{LONGTERMINVESTORS} Welspun-Tangled

Welspun-Tangled

Target, Bed, Bath & Beyond and JC Penney to Investigate whether company defrauded consumers by supplying Cotton other than 500 count Long Staple Egyptian Cotton for the past 8 years.

Management's ambiguous commentary raises concerns

Welspun India's (WLSI IN) conference call today was vague on facts and threw up more questions than answers. The root cause behind Target (its second-largest client) severing all business ties with the company stems from the "quality issue" of Egyptian cotton bed linen, which forms 10% of total INR 6bn revenue generated from Target. However, we believe Target's decision to cancel the entire INR 6bn contract is an overreaction. Management failed to assuage concerns on how Target's internal audit and third-party quality checks appointed by it failed to raise any alarms over a period of two years. Other unanswered queries pertain to 1) Welspun's share of any onetime penalty facing Target (1-2% of total revenue over two years), 2) the risk to earnings may extend to the entire Egyptian cotton bed linen business (6% of total sales), and 3) lower order inflows due to loss of reputation among other clients.

Lower sales, EBITDA and PAT by 9%, 16.5% and 22% for FY18E We lower our sales estimates by 2.2% to INR 67.9mn in FY17 and by ~9% to INR 72.7mn in FY18. We cut our EBITDA margin from 26% each in FY17E and FY18E to 24.4% in FY17E and 23.8% in FY18E based on higher fixed cost and a change in client mix. Hence, we reduce our EBITDA estimates by 8.0% to INR 16.6mn in FY17 and by 16.5% to INR 17.3mn in FY18. Consequently, we lower our adjusted PAT estimates by 11.7% to INR 7.6mn in FY17 and by 22.3% to INR 8.2mn in FY18.

Valuation – downgrade to Sell with a revised TP of INR 74 We downgrade Welspun India to Sell from Buy based on 1) a sharp earnings cut (~22% in FY18E), and 2) lower multiple from 8x to 5x FY18E EV/EBITDA and 14x to 10x FY18E P/E. We also lower our TP to INR 74 from INR 147 based on a weighted average of FY18E P/E and EV/EBITDA. In the near term, we recommend investors to reduce their positions, given lower visibility of earnings. In the medium to long term, we expect earnings to recover as the company focuses on improving its quality control processes and better sourcing of cotton.

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