Pantaloon refines its core

In the March quarter, Pantaloon Retail (India) Ltd paid as much as 90% of its profit before interest and tax as interest cost. So, although it earned Rs 300 crore before interest costs and taxes, its net profit stood at a meagre Rs 15 crore. The sale of its stake in subsidiary Future Capital Holdings Ltd to private equity firm Warburg Pincus Llc marks an important step in strengthening its balance sheet, exiting non-core businesses, and stemming the effect of interest on its net profit.

Pantaloon will sell between 40-53.67% in Future Capital—the exact number is linked to the success of the 20% mandatory open offer—for a price of Rs 162 per share. That translates to a consideration in the range of Rs 420 crore to Rs 563 crore. Since Future Capital will cease to be a subsidiary, its debt will exit Pantaloon’s balance sheet along with the investment.

Future Capital’s debt (short-term plus long-term borrowings) had risen to Rs 3,871 crore as of 31 March, from Rs 2,371 crore a year ago. As of 31 June 2011, Pantaloon had a debt of Rs 7,846 crore. Thus, the transaction will lead to a significant drop in its debt-to-equity ratio, which Pantaloon estimates at 0.8 times at present. This is after considering the impact of the current transaction, the Aditya Birla Group joint venture for the Pantaloon garment business, and a preferential equity issue worth Rs 200 crore recently. The number compares well with a debt-to-equity of as high as 2.5 times as of June 2011.

“For the core retail business, debt will come down to approximately Rs 3,000 crore over the coming quarters, from Rs 5,100 crore in December 2011. This should lead to savings in interest expenses to the tune of Rs 50 crore per year for the core retail business,” according to Abneesh Roy, associate director of institutional equities research at Edelweiss Securities Ltd.

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Pantaloon can now focus entirely on its core retail business, with divestments largely out of the way. A stronger balance sheet gives it the flexibility to invest in its existing stores, fund expansions where necessary, and most importantly, provide working capital finance, which is critical for a retail business. The company has turned cautious both in opening new stores and booking retail space. Needless to say, the state of its balance sheet would have led to the caution.

Investors are already cheering the move, with Pantaloon’s share price up by 7% on Monday. Additionally, the company has transferred its home retail business to a subsidiary, in which it may bring outside investors to fund growth.

Now, investors will wait to see Pantaloon’s growth strategy for the core retail business—whether the company will consolidate further or renew focus on growth, and whether consumer confidence (in the broad economy) improves and same-store sales growth picks up. These factors will drive valuation in the medium to longer run, once the cheer about the debt reduction fades away.