Sometimes in investing you just get lucky! (Or, the more lessons you’ve learnt in the market, the luckier you get.)
Last August IM wrote a piece on Pepkor after the share price had fallen about 42%; we concluded that "buying good-quality counters at knock-down prices, providing that structural issues within the business haven’t caused the fall in share price, has proved to be a rewarding investment strategy. Pepkor’s sound business model should ensure that it not only survives the current crisis but gains market share in the medium term."
Well, the share price has rewarded investors by doubling since then.
The recent set of results for the interim period ended March 31 2021 justifies the share price performance, with strong headline earnings of 68.8c a share from continuing operations (growth of about 50.6%) and a sound balance sheet with improved cash flow, which helped reduce net debt by R8bn to R6.1bn. This reduction in debt will lessen financial risk, and the fall in the finance charge will also help boost earnings.
For the record, the interest component of the company’s net finance charge fell about 53% to R326m compared to the first-half 2020 results. Pepkor’s net debt/ebitda (earnings before interest, tax, depreciation and amortisation) and interest coverage ratios are well within the funding covenants.
When you consider that the comparable period (for the interim results ended March 2020) was largely unaffected by Covid, you get a sense of just how well the business did during the current period.
While many businesses have been merely trying to survive, let alone achieve any revenue growth during the pandemic, Pepkor was able to grow revenue by 8.1% to R36.5bn for the period. IM needs to point out that revenue would have been up 9.9% if you adjusted for the impact of curtailed credit granting. The group opened 108 new stores across its various brands during the period.
This growth comes despite consumers’ wallets being under pressure. Cash sales grew 10.7% (likely boosted by social grants), while credit sales were down about 3.8%.
According to data provided in its recent results presentation, Pepkor has consistently grown its market share in the clothing, footwear and homeware sector since 2017. It is now 16.2% larger than it was in 2017, while the market has shrunk by about 3.1% in that time. In effect this means Pepkor has actively taken market share from its competitors.
Operating profit of R4.59bn was an 18.5% increase over the comparable period and was achieved due to effective cost control and a reduction in debtor costs during the period. Operating profit expanded across all of the group’s divisions.
Despite the strong cash generated and the reduction of debt, no dividend was declared for the interim period on the back of management’s strategy to strengthen the balance sheet. Dividends are expected to resume at the end of the current financial year.
The sale of the building materials division (which is treated as a discontinued operation in its financials) for just over R1bn to Cashbuild, which would have gone to further reducing Pepkor’s debt, has hit a snag — the Competition Commission recently recommended that the transaction be prohibited. It is now up to both parties to put up convincing arguments to get the Competition Commission to change this recommendation and rule in favour of the deal.
After the strong run in the share price since August last year, there might be a temptation to bank some of those gains. Though there may be some headwinds, such as a reduction in the government’s social grants programme, management highlighted in the results presentation that like-for-like sales across the group’s brands for April and May this year were comfortably outperforming the same periods of 2019 (2019 levels are used to illustrate pre-Covid conditions). This is happening as Pepkor continues to benefit from consumer trends such as shopping closer to home, and a more value-orientated casualwear focus.
With the current reported interim headline earnings already exceeding what the group achieved at the bottom line for the full 2020 financial year, management now believes that group headline earnings could exceed what it achieved in 2019.
Headline earnings will receive the additional benefit of a lower interest charge due to curtailed debt levels, as well as savings on rental expenses due to the group acquiring some properties it currently leases from Steinhoff.
On this short-term view, the current earnings multiple will therefore unwind into the upper teens — meaning that though at the current share price the counter is not the proverbial "dripping roast", Pepkor is a comfortable HOLD in IM’s opinion, due to its quality cash-generating abilities and focused strategy on strengthening the balance sheet.
The writer holds shares in Pepkor Holdings
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