Sanlam Private Wealth chief investment officer David Lerche said retailer Pepkor is set for healthy growth in the years ahead – and worth an investment.
Lerche said Sanlam Private Wealth recently added Pepkor shares to its clients’ portfolios, despite South Africa’s current economic climate being unfavourable to most retailers.
Pepkor is South Africa’s largest non-food retailer and a well-established entity in and outside the country, spanning over 5,800 stores across Africa and Brazil. The company’s primary brands, PEP and Ackermans, make up more than 80% of its operating profit.
However, the retailer’s latest results showed a 9.8% decrease in operating profit to R5.1 billion and an 11.7% decrease in HEPS to 80.8 cents.
Pepkor ascribed this to the country’s constrained consumer environment and persistent load-shedding, which saw the retailer lose around 211,000 trading hours.
However, Lerche said that South Africa’s retail sector – particularly clothing retail – is cyclical by nature.
“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 mean it is not immune to the cycle,” he said.
He added that this negative outlook has already been baked into Pepkor’s price, meaning 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 load-shedding seems to have passed its zenith,” he said.
“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.”
In addition, Pepkor’s move into Brazil in 2022 is still in its infancy, with the Avenida business contributing only around 4% of group revenue. Lerche expects it to contribute more than 10% of group revenue within the next three years.
Pepkor’s scale is another factor in its favour, as it allows the retailer to offer lower prices than its competitors. Its scale ensures that 95% of the items sold in PEP stores cannot be found cheaper elsewhere in South Africa.
Lerche believes Pepkor CEO Pieter Erasmus will also drive the company forward.
“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,” he said.
“While we can’t accurately predict where or when this will occur, 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.”
In the short term, Lerche expects 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%.
However, beyond the short-term view, Pepkor’s outlook becomes more attractive as load-shedding-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.”
Lerche believes Pepkor should be trading at a 13- or 14-times forward price-to-earnings ratio – a significant increase from its current base of around 10 to 11.
“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.”