Elongated capital cycle at retail jewellers
Retail Jewellers Facing Elongated Working Capital Cycle amid Lockdown!
This is the second and last wire under the series of India Ratings and Research’s (Ind-Ra) assessment of the impact of Covid-19 pandemic on the retail jewellery sector. The wire focuses on the impact on profitability, liquidity and credit profile of sector companies.
A non-exhaustive study of a few Ind-Ra-rated retail jewellery players in ‘IND A-’ and ‘IND AA-’ rating categories reveals that they either have sufficient liquidity available or are backed by strong bank funding or outstanding free cash, which will enable them to manage liquidity in the short term.
The demand shock due to Covid-19 outbreak and consequent lockdown will lead to a 25% decline in overall jewellery sector revenues in FY21. This certainly necessitates meaningful revisions to Ind-Ra’s base case assumptions for FY21. For FY22, Ind-Ra expects a recovery in revenues as well as profitability supported by higher gold prices, continued consumer interest in gold jewellery for traditional reasons and gold being an attractive investment destination.
Higher Gold Prices and Cost-cutting Measures to Support Profitability: Ind-Ra expects that the average profit margin of its ‘IND A-’ and above rated portfolio shall be negatively impacted in the range of 25-50bp in FY21, but will remain comfortable at 4%-6%.
In FY21, the profitability of retail jewellers is likely to be impacted adversely because of lower business volumes. Fixed costs such as salary shall increase as a percentage of revenue, as most jewellers may not find it prudent to cut salaries or manpower, which may not prepare them for a revival in business next year.
Furthermore, existing showroom locations are crucial to maintaining footfalls in the peak season, thus deferring or renegotiation of rentals could be a challenge due to high shifting costs. Nonetheless, Ind-Ra expects some relief from the postponement/lowering of rentals.
For most jewellers, the flagship stores are owned either directly or through promoter entities, and the revenue from these showrooms contributes at least 20%-25% to the annual sales. Ind-Ra notes that rentals as a percentage of sales are for the sector are far lower than other retail industries. Additionally, jewellers will have to give out more offers/discounts to revive demand.
In this regard, jewellers are initiating multiple cost-cutting measures under advertisement, promotion and travelling expenses. As per discussion with multiple industry players, the average gold purchase rate for the current holding inventory is below INR4,000 per gram. Ind-Ra believes that profitability shall be supported in the short-term by higher realisations, given the gold prices have soared in FY21.
Credit Metrics to be Adversely Impacted: Borrowing for the sector is predominantly in the form of working capital. Due to Covid-19 outbreak and potential impact on demand, most of the jewellers are expected to conserve cash with reworking on expansion plans and are likely to curtail bank borrowing.
Interest costs are expected to remain elevated due to higher carrying costs for inventory on back of higher gold prices. The average interest coverage ratio for Ind-Ra ‘IND A-’ and above rated portfolio is expected to decline to 3.6x in FY21 (FY20 estimated: 4.9x) with minimum coverage ratio remaining well above 2.0x.
Working Capital Cycle to Remain Elongated: At end-FY20, the sector’s inventory cycle is expected to have optically stretched due to higher inventory holding cost and inability to sell accumulated stock due to the lockdown.
Ind-Ra believes that the inventory holdings shall be consolidated during FY21 in volume terms and expects the inventory cycle to remain elongated at 105 days in FY21 (FY20: 84 days, FY19: 75 days), on account of an increase in gold prices and estimated decline in revenues. The working capital cycle shall be partially supported by 5 to 10 days of extension to creditor days.
Any jewellery Capex is heavy on inventory and light on fixed assets. Thus, the working capital cycle for players with high Capex plans is expected to have elongated due to incremental inventory being placed at new showrooms that may not pick-up sales immediately.
Funding Challenges to Support Higher Inventory: Ind-Ra expects the sharp rise in the gold price to have increased inventory carrying costs for jewellers during the first few months of FY21. This leads to incremental funds being locked in inventory for the same level of volume holdings. Thus, the funding requirement is expected to have increased to maintain the existing unsold inventory and will lead to a reduction in return on investments.
Overall, gross bank credit deployment in gems and jewellery declined by 17% YoY in FY20 (FY19: down 0.9% YoY) compared to the 0.7% (6.9%) growth in overall industries. Although gems and jewellery exposure includes the adversely impacted cut and polished diamonds industry, any incremental exposure to retail jewellery is also rare.
The possibility of getting incremental bank funding to support higher inventory is remote, except the 10% additional discretionary lending offered by public sector banks to their existing borrowers, basis the COVID-19 regulatory package.
Thus, jewellers with existing banking lines from public sector banks may get temporary relief with incremental COVID funding, however, jewellers with funding primarily from private banks may have to shell out of their own funds to support incremental working capital requirements.
Liquidity Buffers to get Tested: Ind-Ra’s A- and above rated portfolio has sufficient liquidity buffers in the form of unutilised bank lines, cash and fixed deposits to support fixed costs during the lockdown and subsequent lean periods. Also, the debt moratorium on interest payments has given some breather.
The ability of jewellers to renegotiate rental payments needs to be seen. Furthermore, companies are expected to curtail Capex plans and dividend pay-outs. Thus, the liquidity buffers shall get tested during the time of slow economic activity.
Few jewellers may face difficulty in honouring repayment of gold metal loans that matured during 1QFY21 and thus have opted for the debt moratorium. The depletion of sales amid higher gold prices may increase the margin requirements of existing gold loan contracts and thus adversely impact their liquidity position.
Ind-Ra believes that jewellers with aggressive store expansion plans and long working capital cycles may take a longer time to recover due to their inability to mobilise adequate funds to capture demand in 3QFY20. However, entities with a stable regional or nation-wide presence along with free cash to support 4-5 months of fixed costs shall be able to recover soon.
Lack of Labour Availability and Supply Chain Disruptions May Derail Recovery: Jewellery manufacturing is a labour-intensive business. The retail business depends on the timely availability of the adequate amount of manufactured jewellery which can be displayed at showrooms. As per Ind-Ra's discussion with various jewellery manufacturers, migrant workers constitute the major portion of artisans. Most of these workers have travelled back to their native places and may not come back to work soon.
Majority of the gold is imported through the air. April 2020 has seen almost negligible imports, worst in decades, due to almost shutdown of operations by airlines. Mumbai, which is a major hub for gold bullion and ornament suppliers, is the worst affected in India due to the Covid-19 outbreak.
Depleted jewellery demand has already reduced the requirement of incremental jewellery in the short term. Thus, lack of labour availability and supply chain disruptions may not be an immediate challenge but it may delay recovery further and affect the preparedness for the peak season.