By Hannes Van Den Berg, Portfolio Manager, SA Equity & Multi-Asset
"We believe that Mr Price continues to offer reasonable value."
Mr Price has been a key holding in the Investec Equity Fund
The Investec Equity Fund invests in shares where expected future earnings are being revised upwards while trading at reasonable valuations. Most importantly, these positive revisions in earnings need to be sustainable and operationally driven. During the third quarter of 2017 we materially increased our exposure to Mr Price in line with our philosophy, and we currently have an overweight position in the stock.
A darling of the market for good reason
Mr Price was the darling of investors for over a decade. The share price rose from just over R12 per share in January 2005 to R260 per share by the end of March 2015, implying a share price return of approximately 35% per annum over the period. This stellar rise in the share price was rooted in the superior sales and earnings growth profile, returns on capital and free cash-flow generation. What is even more remarkable is that Mr Price grew sales and market share without reliance on credit sales, a model that was a popular strategy for targeting less affluent consumers during that time period. Its success in inducing cash-strapped consumers to switch from credit retailers to cash, is testament to the perceived value of its apparel. In short, Mr Price lived out its self-stated DNA of “quality and fashion offered at the best price” and successfully grew its footprint in South Africa.
At the heart of the Mr Price Group are the Mr Price apparel stores. Although the group now operates various trading divisions including mrphome, mrpsport, Miladys, Sheet Street and mrpmoney, more than 60% of group sales are generated from its key apparel divisions. It should be no surprise, therefore, that when these important divisions missed on expected sales forecasts in mid-2016, the share price derated severely.
Mr Price fell from glory when it disappointed the market with weak results and the share hit a low of R130 in 2016 – well off its share price peak. The catastrophic decline in Mr Price apparel like-for-like sales for the first quarter of the company’s 2017 financial year (April – July 2016) compounded what was already a challenging operating environment. Weak consumer spending, increased regulatory hurdles, increased foreign competition and a local competitor slashing prices in a bid to stay afloat, had already made for harsh conditions. Merchandising and pricing mistakes by Mr Price during this time worsened the impact on its sales.
Figure 1: 2017 like-for like sales’ collapse
Source: Investec Asset Management, company financials and presentations.
The initial purpose of our research was to establish whether the fall of the company’s share price was structural and if Mr Price’s winning model was permanently broken. Mr Price had long been rewarded for being a long-term industry winner and it was important to understand the extent to which we could expect an operational recovery. Our extensive research helped us to identify signs of a recovery earlier than market expectations, and we were able to allocate capital to this investment idea opportunely.
Establishing the sustainability of Mr Price’s earnings power
Given Mr Price’s value proposition and low contribution from credit sales, its model should have performed better relative to peers. We therefore believed that the weak sales result in the first quarter of Mr Price’s 2017 financial year, which was well below its peers, was unlikely to be repeated and that the retailer should recover from scoring own goals.
Analysis of market pricing data showed that the pricing gaps between Mr Price and its peers had significantly narrowed. Historically, the value retailer’s pricing had been well below the majority of its peer group. It was in an attempt to defend its sales that we believe Mr Price pushed the ‘fashionability’ of its merchandise and sacrificed on quality rather than focusing on its value for money offering. Unfortunately, pricing and quality suffered and the fashion mistakes worsened the impact.
Management’s quick response to these mishaps was key to the speed of the company’s recovery and our interactions with management indicated that it had not only identified these mistakes but were taking active steps to correct them. Management planned to return to its core offering and had made the necessary leadership changes to ensure this was done. However, it would take time before management’s hard work would pay off. Our extensive analysis helped us identify this inflection point ahead of the market.
Our bottom-up analysis is necessarily extensive and rigorous and not only reliant on the analysis of financial metrics. Engagements with senior management, visits to distribution sites, discussions with store managers, consultations with independent apparel specialists were all crucial to understanding the turnaround progress in the business. We also have access to our property investment team, who gave us regular corroborative research on footfall, trading trends and feedback from shopping centre landlords.
From this extensive research process, we were able to gain insight into the potential short-term nature of the challenges facing Mr Price as well as better understand where market consensus might be undervaluing the recovery potential. We were convinced that the market’s earnings expectations were not fully reflective of what the company could earn. In anticipation of these continued upward earnings revisions, we increased our shareholding, which benefited performance.
Figure 2: Increased allocation reflects conviction that earnings per share (EPS) downgrades had abated
Source: Bloomberg, Investec Asset Management as at 15.01.18.
After the prior year’s poor results, Mr Price experienced a turnaround in performance and its reported interim results in November 2017 was ahead of market expectations. The market underestimated the leverage effect that the improved sales momentum would have on the company’s earnings. Restructuring and management changes to address merchandising and pricing mistakes helped the retailer to increase volumes and regain market share. Inventory levels improved and gross margins benefited from fewer markdowns, a stronger rand and improved efficiencies from various internal initiatives.
Recent trading points to a continued recovery and market share gains, and our earnings expectations have been ahead of the market.
Positive tailwind in current environment
Further to the above bottom-up fundamentals, the cycle appears to have turned in favour of discretionary retailers. The domestic inflation outlook continues to improve on the back of moderating food prices and a strengthening rand. The election of Cyril Ramaphosa as the new ANC president in December 2017 was well received by the market. Improved confidence and a potentially higher GDP growth rate, can have a tangible impact on retail sales. This has resulted in a sharp rerating of the retail sector over recent weeks as share prices increased on expectations of an improvement in future earnings growth. We believe that Mr Price continues to offer reasonable value as the operational improvements should provide additional scope for margin expansion.
While we are cognisant of the opportunities that macroeconomic factors can present, our equity portfolios are ultimately built from the bottom up through stock picking. Not only is the macro environment supportive of the ‘SA Inc. trade’ but a detailed analysis of the consumer wallet and a breakdown of the consumer price index (CPI) show that Mr Price’s core consumer is experiencing inflation levels below that of reported CPI. This has improved consumers’ capacity to increase discretionary spending.
We have built a position in Mr Price over the last few months based on the evidence of a turnaround, which was reflected in positive earnings revisions. We continue to hold a significant position as we believe that the trend in upward revisions is not yet over. Further revisions, in our view, will come from:
- Regaining lost market share. We expect the improvement in merchandise and pricing strategies to still benefit the sales numbers of mrp and Miladys.
- More improvements in gross margins. We believe we should see a similar improvement in gross margins in the second half of the new financial year (2018). Lower markdowns, greater efficiencies and cost savings resulting from the new distribution centre and a revamped IT planning system, should benefit margins.
- Better cash-flow profile. Mr Price has come out of a capital expenditure cycle (material investment in IT) and the company is highly cash generative. We like the fact that management has been conservative in its approach towards acquisitions, both foreign and local, with a strong preference for a unibrand and organic growth.
If the company’s definition of passion is anything to go by “…ordinary people doing extraordinary things”, then the recent blip in operational performance gave us an opportunity to invest in a company of true pedigree with ample runway for sustained growth.
Additional contributors: Unathi Loos and Kristin Milne, Investec Asset Management.
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