In the view of many South Africans, as well as that of Pepkor management, a town isn’t a town unless it has a PEP. Although the listed Pepkor entity is about more than just the PEP brand, this idea encapsulates what the business is all about: providing discount clothing to all South Africans. PEP is the biggest seller of school clothing – as well as mobile phones – in the country.
Pepkor is South Africa’s largest non-food retailer, with over 5 900 stores across primarily this country but also the rest of Africa and Brazil. Within Pepkor, PEP has more than 2 900 stores and Ackermans 999. Together, these two brands make up more than 80% of the group’s operating profit.
Regular readers of our newsletter will know that we favour businesses with superior scale. This is particularly important to Pepkor, for which product price points are essential (the group has stated that it has three ‘obsessions’: its customers, its price points and the cost of doing business). As an example, 95% of the items for sale in a PEP store can’t be found cheaper elsewhere in South Africa.
Among the things we like about Pepkor is its organisational culture. When running a lean, cost-conscious retailer with around 38 000 employees, having a central purpose is vital to ensure a motivated workforce. Management achieves this by ensuring that all staff members understand their role in ensuring that the average South African has access to affordable clothing.
CYCLICAL NATURE OF RETAIL
Retail in South Africa, particularly clothing, is by nature cyclical. The clothing retail sector typically does best when the economy is growing well and food inflation is low. It is also aided by lower interest rates. Although Pepkor is less cyclical than its peers due to the discounted nature of its products, its strong skew towards schoolwear and its low reliance on credit sales, it is not immune to the cycle.
You may therefore well ask why we’ve decided to add to such a business at a time when interest rates are high, GDP growth is poor and the outlook hardly exhilarating. The simple answer is that this negative outlook has already been baked into the price. The market is pricing the stock as though the current environment will persist indefinitely.
In our view, we are now close to the most painful part of the cycle. Interest rates appear to be nearing a peak, while loadshedding seems to have passed its zenith. Food inflation remains high and will be hit by currency weakness, but it should cool into the latter part of the year. All of this means that from late 2023 or early 2024, we can expect to see some improvement in the ability of Pepkor’s customer base to spend.
Pepkor’s move into Brazil in 2022 is still in its infancy, with the Avenida business contributing only around 4% of group revenue. This operation is in the value fashion space, which Pepkor understands well and is growing rapidly in a fragmented market. We expect it to contribute more than 10% of group revenue within the next three years.
DRIVING GROWTH
Pepkor CEO Pieter Erasmus has been in this role for less than a year but has a long history with the group from before the Steinhoff disaster. Now that Pepkor’s debt is no longer a burden, we expect him to employ a more external focus than his predecessor and to drive growth through the deployment of capital. While we can’t accurately predict where or when this will take place, it does provide a degree of optionality. And if there is no material corporate action, Pepkor’s near-100% conversion of accounting profits into cash means that the group will rapidly build a net cash position.
At Sanlam Private Wealth we prefer to look through the cycle when analysing and considering businesses. In the short term, we expect Pepkor’s normalised headline earnings to decline marginally for the year to the end of September 2023, while reported headline earnings per share should fall by around 8%.
Beyond this, the outlook becomes more attractive as loadshedding-related costs should ease in the 2024 and 2025 financial years. In addition, interest rates will likely moderate, GDP growth should accelerate off the current low base, the Brazilian business is likely to start contributing and debt levels should decline. All these factors should drive healthy growth in the years ahead.
In our view, Pepkor should be trading at a 13 or 14 times forward price-earnings multiple. At the time of writing, despite the recent recovery in the price, it is still trading at only 10 times September 2024 earnings. Pepkor’s combination of positive medium-term earnings growth, balance sheet optionality, great cash conversion and attractive valuation leaves us comfortable with our new, higher holding of this share in our clients’ portfolios.
