Nomura has downgraded Titan Industries to a Neutral rating from Buy as it believes the near-term concerns over falling gold prices and the uncertain demand environment will likely mean earnings growth could be much more tepid than what consensus is building in

Nomura Equity Research has downgraded Titan Industries to a Neutral rating from Buy as it believes the near-term concerns over falling gold prices and the uncertain demand environment will likely mean earnings growth could be much more tepid than what consensus is building in. The brokerage is 10% below consensus on FY14F earnings estimate and believes that over the next couple of months there will be a meaningful correction to consensus earnings estimates.

While FY14F is going to be a tough year for Titan, the long-term dynamics for the organized jewellery retail business remains strong with the possibility of gaining market share, according to Nomura. Nomura has downgraded Titan to Neutral and look for the near-term uncertainty to dissipate, and cut the target price (TP) to Rs250 from Rs321.

One of the key catalysts for Titan is how the price of gold moves in the next couple of quarters. Nomura assumes that prices will likely remain range-bound at current levels, which, however, means they are down more than 10% y-y versus FY13. Any further drop in gold prices will be a negative for the company, as per Nomura’s observations.

Titan trades at 21.7x FY15F earnings (Rs11.4) versus the sector average of 24x. While the stock trades at a discount to the sector average, the brokerage believes it is justified as Titan will deliver an average 15% earnings growth over the next couple of years against the sector average of around 18%.

Nomura has factored in a lower valuation multiple of 22x to account for the potential slower growth. Uncertainty around both gold prices and the demand environment means the stock price is likely to remain range-bound in the near-term and trade at lower than long-term multiples.

Gold prices have corrected significantly in the past one month or so and are down 10% in rupee terms. The spot price is around 12% down from the average FY13 prices.

Gold prices are a significant determinant of the topline growth for Titan’s jewellery segment. Since gold prices are a pass-through for the company, they contribute to the realization impact in the jewellery segment. As an example, we look at the gold price movement in the past three years and Titan’s jewellery segment realization impact.

In the FY10-13 period, average gold prices have been up 21%/22%/34%/17%, while Titan’s realizations have improved by 26%/29%/36%/25%. This clearly shows the impact that gold prices have on Titan’s topline growth.

One of the key reasons for a strong 44% earnings growth recorded by Titan between

FY08-11 was rising gold prices which pushed both realisation and EBIT margins in the jewellery business up. Now, with gold coming under pressure due to: a) global factors such as slowing demand, and b) macro concerns in India, Nomura believes that current consensus estimates may potentially come under pressure.

Nomura’s analysis shows that all other things remaining steady, a 10% movement in gold prices will cause a 6% movement in earnings. However, the practical situation may be different and the impact may by less due to: a) rising demand in a weak pricing scenario, and b) a potential mix improvement.

Over the past few quarters, volume growth has also been subdued for the company as the macro economic slowdown has had an impact on consumer offtake. While it has recovered somewhat in Q3FY13, the brokerage is still cautious on how robust this recovery can be. One reason for volume growth likely to be subdued over the next couple of quarters is a sharp fall in gold prices.

Consumers tend to postpone their buying decisions when gold prices are volatile. However, once gold prices settle down, we are likely to see a strong pickup in demand. Historically, volume growth trends have been either robust (FY06-09 average volume growth of 34% vs. FY10-13 average volume growth of around 5%). The brokerage expects a pick up in volume growth over the next couple of years, although not anywhere near the growth rates seen in FY06-09.

There have been a number of changes on the regulatory front in recent months. Here is a quick snapshot of the key measures and their likely impact. The basic aim behind these measures is to cap gold consumption as it has been one of the key factors causing the current account deficit for India to widen over the past couple of years.

Increase in customs duty on gold: Recently the government had increased customs duty on gold from 4% to 6% and one cannot rule out further increase in customs duty. This will increase the landed price of gold in India, according to Nomura.

Limiting the credit period to 90 days in case of direct imports: Currently, Titan leases gold from domestic banks which is expensive and hence was contemplating direct gold imports which would have been significantly cheaper. However, a 90-day credit period effectively takes away the margin expansion benefit by negatively impacting the working capital.

Limiting the lease period to 90 days when leased from domestic banks: If implemented this will impact the balance sheet significantly and the benefit derived over the past two-three years (working capital days reduced from 42 days in FY08 to three days in FY12) will be lost. However, management has clearly mentioned that no such rule has been implemented yet and management continues to get 180 days credit from domestic banks.

Removal of the base rate exemption for gold lease: Currently, leasing of gold by domestic banks happens at a rate below the designated base rate. Typically, for Titan the cost is around 5%-6% while the base rate is 10% (for most PSU banks). According to RBI, there is no case for this base rate exemption and RBI proposes to remove it. This will be negative for the jewellery industry as a whole, opines Nomura. Most of the big jewellers are either sourcing gold through the lease route or are incrementally shifting to it. So this will impact everyone and can be negated by a fairly small price hike. According to the company CEO, if implemented, the rate is going to rise from the current 6% levels to between 6%-10% levels.

Mandatory KYC norm implementation for all sales: The company is already a complaint in its own way as all sales are accompanied with a legitimate invoice which mentions the customer’s name and address. All this is already mentioned by the company in the bill. The only additional thing it might have to do is to ask the customer for a verification of the data provided, which is also being followed by the company.

Nomura has cut its FY14F earnings estimate of Titan due to the sharp drop in gold prices in recent months. The brokerage now assumes a volume growth of 10% in the jewellery division and realization of -5%. Gold prices, as mentioned earlier, are now down 12% against the average prices in FY13. It believes the impact on realization will be less than what the company will benefit somewhat from the mix improvement (a shift to studded jewellery compared to plain gold). There is also a possibility that gold prices could recover from the losses over the past weeks during the course of the year.

Nomura’s revenue growth assumptions are down from 19.4% to 9.4% for FY14F, largely as a result of the changes to its assumptions for the jewellery division.

The brokerage has also cut its margin assumptions from the earlier 10 basis points (bps) improvement to flat now. It believes the company will benefit from higher volume growth over the next couple of years, as well as some likely improvement in the product mix. These factors will help the company maintain margins at current levels in the next couple of years.

While the business mix should change next year with the share of studded jewellery going up compared to plain gold, the watches business, which is 21% of the overall business, is likely to face some margin pressures as discretionary spends continue to remain under pressure.

As a result of these changes, the brokerage expects net income growth for FY14F to be 10.1%, which is around 4% lower than consensus.

Nomura has cut its target price from Rs321 to Rs250. This cut is on account of two factors: first, earnings estimates are cut by around 7%/9% for FY14F/FY15F and secondly the brokerage has also cut its target multiple to 22x from 26x. The cut in the multiple is to reflect the higher risk to earnings as well as our lower earnings growth estimate for FY14F. The new TP of Rs250 is based on 22x FY15F EPS of Rs11.35, according to Nomura.

Nomura’s new target multiple of 22x one-year forward is at an 18% discount to the past three year average and at a 12% discount to the long-term average trading multiple. While a multiple de-rating could happen for Titan, the long-term fundamentals continue to remain intact and there will be a rebound in the earnings growth trajectory in FY15F. Hence, the brokerage is not taking multiples to the mid-teens number which has been the case when the company has had a prolonged period of uncertainty.