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Margins under pressure; high base adversely affecting volume growth

* Sales growth is in line and volume growth seems to be tapering off on a high base of athleisure and mask sales (1% volume growth YoY and 7% YoY excluding masks) in 2QFY23.

* Higher yarn/packaging costs YoY (albeit yarn prices declining from its higher levels), staff costs, and ad-spends led to an EBITDA miss in 2QFY23 and are likely to adversely impact 2HFY23 results as well.

* While medium-term sales and earnings outlook are healthy, we reiterate our Neutral rating on account of rich valuations.

Sales and Gross profit in-line; miss on EBITDA

* PAG reported 15.8% YoY sales growth to INR12.6b (in-line) in 2QFY23.

* EBITDA was flat YoY and declined 20.1% QoQ to INR2.4b (est. INR2.7b). PBT was also flat YoY and declined 22.6% QoQ to INR2.1b (est. INR2.5b) in the quarter.

* Adj. PAT was flat YoY and declined 21.7% QoQ to INR1.6b (est. INR1.8b) in the quarter.

* Gross margin expanded 100bp YoY/130bp QoQ to 55.8% (est. 56%) in 2QFY23.

* As a percentage of sales, higher employee expenses (up 200bp YoY to 18.3%) and other expenses (up 150bp YoY to 18.5%) led to EBITDA margin contracting 250bp YoY to 19% (est. 22%) in the quarter.

* 1HFY23 sales/EBITDA/Adj. PAT grew 63.7%/100.1%/115.3% YoY to INR26.0b/5.4b/3.7b in 2QFY23.

* Board of Directors has declared second interim dividend of INR70

Highlights from the management commentary

* The demand environment was lukewarm during the quarter with low consumer spending. Core volume growth was 7% YoY and including mask it was 1%. Athleisure sales growth tapered off from earlier quarters.

* Cotton/packaging/fuel prices were all high this quarter. However, cotton price has started to moderate. Opex has increased significantly, owing to higher advertisement costs. Even the employee expenses were high, owing to hiring new talents to build new warehousing capacities.

* Going forward, EBITDA margin would revert to its historical levels, i.e., ~20- 21%.

* Tax rate will be ~24% in FY23 and FY24.

Valuation and view

* Changes to the model have led to ~9%/~3% reduction in FY23/FY24 EPS, respectively, because of lower pace of volume growth over a high base and near-term margin pressures. If not for lower tax rate guidance, the adverse impact on EPS would have been higher.

* After a few years of an earnings decline (down 4.3% PBT CAGR over FY18-21), PAG’s performance in FY22 was encouraging on this high base, however, in 2HFY23, earnings growth is likely to be tepid.

* PAG’s medium-term earnings prospects have improved for the better because of investments made in distribution, designs, and technology (which has led to significantly lower inventory levels). RoCEs are also likely to sustain at over 50%, having dipped to the late 30s in FY20 and FY21. However, valuations at 61.8x FY24E EPS are rich, leading us to reiterate our Neutral rating on the stock with a TP of INR46,750.

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