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Which retail model rules?

Jun 30 2011 00:00 Andile Makholwa

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Fashion retailing – a perennially sexy sector for many professional investors – could become a little ragged around the edges as more players begin strutting their stuff on the profit ramp. Does that mean investors should re-look at some of the JSE’s mainstay fashion retailers, which have – save for the odd blip – generated smart returns over the past decade and a half? Maybe. The segment is changing style rather quickly.

Players traditionally not plying the fashion trade – most notably supermarket group Pick n Pay Holdings [JSE:PWK] – have over recent years thrown their hat into the ring. Meanwhile, market leaders Truworths, Mr Price and The Foschini Group (TFG) have been unrelenting in growing their businesses and fighting for market share.

In the process, small independent operators have been gradually evaporating (see Conservative Cinderella). Apart from the re-listing of sports retailer Holdsport (the former Moresport), there – perhaps significantly – hasn’t been a trend of fashion retailers pushing for listings on the JSE, not even during the mid-noughties small cap boom.

In fact, a number of fashion-related listings have disappeared off the JSE over the past two decades. They include Fashion African, Dynamo Retail, Romens and AK Peer’s much-loved LA Group.

Empowerment company Brimstone Investment Corporation [JSE:BRT] valiantly tried its hand at building a fashion house by leveraging off its clothing manufacturing capacity. Hosken Consolidated Investments appears to be considering something similar at Seardel with its Speedo brand, but the retail component will initially be on brand building rather than any chain store ambitions.

While breaking into a fashion retailing sector dominated by a handful of large players is no easy ask, Pick n Pay’s surprisingly strong clothing thrust has already rattled a few cages. The arrival of Walmart – the world’s biggest retailer – on our shores also means there’s a possibility of Massmart stepping on to the fashion retailing catwalk. Massmart already sells clothing in small quantities at its Makro outlets.

Zara – owned by Spanish group Inditex – is also expected to open its first store in Sandton (Johannesburg’s most affluent suburb) later this year. Though plainly speculative at this stage, some believe the coming of Zara may trigger other global players to also pursue SA’s fashion retail market.

“Africa is seen as a huge growth opportunity and SA has a fast-growing middle class,” says Abri du Plessis, chief investment officer at Gryphon Assert Management. “If Zara and the likes are interested in SA, others will definitely consider coming as well.”

SA’s clothing retail industry is estimated to be worth more than R50bn/year in turnover. Much of the sector’s growth has been achieved over the past two decades. Driving that expansion, as Du Plessis notes, has been the growth of SA’s middle class, which has benefited chains such as Truworths, TFG and Edgars that mainly target that market segment. The increased popularity of malls and bigger shopping centres has triggered the formalisation of the sector, with bigger players taking market share from independent “mum and dad” stores or relegating them to old CBD buildings.

Pick n Pay’s foray into apparel retailing hasn’t been modest but has yet to grab major headlines. The group initially had a clothing offering in its hypermarket stores. It opened its first stand-alone clothing outlet in 2002 in Menlyn Park, Pretoria. It now operates 60 clothing outlets: 50 corporate owned and 10 franchised.

Michael Coles, head of the group’s clothing division, says Pick n Pay aims to become one of the biggest clothing retailers countrywide over the next decade. “The clothing format has proved to be highly popular with our customers, with all stores contributing to group profitability,” he says. “Our clothing stores offer real growth opportunities for the future.”

Coles says growth has been great, with like-for-like sales growing by more than 10%. The group plans to add at least 10 outlets/year but could push that number to 20 when opportunities arise.

“This is a good opportunity for Pick n Pay,” says Simone Kruger, a retail analyst at Avior Research. “Though it’s still basic it gives them better margins.” She commends the group’s introduction of a more fashionable range as a step in the right direction.

Coles says the target market is essentially Pick n Pay’s food customer, with a wide appeal catering for all LSM ranks: a female shopper who buys for her family, but mainly looks for affordability.

Admittedly, it will take a while for Pick n Pay to reach the level of success its competitor Woolworths has achieved in offering a full line food and clothing product range. Woolies – a traditional apparel retailer – has an almost evenly split revenue stream coming from both its food and clothing businesses. Clothing gives Woolies better margins than food.

Massmart currently has no major plans for its clothing division. Other than its small range in Makro stores, it doesn’t have a retail division. However, new parent Walmart is big in clothing in the many countries it operates in. Kruger expects the merged entity to eventually venture into clothing retail in SA, though she says that’s still distant because Massmart’s current focus is food retailing. For that reason she doesn’t expect the arrival of Walmart and Inditex to shock the earnings of dominant players.

Pick n Pay still has a long way to go to pose significant competition to Mr Price and its ilk. Nevertheless, Du Plessis reckons things are poised to heat up. What will make it even more difficult is SA’s fragile textile industry. With the rand getting stronger, some retailers have hiked their imports from cheap Asian markets, such as China. Says Du Plessis: “The differentiator will be the quality of the product.”

CREDIT VS CASH

Paying premium

FOR INVESTORS, it’s often a question of credit versus cash when it comes to fashion retailers as an investment. Truworths and The Foschini Group (TFG) have the reputation of being the best credit retailers in the sector; Mr Price the king of cash.

Below we take a look at the three shares. We exclude Woolworths because of its significant exposure to food, which would distort our comparison.

The three shares seem to be mainstays in quite a number of well-regarded asset managers’ portfolios – judging by the latest unit trust holdings. Warren Buys, a portfolio manager at Cadiz Asset Management, says the big selling point for these growth funds is the large number of people in SA moving up the LSM curve. During the full blast of the recession credit retailers across the board took a dip in their earnings – in varying degrees, of course. TFG, being the weakest, was the hardest hit. However, cash-driven Mr Price had a ball.

MR PRICE GROUP

Mr Price Group [JSE:MPC] ’s story is intriguing. Largely aimed at the lower young LSM market, less than 15% of its sales are on credit. Its model has delivered handsomely over the years. The group has seen compound growth of 23,5% in headline earnings per share (HEPS) over the past 25 years, while dividends per share have grown by 25,3%. Coming from a very high base, the group pleasantly surprised many when it posted a 51% rise in HEPS in its 2011 financial year. It has over the years diversified its business and ventured into home textiles, kitchenware and home accessories through Mr Price Home and Sheet Street and has operations throughout Africa, where it wants to accelerate.

“Mr Price should be losing market share to the likes of Foschini and Truworths because credit sales are picking up – but it’s not. And that’s because of its huge appealing iconic brand,” says Chris Gilmour, a retail analyst at Absa Investments. He says Mr Price has developed a highly successful model of offering great fashion at cheap prices.

However, the question on most analysts’ lips is whether Mr Price will sustain its phenomenal growth when credit is expected to outperform cash. Gilmour says the group may loosen up on credit to extract maximum benefit of the upturn.

Abri du Plessis, an analyst at Cape Town-based Gryphon Asset Management, expects Mr Price to grow slower than Truworths and TFG over the next couple of years but says its performance will continue being robust, boosted by an increase in social grants recipients.

TRUWORTHS INTERNATIONAL

Truworths International [JSE:TRU] is often touted as the jewel of SA’s credit-orientated fashion retailers. It’s been consistent in performance, even throughout the recession. Once bundled with Woolworths to form the Wooltru Group, it’s been charting its own path since partially unbundled from Wooltru in 1998. The group operates more than 530 stores, with popular brands for young people such as Uzzi and LTD. Its emporium stores’ design and its ability to spot fashion trends have been its strong points compared with TFG.

Warren Buys, of Cadiz Asset Management, adds supply chain efficiencies have been another differentiating factor. “Truworths has operated on shorter lead times, which has enabled it to mitigate any problems with its ranges. Foschini’s lead times are longer, which makes it more difficult for it to make changes and limits any damage done as a result of getting its offerings wrong.”

If consistency and predictability are what you’re looking for, surely Truworths will impress you. In its past financial year it reported a 40% compound return on equity growth over the past decade. In its 2011 interim numbers it posted a 19% rise in HEPS and widened its trading space by 4% as it continues to open new stores. It said its debtors book continued to perform satisfactorily.

Though credit sales remained stagnant at 65%, its doubtful debt allowance and net bad debts to gross trade receivables improved to 10,1% (2009: 11,3%) and 7,5% (2009: 11,3%) respectively. It has predicted a lukewarm performance in its second half, which ends this month.

THE FOSCHINI GROUP

While Truworths’ track record over the past decade is impressive, some analysts believe the money is in TFG. The group began its upward cycle last year after about three years in a downward curve. Group CEO Doug Murray says the business is now in good shape. The group has invested time, money and energy re-engineering the business, particularly its division for women via Foschini [JSE:FOS].

It received much praise when it posted a sterling set of annual results for its 2011 financial year. Murray says TFG is growing ahead of its competitors, having achieved a 15% increase in retail turnover and a 21% hike in HEPS in the year to February. “We’re seeing the effects of our strategies in the supply chain. We’ve reduced lead times and established better relations with our suppliers.”

Nino Frodema, a portfolio manager at Metropolitan Asset Management, agrees. However, he says the group’s problems are not yet over. “We believe Foschini still has some work to do [in supply chains] – but it’s certainly made good progress.”

TFG is a much more complicated business than Truworths. It has a portfolio spanning apparel and jewellery retail and owns a majority stake in consumer finance group RCS. Among its popular apparel brands are Markham and Totalsports. Its jewellery portfolio includes leading chains American Swiss and Sterns. RCS extends credit to a number of retail chains, even those not owned by TFG. With the SA Reserve Bank widely expected to start lifting interest rates later this year, RCS is expected to boost TFG’s bottom line. Nedbank’s economic desk expects the hike to begin earlier next year, because the economy remains volatile.

Edcon and Pepkor

Still rule

“IF YOU AREN’T IN fashion, you’re nobody.” We believe that quote by British statesman Lord Chesterfield has some merit for Finweek readers. Let’s be honest: we all have our own favourite retail outlets. Asset managers will talk up Foschini because they can afford to shop there. Stockbrokers like Woolies because you can get your grub on the run along with your polyester suits. And journalists and those unfortunate Sharks supporters favour Mr Price because they don’t have too many choices.

However, none of that answers the question of how our readers are going to actually make any money by investing in South Africa’s fashion retailing sector. The acid test for us when we write about would-be investments is to take whatever money is in our wallets – normally not much, having blown it at Mr Price – and asking ourselves: “Would we put this money into the investments we’re writing about?”

In our view, the two best fashion retail investments aren’t even on the JSE… yet. Our first pick is Pepkor, the Christo Wiese controlled retailer. Investors can currently access Pepkor through investment holding company Brait. The company has recently undergone a restructuring, which sees it now as a majority shareholder in Pepkor and Premier Foods. There are a few other investments but nothing of any real substance. So if you put your money down you can effectively say you’re primarily a buyer of Pepkor.

Stockbrokerage Barnard Jacobs Mellet (BJM) recently encouraged clients with a high risk appetite to follow their rights at Brait, pointing out much of the new Brait’s NAV is made up of Pepkor. BJM notes: “Pepkor is currently undervalued relative to other SA clothing retailers and is likely to make up a considerable percentage of Brait’s NAV (around 70%).”

BJM also advises: “Recent corporate activities and price movements in the retail sector could provide upside for Pepkor and Premier, since high liquidity and greater transparency will impact positively on their valuation.”

The beauty of Brait is if you want to put your money into fashion retail now you get all the defensive characteristics of a cash retailer, coupled with plenty of upside. Simplistically, you’re paying a 10 times price earnings multiple against 13 to 15 for the other fashion retailers – receiving a comparable dividend yield and you get the reinforced balance sheet of Brait behind you. If the idea is to grow your footprint you can do so without tapping the market for expensive debt.

A straight price earnings valuation is important on a second front and that’s because as many as six offshore retail players are eyeing the African market through a South African entry. So there’s going to be competition for quality assets. With Walmart already setting a bar by paying 22 times earnings for Massmart, you have to ask how much room is left in the price of SA’s other retailers.

Throw in the fact that you’re paying a discount to NAV for Brait assets because of its investment holding company structure and you have to believe the patient investor can’t lose from here on.

The second play is Edcon, once the JSE’s retail darling but now out of sight and mind for most investors. That doesn’t necessarily mean it will remain there. Though there’s far less information about Edcon than there is on SA’s other listed retailers, we do know that for its past financial year it lost R1,6bn despite growing its trading profit by 14%. The losses incurred were due to derivative hedging and a R2,6bn interest bill, which all calls into question just how much value private equity firm Bain has created by taking this business private. That’s a far cry in profit from the R3bn in headline earnings and R22bn in revenue it was generating in the year it was de-listed.

As noted by Standard Securities in a recent note to clients, Edcon is still SA’s largest clothing retailer by both sales and cash flow. However, it’s heaving under a mountain of debt, taken on when the business was delisted. And that may see it come back to the market for an alternative source of funding.

But analysts say its future working capital investment is likely to continue to be constrained while it tries to balance its debt with cash flows – and that presents opportunities for other players. “As a result, the listed clothing players – TFG [the Foschini Group], Mr Price, Truworths and Woolworths, and unlisted Pepkor – are likely to continue to benefit from relative market share gains, in our view,” the firm advised clients.

Standard Securities says its preferred pick in the sector is Woolworths, saying Mr Price and Truworths are too “highly rated on a price earnings basis relative to their earnings prospects”.

While its debt is an obvious concern, what people forget about Edcon is it’s an absolute monster in SA’s retail sector. It has an 80-year trading history, 3,7m private label credit cards and it’s almost twice the size of its nearest competitor. Its credit and financial services business is what sets Edcon kilometres apart from its competitors. When it delisted in 2007 this division contributed around R360m in operating profit. That currently tops R1bn at a time when credit is tough to come by and consumers are cutting back on their spending.

You aren’t just acquiring a retailer but also a micro-lender with a massive balance sheet and reach. You have only to look at the cash flows African Bank generates (coupled with its attractive dividend yield) to understand why this is a good story.

When – not if – Edcon comes back to the market in time for the next consumer boom, shareholders are going to again be able to cash in. Why rush to put your money into a BMW 3-series like Mr Price or Woolies when you can conserve your capital for the Mercedes AMG with a bit of patience?

Just as we kicked off this report with a quote, we’re going to end with one from fashion guru Giorgio Armani. It might make investors think a little harder before putting their money into SA’s listed fashion retailers:

Armani said: “The goal I seek is to have people refine their style through my clothing without having them become victims of fashion.”

Marc Ashton

Ashton holds shares in Brait.

REX TRUEFORM

The conservative Cinderella

Needing a bit of bling

While there haven’t been too many successful entrants into South Africa’s competitive fashion retailing segment, Cape Town-based family-owned business Rex Trueform Clothing Company [JSE:RTO] has managed to carve out a very viable niche with its Queenspark chain. Queenspark was founded in the early Nineties as a sideline business to Rextru’s core clothing manufacturing operations. It didn’t take long for its retail arm to overtake and then render almost insignificant its traditional manufacturing business. In fact, Rextru’s clothing manufacturing arm probably earns the bulk of its keep manufacturing for Queenspark.

In the year to end-June 2010, Rextru generated profits before tax of R45m from turnover of R480m – showing a smart net operating margin of 9,4%. Things became even better in the interim period to end-December 2010, with turnover up 18% to R290m and pre-tax profits coming in 45% higher at R32m – meaning the all-important margin had extended to 11%.

But the most reassuring aspect of Rextru’s business model is its ability to pump cash. In the year to end-June last year its cash flow from operating activities was R53m – equivalent to more than 260c/share. Its interim operational cash flow was R37m, or 185c/share.

At current prices the Rextru ordinary and N-shares (as well as parent company Africa & Overseas Enterprises) represent remarkable value in a sector where earnings multiples are mostly in excess of 15 times. The discount (the market rates Rextru/Af&Over on a multiple of between five and seven times) placed on the share is only partly prompted by the fact that the company is so much smaller than its larger listed competitors.

Finweek believes the main reason for discounting Rextru’s prospects is because its controlling shareholders – the Shub family – rule the company with a conservative rod.

The Queenspark chain has been cautious, with the result that – other than Spur Corporation – there can’t be many other listed companies that hold such a large cash balance in relation to turnover and profit. At its interim stage Rextru held net cash of almost R150m – three times more than its last annual profit after tax number and equivalent to a rather hefty 750c/share. Its dividend policy also remains tight and earnings covered Rextru’s annual payout of 40c/share almost four times.

The critical question is whether Rextru needs to adopt a more aggressive model – especially in terms of expanding its Queenspark footprint. Brimstone is currently the biggest shareholder in Rextru, but its N-share and pyramid holding structure has left the empowerment group without much influence.

Whether Brimstone can coax Rextru’s controlling shareholders out of their conservative state to unlock both value and growth opportunities remains to be seen. There are market watchers who believe Brimstone should simply sell its stakes in Rextru and Af&Over to one of SA’s larger fashion retailers or perhaps dangle the stake in front of overseas players wanting to buy exposure in the local market.

Unfortunately, the Shub family’s artificial control of Rextru will probably keep a lid on any predator’s enthusiasm for acquiring a large stake in the company – even if such a large shareholding can be garnered at below fair value. Perhaps it wouldn’t really suit Rextru shareholders to see Queenspark swallowed up by a large listed fashion retailer.

A one-off settlement is one thing, but there’s the long-term potential to consider even if operations remain cloaked in conservatism. Rextru’s done the hard yards with the brand and it would be sad to see a large corporate walking off with the undeniable upside in the Queenspark business.

Then again, a company such as Pick n Pay – which is keenly aware of intricacies and eccentricities of family ownership and might want to expand its fashion retailing format – might make a far more sympathetic suitor or equity partner for Rextru.

Marc Hasenfuss

 
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