Why investors back Pepkor’s Brazilian samba

"I know people are saying all SA retailers that go abroad don’t make it but we were very successful in our foreign ventures and I believe we can do it again," Pepkor CEO Leon Lourens tells the FM.

It’s a justified fear in the local investment community if you think about the billions written off by such august retailers as Woolworths, TFG and Truworths when they’ve tried to expand outside SA.

But the price for taking an 87% stake in Brazilian retailer Grupo Avenida — announced last week — is understood to be about R3.2bn, representing less than 4% of Pepkor’s market capitalisation, which stands at R83bn. It means the group, which has entrenched itself as SA’s low-cost retailer of choice through brands such as Pep and Ackermans, is not betting the house on its new venture.

In fact, Pepkor is possibly unique in SA in successfully expanding abroad.

It previously owned Pepco in Central and Eastern Europe, a business that it grew from 13 stores to about 3,500 today.

That business was swallowed up into Steinhoff in the 2014 deal it did with Christo Wiese’s Pepkor, after which the African business was spun off and separately listed. Pepkor was also successful with its 1998 acquisition of Best & Less in Australia, based on the same high-volume, low-margin business model.

The company sees huge expansion potential in Brazil. The country of 211-million people is one of the world’s 10 largest apparel markets, and about five times bigger than the SA market.

Yet Pepkor, with 5,470 stores in 10 countries, dwarfs Avenida. The 42-year-old Brazilian chain has just 130 stores. So why the interest?

"We had a desktop study that led us to South America, and a couple of the team had gone to look at Chile, Colombia and Brazil," says Lourens. And like good chemistry "you almost got a sense this could work for us".

While scouring emerging markets, Pepkor executives happened to meet Avenida’s leaders in 2018 when they were preparing for a listing.

Avenida — which was started by the Caseli family in 1978 — had by then endured seven years of private equity involvement with Kinea Private Equity, and was starved of capital.

Pepkor would make a nonbinding offer provided Avenida let go of their listing aspirations.

"It was a choice — [and] they decided they would walk a road with us," says Lourens.

Despite Brazil’s obvious potential, Avenida, which trades mostly in the midwest and northern regions of Brazil, has opened only 13 stores in the past seven years. It operates in the bargain end of Brazilian retail, and preliminary results for the 2021 financial year indicate that Avenida surpassed 2019 sales levels with a turnover of BRL773m.

Lourens sees the company as culturally similar. "I think these are people who are prepared to listen, to change — they’re very receptive to our best-practice type of views. That’s not always so easy — a lot of businesses, especially in the First World, you battle with. In this case their culture is ‘let’s work together, it’s also in our best interests’."

The Caseli family will keep a 13% stake and the sons of the founders (who’ve been in the business for 20 years) will stay on as a director and CEO, respectively. Two Pepkor executives will be placed there permanently and on the board, with an ex-Pepkor executive in an advisory role.

Lourens has previously said that an acquisition outside Pepkor’s home market would probably be in a company that was not too big, had proved itself, needed capital and had good management. He believes that part of Pepkor’s expansion success is that it is not as exposed to fashion risk as other retailers.

"There are lots of reasons why it sometimes doesn’t work — in our case we’re less exposed to that. We’re good at children’s wear, babywear, shoes and general merchandise.

"My favourite saying is, a Superman T-shirt for a 10-year-old boy is the same here as it is in Brazil or somewhere else."

Pepkor will also draw on its vast sourcing platform, which provides the company with extra scale.

The first two years will be about preparing Avenida for growth, so SA shareholders should not expect any sort of initial dividend from the purchase. "They’re not used to growing anymore," says Lourens. When asked if this is the start of a bigger expansion spree, Lourens says: "There’s so much opportunity, why would you even consider complicating things?"

Fortunately, Pepkor is also in a strong financial position to fund the deal, which means the market expects no changes to its dividend policy as it grows the Brazilian business.

Ya’eesh Patel, research analyst at SBG Securities, says the only concern from investors is that management’s attention may be diverted to a completely new region, away form the core business of SA — where Pepkor has promised to add 300 stores over the next three to five years.

"The concern is founded on previous acquisitions by SA retailers in other regions globally resulting in a shift of their attention and ultimately dropping the ball in the home market."

Of course, if you’re going to spend up to 40% of your market cap on a deal — as Woolworths did with David Jones — the pressure is that much higher.

Says Patel: "When the market sees an SA retailer making an acquisition offshore there’s instant caution. But the skill set management currently has, in discount apparel and footwear, aligns with this acquisition."

Apart from Pep, it owns Incredible Connection, BUCO, Timbercity and Tekkie Town.

Pepkor has also taken two years to do the due diligence on its purchase. Patel says Pep and Ackermans have a runway in the SA market of about five years for further store rollouts, while Avenida is only likely to contribute meaningfully to the group in three to five years, so there’s good overlap.

He believes the strategic fit of the purchase is spot-on. Avenida’s target market is the equivalent of the mid-to lower-LSM segments in SA, which account for about 85% of Brazil’s population. Within the business, credit sales contribute about 47% to sales, with about 3-million accounts. Brazil’s apparel and footwear market is expected to increase at a compound annual growth rate of about 9.3% to 2025.

"They’re hoping to leverage off their offshore sourcing office and import stock, particularly in the kids and baby segment — and they believe they can land product in Brazil at the same cost it would land in SA, including import duties," says Patel.

In a research note, Patel estimates that Avenida will initially contribute around 2.8% to Pepkor’s group revenue and about 3% to trading profit, with "aggressive growth" about three years away.

Chris Reddy, portfolio manager at All Weather Capital, says Pepkor is sticking to its knitting by focusing on the discount and value segment. Plus, "Brazil’s clothing, footwear and home market is over 3½ times greater than SA’s, with only 14.5% consisting of formal retail."

But while the opportunity is vast, so is the potential competition.

Says Reddy: "We’ve seen a lot of interest from competitors to grow in the discount space, such as [Chinese retailer] Shein — I’m sure they’re also looking at Brazil — that is something to watch. It’s becoming the hot space right now."

What is also becoming hot is SA’s own value retail segment, where Pepkor is facing increasingly fierce competition from the likes of Mr Price and Pick n Pay Clothing.

But, says Aeon Investment Management’s Asief Mohamed, "Pepkor has a lot more scale and can buy at lower prices and people know it". Mohamed says many middle-income earners are increasingly buying products at Ackermans. "Another positive is that grants are most likely going to be made permanent."

Still, Casparus Treurnicht, portfolio manager at Gryphon Asset Management, says: "There will come a time when the value segment will become a war zone, though for now it is still a unique destination."

For Treurnicht, "the acquisition in Brazil came as a bit of a surprise. Sellers usually know more than buyers but more importantly it happens very seldom where a family sell their majority stake. This turns the whole thing upside down. What do they know that Pepkor does not?"