In Search of the Sources and Drivers of Competitive Strength, Growth, and Profitability
Titan Company has a market capitalisation of ₹2.75 lakh crores – its stock trades at a highly elevated valuation – with a price-earnings ratio of 86 and a price-to-book value of 23.2. This is not my niche: Normally, my analysis focuses on companies with a market capitalisation ranging from ₹100 crores and ₹2,000 crores. Why…? Because whether we call them ‘microcaps’ or ‘nanocaps,’ these stocks are usually available at cheap valuations – an essential ingredient for achieving superior returns.
Then why choose Titan Company now? Two reasons: ‘Curiosity’ and the ‘Joy of Learning.’ The stock of Titan Company has been a Dalal Street darling for almost two decades due to its superior stock return. The stock has gained 26.66 percent annually over the last five years – from ₹920 per share in August 2018 to ₹3,100 per share in August 2023. During the period, its net profit rose 24.33 percent annually from ₹1,102 crores in FY18 to ₹3,274 crores in FY23. Like others, I am too curious about how it achieved (and sustains) the feat. And then the joy of figuring out the underlying reasons that led to the superior return.
Performance
Titan Company’s long-term annual growth in sales, profit, and book value was 14 percent, 15 percent, and 17 percent, respectively. The 5-year median return on equity and dividend payout ratio was 23 percent and 30 percent, respectively. It has low capital expenditure needs and zero reliance on outside capital (equity/debt) to finance its operations. With a dividend payout ratio of 30 percent, Titan Company is a ‘dividend stock’. Moreover, the growth in dividend-per-share (DPS) has outpaced the earnings-per-share (EPS) growth over the past decade: The DPS grew at an annual rate of 19 percent against EPS’s annual growth rate of 14 percent.
The stock has, at least for the past decade, commanded a lofty valuation: a median price-earnings (PE) ratio of 81 over the past five years. The above-average growth in sales, earnings, and book value, alongside the superior return on equity and high dividend payout, could probably be, the reason for the lofty valuation commanded by Titan Company.
Business
The company has five major business segments: The jewelry division manufactures and retails jewelry products under various jewelry brands like Tanishq, Zoya, CaratLane, and Mia by Tanishq. It makes smartwatches under its ‘Watches and Wearables’ division and is among the top four smartwatch brands in India – with an in-house technology centre (Titan Smart Labs) dedicated to the development of the next generation of smartwatches and audio devices. It has an eyecare division that provides a wide range of eyewear products under brands such as Titan, and Fastrack, as well as top-tier international brands. Its eyewear store, TitanEye+ is India’s leading optical retail chain. Additionally, the Fragrance and Fashion accessories division sells lifestyle products such as perfumes, bags, and belts. The Indian Dress Wear division sells traditional women’s wear under the brand ‘Taneira’ through a total of forty-one stores.
Despite having varied business segments, Titan Company belongs to the Gems and Jewelry Industry as its jewelry division contributes 88 percent to its annual revenue and 91 percent to net profit. To be more specific, it belongs to the ‘Jewellery Retailer’ sub-sector within the Gems & Jewellery Industry. Therefore, for analytical purposes, particularly for peer comparison, we consider four other major listed Jewellery retailers – Kalyan Jewellers, Senco Gold, Thangamayil Jewellers, and Tribhovandas Bhimji Zaveri (TBZ).
Industry
The Indian gem and jewelry sector sources, manufactures, processes, and markets gold, silver, platinum, diamond, and other precious gemstones. Gold and diamonds occupy the top spot. Diamonds are mostly processed and exported, while gold jewelry caters to domestic demand. Indian gems and jewellery market was valued at ₹4,70,000 crores in fiscal 2023 with gold jewellery dominating with 66 percent share of the market. India sources its gold needs primarily through imports. In FY23, the domestic gold consumption was 889 tonnes of which the share of imports was 609 tonnes. The long-term prospect of the industry will be driven by economic growth, rising urbanization, and increasing disposable income.
Indian jewelry retailing is dominated by unorganized players – regional, family-owned, or standalone stores – with a share of 65 percent, but organized players – like Titan – have been making inroads over the last two decades: their share increased from 10 percent at the start of the century to 35 percent by 2022 and is expected to increase further to 47 percent by 2026. In India, the South dominates the gold demand with a 38 – 43 percent share.
Jewellery is a discretionary item. In India, its demand is closely aligned with the wedding season. Jewelry consumption in India can be broadly categorized as bridal, daily wear, and fashion jewelry: Bridal has the largest market share (50-55%), followed by daily wear (35-40%), and fashion (5-10%).
Competitive Position
The foremost distinctive feature of a good stock idea is the presence of a sustainable competitive advantage, and a straightforward method to measure a stock’s competitive position is its Gross Profit Margin (%). A high (or relatively high) and stable GPM (%) is a reliable indicator of a strong competitive position. Titan Company has a gross profit margin of 25.2 percent which is far superior to the other four major listed Jewellery retailers – Kalyan Jewellers, Senco Gold, Thangamayil Jewellery, and TBZ. These four players have gross profit margins of 16.5 percent, 16.0 percent, 10.7 percent, and 17.9 percent, respectively. Among the five retailers, only Titan Company and Kalyan Jewellers have a stable gross profit margin profile.
Now we know Titan Company has a strong competitive position – as evident from its superior gross profit margin – but our question is, what enabled it to achieve and sustain a competitive position this long? There should be one or two critical activities that the firm performs better (and consistently) than others that endow it with a strong competitive position. Following the cost trail may reveal answers.
For Titan Company and the other four jewelry retailers considered here, material costs, employee benefit expenses, and advertising & selling expenses are the largest costs. An analysis of the last two costs – ‘advertising & selling’ and ’employee benefit’ expenses – uncover (at least partially) the cause of Titan’s competitive advantage.
The competitive strategy employed by major Jewellery retailers is differentiation. The industry players try to achieve – awareness, store footfalls, customer trust, and loyalty – through advertising, sales promotion, and other marketing activities. It requires quality talent for the effective implementation of a competitive strategy however good they might be. Quality talent requires higher compensation, so higher employee compensation should be considered imperative for the optimal execution of a finer competitive strategy.
Titan Company spent a median of 5.72 percent of its annual revenue on ‘advertising & selling’ activities. Over the past decade, this percentage value has ranged between 4.00 percent and 6.6 percent. This is significantly higher than the other four listed Jewellery retailers considered in our analysis. The spent on ‘advertising & selling’ activities for Kalyan Jewellers, Senco Gold, Thangamayil Jewellery, and TBZ are equivalent to – 2.0 percent, 1.72 percent, 1.05 percent, and 1.80 percent, respectively – of their annual revenue.
The other cost – employee benefit expenses – that contribute to building and sustaining competitive advantage for a company also places Titan Company in a favourable position relative to its competitors. Titan’s employee benefit expense is equivalent to 4.92 percent of its annual revenue. For the other players, it averages 3.50 percent.
The current chosen approach of Jewellery Retailers to achieve growth and market share is – winning the trust and loyalty of customers – by differentiating themselves from the competition – through aggressive brand building, advertising, and other selling activities. Under existing industry dynamics, Titan Company has built a formidable position and may remain so as long as the status quo continues.
Jewellery retailers need to carry high inventory on their balance sheets. The inventory is composed of both gold metals and finished jewelry. It is the biggest component on the asset side of the balance sheet. In FY23, for Titan Company, inventories constituted 61.4 percent of total assets. Since inventories have such a high share in total assets, the companies that are most efficient in managing their inventories may possess a competitive advantage. But how do we measure this efficiency from the balance sheet?
The ratio ‘Inventory days,’ to a certain extent, can capture a company’s inventory management efficiency. It calculates the days needed to convert the inventory to sales – the lower the value of inventory days, the higher the efficiency in inventory management.
Titan Company’s latest 5-year median ‘Inventory days’ stood at 195 days: it is not the best in the industry. Among the five Jewellery Retailers considered in our analysis – Titan Company, Kalyan Jewellers, Senco Gold, Thangamayil Jewellers, and Tribhovandas Bhimji Zaveri (TBZ) – Thangamayil Jewellers has the lowest inventory days at 139 days and TBZ has the highest inventory days at 293 days. If the ‘inventory days’ is a good measure of efficiency of a company’s working capital management, then among the five players, Thangamayil Jewellers is the most efficient and TBZ is the least efficient: Titan Company is just average.
But the above ‘inventory days’ ratio is calculated by comparing a company’s inventories to its cost of sales – inventory days (cost). How would the picture look like if we compare the inventories to the company’s revenue – the inventory days (revenue)? The inventory days (revenue) for Titan Company at 142 days is just a little better than the median of 144 days among the five players. The picture looks the same: The efficiency of Titan Company’s inventory management is average.
Profitability
A company derives its earnings potential from its operating activities. For growth and profitability to be sustainable, they should emanate from the firm’s core operating activity. Therefore, for the analysis of growth and profitability, we need to first segregate the firm’s assets, liabilities, income, and expenses, each, into two separate components: the operating components and financing components. Operating components are directly involved in the company’s principal business activity whereas financing components finance or support the operating activities. The assets are segregated into operating assets and financial assets; the liabilities are segregated into operating liabilities and financial liabilities.
The net operating assets = operating assets – operating liabilities.
Net financial obligations = financial liabilities – financial assets; or net financial assets = financial assets – financial liabilities.
The income also can be segregated similarly into net operating income and net financial income.
We consider, at first instinct, the finance cost as a financial expense. But a more thorough analysis shows that for jewellery retailers, the finance costs include – interest on borrowings, interest on lease liabilities, and interest on gold on loan. Of these three, the last two items should be considered under the operating expenses because of their direct involvement in the business operation.
The primary measure of a firm’s operating profitability is,
Return on net operating assets (RNOA) = net operating income/net operating assets.
| Stock | RNOA (%) |
| Titan Company | 26.00 |
| Kalyan Jewellers | 8.20 |
| Senco Gold | 16.50 |
| Thangamayil Jewellers | 16.50 |
| TBZ | 6.60 |
Titan Company with RNOA of 26.00 percent has the highest operating profitability; Senco Gold and Thangamayil Jewellers with RNOA of 16.50 percent each have above average profitability, while Kalyan Jewellers and TBZ with RNOA of 8.20 percent and 6.60 percent have poor profitability.
Capitalisation ratio – measures the capital intensity of sectors and companies: the higher the capitalisation ratio, the higher capital-intensive is the stock. From an investment perspective, we should prefer less capital-intensive sectors and stocks, and for that a lower value of capitalisation ratio is agreeable.
Capitalisation ratio = net operating assets/net worth.
| Stock | Capitalisation Ratio |
| Titan Company | 0.81 |
| Kalyan Jewellers | 1.36 |
| Senco Gold | 1.26 |
| Thangamayil Jewellers | 1.65 |
| TBZ | 1.40 |
As the table above illustrates, Titan Company is the least capital-intensive while Thangamayil Jewellers is the most capital-intensive within the group. A company whose business is less capital-intensive than its peers – surely that is a sustainable competitive advantage, and in that respect, Titan Company leads its competitors by a wide margin.
Thangamayil Jewellers
One noteworthy observation among the competitors is the performance of Thangamayil Jewellers. Its stock price has appreciated 126 percent in the past 15 months. It has a return-on-equity of 20.5 percent, a dividend payout ratio of 20.6 percent, a superior long-term book value growth rate of 16.4 percent, and a low inventory days ratio of 139 days (lowest among the five players).
The performance is good but sustaining the superior performance requires the presence of a durable competitive advantage. The gross profit margin (our go-to ratio to measure competitive position) of Thangamayil Jewellers at 10.7 percent is the lowest among the five players. But a more detailed temporal view shows the GPM to be improving – from 7.6 percent five years ago to 10.7 percent now. So, Thangamayil Jewellers, even though it lacks a strong competitive position now, the competitive position is improving gradually. However, our inability to unearth the cause of the improving competitive position leaves us in uncertainty.
The superior growth and profitability could slip away if the company lacks sufficient competitive strength. We posited that Thangamayil Jewellers has the most efficient inventory management as it has the lowest ‘inventory days’ within the group – but those who have high inventory on books need not be less efficient – it might be intentional to meet high expected demand.
A more reliable and convincing measure of competitive strength is gross profit margin and capitalisation ratio – and on those measures, Thangamayil Jewellers ranks the lowest among the group. It is Titan Company that fares the best on those measures: Titan’s gross profit margin (%) is 25.2 percent; for the other players it ranges from 10.7 – 17.9 percent: Titan’s capitalisation ratio (lower the better) is 0.81; for the other players it ranges 1.26 – 1.40.
Analysis of Cash Flow
The cash flow statement, as the name suggests, describes how cash comes in and goes out of a company. These days, equity analysts assign high prominence to a firm’s cash flow, particularly the free cash flow. Free cash flow is what remains after we deduct operating investments from a firm’s operating cash flow.
The discounted cash flow (DCF) valuation model states that the present value of a stock is the sum of all cash flows the firm expects to produce over its useful lifetime, discounted for – the time value of money and the uncertainty of not receiving those cash flows.
Of course, we should value firms with positive free cash flow higher than firms with negative free cash flow. But the problem is – firms reporting positive free cash flow currently may report negative free cash flow later if they had to incur higher capex. Similarly, firms with negative free cash flow presently may later turn free cash flow positive – due to increased cash from operations – or when the capital cycle gets over. I believe, that because of the transient nature of free cash flow, relying on it to determine a firm’s value is prone to misapprehension.
A more reasonable use of a cash flow statement would be to determine the firm’s earnings quality; and its capital allocation efficiency – whether capital is allocated in a value-accretive way or not. Normally, we consider a significant amount of cash outflow towards accruals a “red flag.” But for Jewellery retailers, inventories being their biggest asset component and change in inventories being accounted within accruals, all jewelry retailers have large accrual cash outflow – it is idiosyncratic to jewelry retailers, and not a “red flag.”
The normal and straightforward method to measure ‘free cash flow’ is to reduce ‘cash operating investments’ from ‘operating cash flow.’ However, this is cumbersome because – accruals may distort the ‘operating cash flow’ – and considering only the ‘capex’ as ‘cash operating investments’ is a flawed perspective.
A less erroneous method to measure free cash flow is to determine what a firm would do if it had free cash flow, and then measure those parameters. If a firm has free cash flow it could do any of the following: 1) pay dividends, 2) repay debt, 3) buyback shares, or 4) buy financial assets. If it has negative free cash flow, it will fill that deficit by raising capital through debt or equity. In simple terms, measuring and analysing a firm’s financial cash flow can describe its free cash flow with lesser inaccuracy.
We use 5-year averages in our analysis as it could cancel out year-on-year volatility in principal business parameters. Titan Company – as per the latest 5-year average cash flow data – paid dividends worth ₹461.88 crores and bought financial assets worth ₹477.15 crores: a totalof ₹939.02 crores. But it raised debt equivalent to ₹422 crores. The difference between these two figures: ₹939.02 crores – ₹422 crores = ₹516.81 crores, is the free cash flow. Titan has a positive free cash flow equivalent to 4.36 percent of its net worth.
Tribhovandas Bhimji Zaveri Ltd. (TBZ) also had positive free cash flow worth ₹25.10 crores – equivalent to 4.47 percent of its net worth. All the other three stocks have negative free cash flow: Kalyan Jewellers, -89.44 crores, equivalent to 2.46 percent of its net worth: Senco Gold, -67.49 crores, equivalent to 7.11 percent of its net worth: Thangamayil jewellers, -34.24 crores, equivalent to 8.8 percent of its net worth.
The cash conversion rate measures the extent to which reported net profit is converted to free cash flow. The respective measures for the five stocks are:
| Stock | Cash conversion rate (%) |
| Titan Company | 27.7% |
| Kalyan Jewellers | -57.9% |
| Senco Gold | -89.3% |
| Thangamayil Jewellers | -15.4% |
| TBZ | 91.1% |
Only Titan Company and TBZ have positive free cash flow, and among the two, TBZ has the highest cash conversion rate.
Analysis of Profitability
We discussed one measure of profitability – the return on net operating assets (RNOA) – earlier. It is calculated as the ratio of operating income to net operating assets. Net operating assets is the difference between operating assets and operating liabilities. So, the net operating assets can be reduced using high operating liabilities, and this can lever up the RNOA. It is worth examining the role of operating liabilities in a firm’s RNOA. Two measures – ‘the operating liability leverage’ (OLL) and ‘return on operating assets (ROOA)’ – can help.
OLL is the ratio of ‘operating liabilities’ to ‘net operating assets’: the larger the OLL ratio, the higher the operating liabilities relative to operating assets. ROOA is the return when no operating liabilities are present.
A high value of operating liabilities itself is not bad, but operating liabilities come with a cost and if that cost is higher than ROOA, then it will depress the RNOA. So, it is the cost of operating liabilities and their impact on RNOA that matters. A high value of ROOA along with a low cost of operating liabilities is befitting. The OLL, cost of operating liabilities, ROOA, and their impact on RNOA are tabled below:
| Stock | ROOA | OLL | Cost of OL | RNOA |
| Titan Company | 14.10% | 1.23 | 5.77% | 26.00% |
| Kalyan Jewellers | 7.60% | 0.92 | 7.00% | 8.20% |
| Senco Gold | 12.70% | 0.89 | 9.38% | 16.50% |
| Thangamayil Jew. | 11.70% | 0.88 | 8.00% | 16.50% |
| TBZ | 8.00% | 0.81 | 9.88% | 6.60% |
Titan Company has the highest ROOA among the group, it also has the highest share of operating liabilities, but because of the low cost of its operating liabilities, its RNOA got geared up by 84 percent to 26.00 percent. All others, except TBZ, have their respective RNOA levered up using operating liability leverage – but no one has done it as well as Titan Company.
The most popular and widely used measure of profitability is ‘return on equity’ (ROE). It is the percentage ratio of net income to net worth (shareholder’s equity). Above, we saw how operating liability leverage levered up or down a firm’s RNOA. Similarly, if a firm needs outside capital to finance its operations – ‘financial leverage’ – those obligations can lever up or depress ROE – and here too, the degree of financial leverage and the cost of net financial obligations will determine the impact on ROE.
Financial leverage is the ratio of ‘net financial obligations’ to ‘net worth’: the higher the value, the higher the use of financial leverage. Titan Company does not use financial leverage – it has net financial assets – its financial assets exceed its financial liabilities. The return on its financial assets is 6.8 percent, much lower than its RNOA of 26.00 percent, because of which its ROE descended to 22.4 percent: still a superior value and the highest among the lot.
Kalyan Jewellers has a financial leverage of 0.19 – and a net borrowing cost of 13.1 percent – which is higher than its RNOA of 8.20 percent – lowering its ROE to 7.3 percent. Senco Gold has a financial leverage of 0.11 – and a net borrowing cost of 10.7 percent – which is lower than its RNOA of 16.50 percent – slightly boosting its ROE to 17.1 percent. Thangamayil Jewellers has the highest financial leverage of 0.91 among the five – and with a net borrowing cost of 13.2 percent – the ROE got boosted to 19.5 percent. TBZ is in an unpleasant situation concerning profitability. The excessive cost of its operating liabilities reduced its return on capital from 8.00 percent to 6.60 percent, and again, the excessive cost of financial leverage further reduced its return on capital to 5.1 percent.
Above, we analysed the profitability of Titan and its peers, and how operating liability leverage and financial leverage can lever up their profitability. Next, we check the drivers of this profitability.
There are two principal drivers of profitability: operating profit margin (OPM) and asset turnover ratio (ATR). The OPM measures the portion of sales converted to operating profit – the higher the better; and ATR measures the value of operating assets required to produce a single unit of sales – also, the higher the better.
Operating profit margin = operating profit/sales
Asset turnover ratio = Sales/net operating assets
RNOA = OPM * ATR
A superior OPM and ATR is the most preferable one: Titan has it. Any one parameter superior and another above average is the next best thing: no one has it. Both metrics above average is the third best case: Senco Gold has it. Thangamayil Jewellers has a superior ATR, but a below-average OPM. TBZ is highly disadvantaged: poor OPM and poor ATR.
| Stock | OPM (%) | ATR |
| Titan Industries | 6.60% | 4.06 |
| Kalyan Jewellers | 3.20% | 2.54 |
| Senco Gold | 4.20% | 3.94 |
| Thangamayil Jw. | 3.00% | 4.93 |
| TBZ | 2.70% | 2.35 |
| Average | 3.94% | 3.56 |
The profitability of retailers is driven primarily by sales rather than margins, and jewelry retailers are no exception. The source of profitability is achieving higher sales out of its net operating assets – and the firm’s work to achieve it through marketing & sales activities – which is the largest operating cost component for jewellery retailers.
Analysis of Growth
Growth is the principal driver of a firm’s stock price – particularly earnings growth. But all growths are not equally valued. Growth should add value: and only incremental earnings achieved at a return on invested capital greater than the cost of equity capital – opportunist cost – do add value. If the earnings growth has a return on invested capital less than the cost of equity, then it is value-destructive; if the return on invested capital is equal to the cost of equity, the growth adds no value. We need earnings growth to generate a return on invested capital greater than the cost of equity capital for the growth to be value-generative.
Since growth is the imperative driver of a stock’s price, for achieving superior return over the long-term, we need the growth to be sustainable – earnings that can repeat in the future and grow – and sustainable earnings growth emanates from a firm’s core operating activities. The essential first step in the analysis of growth is to filter out core operating earnings from the reported earnings – which is ‘sales’ less ‘cost of sales’ less ‘other operating expenses’ less ‘tax on operating income.’
Growth adds value only when the ROE is greater than the cost of equity. The earnings a firm earns above its cost of equity capital is its residual earnings – only growth in residual earnings adds value.
Residual Earnings (RE) = (ROE – cost of equity) * Net worth
Residual earnings growth shall happen in two ways: increase in ROE and growth in net worth. Let us consider ROE first. ROE = RNOA + (RNOA – NBC) * financial leverage. We said previously that sustainable growth comes from a firm’s core operating activities, so sustainable residual earnings growth should occur through a change in RNOA; RNOA is driven by sales change and change in OPM.
For Titan Company, over the last five years, RNOA increased from 26.0 percent to 30.6 percent – an increase of 4.64 percent – of which 3.51 percent was contributed by margin expansion, 0.99 percent was contributed by increase in sales, and 0.13 percent contributed by non-core operating activities. Even though sales contributed to an increase in RNOA for Titan Company over the last five years, 75 percent of RNOA gains happened through OPM expansion. A similar trend is exhibited by the other four jewelers during the period.
Now, we discuss net worth’s role in the growth of residual earnings. Net worth is, either net operating assets + net financial assets, or net operating assets – net financial obligations. So, change in net worth is, change in net operating assets + change in net financial assets; or change in net operating assets – change in net financial obligations.
We are concerned with sustainable growth, which is derived from the firm’s operating activities and, therefore, if we are to analyse the role of net worth in earnings growth, we should focus our analysis on change in net operating assets.
Net operating assets are used to generate sales, so changes in net operating assets are driven by sales growth. The ratio ATO measures the relation between net operating assets and sales. So, change in net worth can be explained by three things: 1) sales growth, 2) change in net operating assets needed to generate one unit of sales, and 3) change in financial assets or financial obligations.
But only change brought about by (1) and (2) shall result in sustainable earnings growth. So, we measured those figures – the 5-year median net worth change – by sales growth and change in net operating assets to generate those sales. The change in net worth by (1) and (2) were: for Titan Company – 27 percent; Kalyan Jewellers – 13.4 percent; Senco Gold – 23.8 percent; Thangamayil Jewellers – 41 percent, and TBZ – 4.2 percent. Thangamayil Jewellers shines, Titan and Senco have superior values, Kalyan is mediocre, and TBZ is poor.
Valuation
We forecasted earnings for the five firms – by assuming the current returns, margins, and payout ratio to maintain the current trend – and arrived at an approximate estimated fair value for these stocks.
Our fair value estimate for Titan Company is 2,092 per share – 15.73 times its book value. The stock currently trades at ₹3,110 per share – a premium of 48.66 percent to our estimated fair value.
The fair values for the other four players are: Kalyan Jewellers should trade at 2.03 times its book value – Senco Gold at 1.35 times its book value – Thangamayil Jewellers at 5.08 times its book value – and TBZ at 0.60 times its book value. All four stocks currently trade at a premium to our fair value – which means they are overvalued as per our estimate.
AMN CAPITAL 