidiary, AL DASPA Gems & Jewellery FZE. On the other hand, C Mahendra BVBA has 100% subsidiary, Best Shine Ltd, which in turn holds 100% stake in International Gems & Jewellery FZE.

Ciemme Jewels has a jewellery manufacturing facility in MIDC, Andheri, Mumbai. The company introduced Ciemme, in 2003. This flaghsip lifestyle brand covers rings, earrings, necklace sets, bracelets etc. 7 of the 9 Exclusive retail outlets of Ciemme Jewellery are in western part of India.

The flagship company, CMEL, is into sourcing & trading of rough diamonds, Cutting and polishing of diamonds and marketing and trading of cut & polished diamonds. Ciemme Jewels (CJL) manufactures diamond jewellery. CMEL sources rough diamonds from DTC, ALROSA and other suppliers directly and through C Mahendra BVBA. CMEL along with its subsidiaries CMIL, CJL, C Mahendra BVBA, C Mahendra Exports (HK) and C Mahendra USA through its subsidiary C Mahendra (NY) LLC trade rough and polished diamonds.

At consolidated level, revenue from diamond sales constituted a major chunk of 96.1% and 97.3% of the total revenues in 2009-10 and Q1 2010-11, respectively. A major portion of cut and polished diamonds are sold primarily in the overseas market. Hong Kong, Dubai, USA and Belgium are the major export markets for the cut and polished diamonds of the company. At the end of FY 2009-10, Hong Kong constituted 41% of the export revenues, followed by Dubai at 33%, and USA 8% ..

To expand capacity, and improve brand image and reach, the company is tapping the capital markets to raise Rs 142.5-165 crore, with an issue of 1,50,00,000 equity shares of face value Rs 10 each at price band of Rs 95 – 110 per share through book building. With capex of Rs 36.06 crore and Rs 23.64 crore, it plans to set up diamond cutting & processing unit at Gujarat, Hira Bourse SEZ, Ichchhapore, Surat and a jewellery manufacturing unit in Mumbai. Both the projects will be completed by September and October 2011, respectively. Further, it plans to leverage its expertise and source diamonds directly from the diamond mining companies at competitive rates. It intends to infuse Rs 80 crore in the form of equity contribution to its subsidiary, C Mahendra BVBA (Antwerp).

The group has already 9 exclusive retail outlets and 1 franchisee store in India. However, the company also plans to open 15 new retail outlets by FY 2012-13, with capex of Rs 30 crore. It has also set aside Rs 20 crore for brand development expenses. The company plans to explore options like internal accruals or debt for funds required in excess of the net proceeds from the issue.

Strengths:

* The company is an integrated diamond and diamond jewellery group in India having presence in major markets and a leading exporter of cut and polished diamonds.
* It is also one of the first Surat based entities to receive DTC sight holder recognition in 1991. Direct sourcing of rough diamonds from the primary source suppliers will ensure consistent supply of rough diamonds at competitive rates. The company currently sources 22.45% of rough diamonds from primary suppliers like DTC and ALROSA Company. Top five suppliers constitute 49.24% of the total raw material procured in FY 2009-10.
* Well-established marketing network across different export markets ensures access for export revenues.

Weakness:

* Procurement cost of rough diamonds constituted 92.79%, 94.04% and 94.10% of the total cost of productions in FY 2008-09, FY 2009-10 and Q1 2010-11, respectively. On the other front, diamond and diamond jewellery are luxury products forming discretionary purchases by consumers. Thus, any increase in the rough diamond costs could significantly affect revenues of company.
* The company's operating profits were coming down for three years in succession from Rs 178.45 crore in FY 2006-07 to Rs 146.26 crore in FY 2009-10. During this period, profits decimated from Rs 61.84 crore in FY 2006-07 to mere Rs 6.09 crore in FY 2009-10. The crash in profits in FY 2009-10 was partly due to higher forex losses, surge in interest costs and erosion in margins.
* There were instances of stoppage of supply of rough diamonds to the company / its subsidiaries by DTC in the past. Rough diamonds is an oligopoly market, with dominance of a few players like DTC and Alrosa. So, any problem in sourcing rough diamonds from these players or change in preferences of such suppliers can adversely affect the availability and cost of rough diamonds.
* The company is dependent on its subsidiaries for sourcing rough diamonds, manufacturing jewellery and for marketing of diamonds. C Mahindra BVBA constitutes 27.83% and 20.46% of the company's total rough diamond purchases in FY 2009-10 and Q1 2010-11, respectively. The manufacturing or marketing activities of diamond jewellery are solely undertaken by the company's subsidiary Ciemme Jewels. As the subsidiaries are functioning under different jurisdictions, any disruptions or unfavorable change in the regulatory policy in these jurisdictions could significantly impair the business operations.
* With limited operational history in retailing, the company will have to face stiff competition from the domestic and international diamond jewellery manufacturing and retailing companies in India.
* On consolidated basis, the company along with its subsidiaries has negative cash flows from operations.
* Diamond business is subjected to international market and regulatory risks along with exchange rate fluctuations.
* The company derived 40% of revenues from the brand Ciemme in FY 2009-10, which surged to 77% in the quarter ended June 2010. The company also plans to use about Rs 20 crore from the IPO proceeds for such brand building. But some of the brands are not protected by intellectual property rights. These are yet to be registered under the Trade Marks Act, 1999.
* There are some group companies in the same line of business, with potential conflict of interest.

Valuations:

On consolidated basis, CMEL has posted improved operating margin of 9.3% in the quarter ended June 2010 as against full year margin of 7.9% in FY 2010. It posted net sales of Rs 736.42 crore and net profit of Rs 40.38 crore in the quarter ended June 2010. However, the company reported a drastic 91% fall in net profit at Rs 6.09 crore on 21% rise in net sales at Rs 1852.82 crore in FY 2009-10. The sharp fall in profits are attributed due to erosion in margins and due to forex losses as against gains in the previous year.

CMEL recorded EPS of mere 0.9 in FY 2009-10, and the offer price band of Rs 95-110 discounts the same by 123.6 times at higher end and 106.7 times at the lower end. But that was an exceptional year. The company reported healthy rebound in the quarter ended June 2010, with an annualized EPS of 26.8. The offer price discounts these annualized earnings for the quarter ended June 2010 by 3.5x – 4.1x in the lower and higher end of the price band. Industry majors like Gitanjali Gems was discounted at 6.9x on TTM net profit, while Shrenuj & Co was trading at TTM PE of 5.5x. TTM PE for large diamond cutting jewellery industry is 9.9. The company has healthy operating margins, relative to many other players in the diamond cutting / polishing sector. But the volatility in performance of the company, with gradual fall in operating profits in the past three years and huge fluctuation in forex impact, is a cause for concern.

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