Quarterly Strategy Note December 2013

Transcription

1 Quarterly Strategy Note December 213 Neil Brown & Richard Hasson Boutique Co-Heads Total Returns to end of November month 3-month 6-month 1-year 3-year p.a. -year p.a. JSE SWIX (J43) -1.6% 8.2% 9.4% 21.7% 18.7% 2.% JSE All Share (J23) -1.1% 7.7% 8.7% 21.6% 17.6% 19.6% JSE Resources (J28) -2.2% 2.% 3.9% 2.7% 1.2% 7.8% JSE Industrial (J27).% 9.2% 11.2% 33.1% 28.2% 28.4% JSE Financial (J8) -2.6% 11.% 8.9% 22.% 21.8% 2.% USA S&P (ZAR) 4.7% 1.4% 13.1% 49.1% 32.7% 17.7% Economic Indicators 3-Nov Aug May-13 3-Nov-12 3-Nov-1 3-Nov-8 R/$ Prime Interest Rate 8.% 8.% 8.% 8.% 9.% 1.% Sources: Deutsche Securities and Morningstar STEINHOFF: Africa s IKEA Insights by Izak Swanepoel, Analyst In May this year, the negative sentiment following the spree of acquisitions by Steinhoff over the last few years created a wonderful opportunity for our clients to own a share in Europe s second largest furniture group. As an investment case Steinhoff is controversially perceived, as the number of acquisitions and the accounting thereof has made it difficult to understand the business model and the underlying cash flow. We discuss in this note the rationale for investing in Steinhoff and, in particular, the business model, the key sustainable competitive advantages, free cash flow generation, valuation, and share price performance year to date. Roadmap to Steinhoff today Established in 1963, Steinhoff s core business was then the manufacturing of furniture in low-cost countries such as East Germany, Hungary, Poland and the Ukraine, and selling to retailers in Western Europe. Over time, through various acquisitions and Group restructurings, Steinhoff extended its reach both upwards and downwards through the furniture value chain to become Europe s second largest furniture retailer, with a retail presence in South Africa (6% stake in JD Group) and Australasia. In addition, the Group also owns a 62% stake in the listed KAP Industrial, a diversified industrial company with interests in logistics, timber and manufacturing; and a 2% stake in PSG Group, a financial services holding company whose largest investment is a 28.% stake in bank and unsecured lender, Capitec. Figure 1 is a representation of Steinhoff s current structure. Figure 1: Steinhoff Group Structure 1% 1% 6% 62% 2% International Operations Properties JD Group KAP Industrial PSG Group Steinhoff Europe not listed Properties not listed Listed on JSE Listed on JSE Listed on JSE Retail and industrial Retail Retail Specialist logistics Strategic investment properties Manufacturing Automotive Passenger transport Sourcing and logistics Consumer Finance Integrated timber Industrial manufacturing Source: Steinhoff, ELECTUS 1

2 Given that JD Group, KAP Industrial and PSG Group are separately listed with stand-alone market values, and are reasonably well understood by investors, we have focused our attention on the Group s International Operations (referred to as Steinhoff Europe from here on). We think this division is less well understood by the market and is likely to become the main focus of investor interest, given the potential for a separate European listing of this asset. Steinhoff Europe includes the following assets: Retail household goods (39% of international earnings before interest and tax): Targeted at the value-conscious consumer in the household goods market, the primary retail formats are Conforama (mainly France), and Poco (Germany), as well as Harveys, Bensons for Beds and Cargo (UK). Other retail assets are Freedom, Snooze (Australia), Lipo (Switzerland), Quattro Mobili (Hungary) and Abra (Poland). In total, there are more than 1 retail outlets with around 1.7 million m 2 of retail space. Manufacturing, sourcing and logistics (3% of international earnings before interest and tax): This business, spread across 13 facilities in Poland, Hungary, Germany and the UK, manufactures products for Steinhoff and third-party retailers. Although Steinhoff Europe is currently the largest supplier of upholstery furniture in Europe, only around 2% of its retail demand is sourced in-house with the remaining products sourced from outside manufacturers in approximately 41 countries. Steinhoff Europe s medium-term target is to increase the in-house sourcing to around 3%. Even at this level there is scope for improvement, when considered in light of the 6% in-house manufacturing done by IKEA, the world s largest furniture group. Properties (2% of international earnings before interest and tax): The portfolio consists of retail assets (around 47% of retail space is freehold) as well as the manufacturing plants and distribution centres. The latter includes around 1. million m 2 of warehousing space in Europe, including two modern warehouses in Germany. The company reports property income separately as its property business charges market-related property rentals to the operating divisions that is, very little of its property income derived from external assets. Figure 2: Steinhoff Europe Earnings Before Interest and Tax split, FY13 Business model The business model of Steinhoff Europe is focused on sourcing and manufacturing products in low-cost locations and retailing them in developed markets. Steinhoff has been gradually strengthening this model though the acquisition of retail assets, such as the French retailer Conforama in March 211, to drive greater efficiencies and scale across the Group. Using Porter s Five Forces framework to understand the business better, we believe Steinhoff Europe s business model displays the following key sustainable competitive advantages: The vertically integrated model enables significant influence over the entire supply chain, from raw material input to end-consumer delivery. This improves visibility in the supply chain and margins of the retail segment, in addition to competitive pricing. The manufacturing division, based in Poland and Hungary, provides access to relatively cheap labour, the ability to assemble furniture sourced from Asia and Europe, proximity to the large European household goods market, and an efficient base for repairing products covered by the two-year European warranty requirement. Given the low market share of Steinhoff in Europe (around % market share, but the second largest player in furniture behind IKEA), there is room to gain market share on the back of market consolidation and closure of small independent players. This, in turn, should further accelerate economies of scale. In terms of market focus, Steinhoff s entrenched position in the discount category bodes well for further market share gains given the cash-constrained European customer. Its e-commerce strategy is complemented by a bricks and mortar model. Free cash flow generation One of the key concerns raised by critical commentators on Steinhoff centered on the acquisitive trail that masked the true underlying performance, especially in relation to cash flow generation. During March and April this year, we undertook an in-depth analysis to assess whether the Steinhoff Europe business model described above can produce strong cash flows over time. First, we analysed the publicly available financial statements of IKEA, Steinhoff Europe s closest competitor, from which the following headlines were extracted (Figure 3). Other 6% Properties 2% Retail household goods 39% Manufacturing, sourcing and logistics 3% Source: Steinhoff company reports, based on EBIT before intercompany eliminations; ELECTUS 2

3 Figure 3: IKEA (Ingka Holding) - Key operational and financial headlines (Euro'm) Average New IKEA stores Stores at year end Revenue Growth 14% 7% 1% 8% 7% 1% 8% Operating income Growth -7% -6% % 19% 13% -6% Margin 11% 9% 1% 11% 12% 1% 1% Net financial income Other Profit before tax Tax (71) (46) (384) (77) (781) (69) Effective tax rate 19% 19% 13% 18% 21% 18% 18% Profit after tax Cash and securities Bank liabilities Net cash RoCE (average) 13% 11% 12% 13% 13% 12% 12% RoE (average) 17% 14% 14% 13% 12% 12% 14% Source: Ingka Holding company reports, ELECTUS Despite opening 1 new stores, per annum, on average between 27 and 212, IKEA s net cash position significantly increased from.3bn in 27 to 8.bn in 212 and returns on capital remained constantly at the low teen level. This showed to us that IKEA s retail furniture business model inherently has significant cash flow generation characteristics and admirable returns on capital. In turn, if correctly applied by Steinhoff Europe, this business model should de-risk the balance sheet concerns that the market has regarding the Steinhoff Group. Our analysis then shifted to Steinhoff Europe s financial performance since the acquisition of Conforama in March 211 to determine whether a similar cash flow profile exists or not. Figure 4: Steinhoff Europe abridged cash flow statement for the fiscal year ended 3 June 213 (R'm) 1H213 2H213 FY213 Cash generated before working capital Working capital and other (93) (446) (1 381) Net cash generated by operations Net financing costs and other (29) (993) (1 283) Taxation and other (386) (16) (42) Net cash from operating activities Capital expenditure (1 93) (2 784) (4 737) Investments (793) (714) (1 7) Net cash used in investing activities (2 746) (3 498) (6 244) Free cash flow (12) Source: Steinhoff company reports, ELECTUS case scenario with significant upside risk if the Steinhoff strategy gains traction. This was indeed the case for the annual results ended June 213 (refer Figure 4 FY213) that showed a much better performance with a half-year swing in free cash flow of nearly R1 billion, again with very little revenue growth. Valuation Having established that the Steinhoff Europe business model has sustainable competitive advantages and offers strong free cash flow generation potential, we took a closer look at the valuation of the Steinhoff Group. As a starting point, we discounted the free cash flows of Steinhoff Europe, which included a conservative estimate of the potential scale and integration benefits from the recent acquisitions. As a cross check, we also valued the European business on a conservative earnings multiple based on the most comparable company Kingfisher (a UK-listed home improvement retailer with largely European operations). To this we added the current listed valuations of JD Group, KAP Industrial and PSG Group which in total gave a material value upside, even adjusted for potential downside risks. As a result, we initiated a significant position in Steinhoff on behalf of our clients at the beginning of May this year. Share price performance Since then the share price of Steinhoff has increased by 6% and has outperformed the FTSE/JSE Shareholder Weighted All Share Index (SWIX) by nearly %, as shown in Figure Figure : Steinhoff vs. SWIX 1 May November 213 (capital return; based to 1 from 1 May) Steinhoff SWIX By deconsolidating JD Group and KAP Industrial from the Steinhoff Group results for the six months ended 31 December 212 (refer Figure 4 1H213), we determined that Steinhoff Europe was breakeven at free cash flow level. This is despite marginal revenue growth, very little traction on extraction of costs and vertical integration, and continued heavy investment from converting leasehold retail properties to freehold. Having seen the potential cash flow upside in IKEA s business model, we concluded that the breakeven free cash flow reflected a worst May Jun Jul Aug Sep Oct Nov Dec 213 Source: I-Net 3

4 Most of the outperformance occurred following the release of the FY213 trading update and subsequent detailed results which, not surprising to us given our understanding of the business model, showed progress on: Change in the revenue mix towards higher margin products such as furniture and decoration, and less electronics. Material buying-related volume rebates due to increased scale from more Group supply chain integration. Improved Group-related efficiencies, in particular logistical cost savings. Decisive restructuring action with the closure of the after-sales and buying department in the low margin electronics operation, closure of regional head office structures, closure of the loss-making internet business LMDV that was acquired with Conforama, and the reorganisation of the Australian operations. Looking forward Steinhoff is currently in the process of finalising its acquisition of the kika-leiner group of companies, largely operating in Austria and nearby territories, with the final purchase price to be finalised in the first quarter of 214. We believe that the progress seen this year on Steinhoff s successful integration of Conforama augers well for further earnings accretion and value unlock from the kika-leiner acquisition. Furthermore, given the improved investor sentiment towards Europe, we believe there is currently a window of opportunity for a European listing of Steinhoff Europe or, indeed, the Steinhoff Group. Although we view such a listing as not central to our investment case, with >2% of upside in our valuation this should also assist in further value unlock. Strong operating cash flow generation leading to the declaration of an 8 cents per share cash dividend. Portfolio Positioning: Within the resources sector, we continue to have a bias towards the large diversified and high-quality mining companies, as they are typically low-cost producers, with diversified income streams across various commodities and geographies. Anglo American is our preferred holding in our clients funds, while we have a smaller holding in the leading globally diversified mining company, BHP Billiton. We also hold selected single-commodity shares, such as Lonmin and Sasol, that we believe have a competitive position in their respective industries. All of the above mentioned shares offer meaningful upside as they are trading below our company valuations. In the industrial and financial sectors, we have reduced exposure to a few of the domestic industrials, especially if they are not of a high quality. With the proceeds, we further increased exposure to selected high-quality and better-value randhedge industrial shares, such as British American Tobacco, Steinhoff and Aspen, as well as increasing exposure to South African fixed-investment and construction-related companies. We have also purchased some great quality mid- and small cap local industrial businesses that are trading at attractive valuations. Within financials, based on our research and company valuations, we retain our preference for selected banks. The Funds all have weighted price:earnings (P:E) ratios below their benchmarks, with good metrics for future growth in earnings and dividends. We believe that the JSE is currently trading marginally below its fair value, with many defensive industrials being expensive and several resources and more-cyclical shares offering excellent value. Based on our proprietary equity research, the ELECTUSmanaged Funds have around 22% upside relative to their JSE benchmarks, leaving close to the widest margin of safety that we have seen for over three years. This 22% gap relative to the broader JSE market makes us very excited that the strong excess returns we have delivered for our ELECTUS clients in 213 can continue to be delivered into the next couple of years. 4

5 initial investment Old Mutual Top Companies Fund vs Sector Average 31 July 26-3 November 213 R2 7 R24 R23 Old Mutual Top Companies Fund 7 6 R22 6 R21 R2 R19 4 R18 4 R 17 3 R16 3 R1 2 R14 2 R13 1 R12 1 R11 R * Since managed by Neil Brown and Richard Hasson Old Mutual Growth Fund vs Sector Average 31 March 22-3 November 213 R7 26 R7 R6 Old Mutual Growth Fund R6 2 R 18 R 16 R4 14 R4 12 R3 1 R3 8 R2 6 R2 4 R1 2 R * Since managed by Richard Hasson initial investment Nedgroup Investments Growth Fund vs Sector Average 31 March 21-3 November 213* Old Mutual High Yield Opportunity Fund vs Sector Average 3 September 28-3 November 213 R1 R9 R8 Nedgroup Investments Growth Fund # R22 R2 Old Mutual High Yield Opp A 3 2 R7 24 R18 2 initial investment R6 R R4 R initial investment R16 R14 R R2 4 R8 - R * Since managed by Neil Brown # Due to ASISA sector reclassifications, general equity sector average is used from 1 January 213; prior to that it s the growth fund sector average. Old Mutual Small Companies Fund vs Sector Average (SA - Equity - Mid-/Small Cap) 3 September 29-3 November 213 R * Since managed by Feroz Basa Old Mutual Global Emerging Markets Fund vs Fund Benchmark Inception - 3 November 213 R24 R23 R22 Old Mutual Small Companies SA Equity Mid-/Small Cap R16 R1 Old Mutual Global Emerging Market Fund MSCI Emerging Markets NR Index (ZAR) 6 R21 R R14 4 initial investment R19 R18 R17 R16 R1 R initial investment R13 R12 R R13 3 R12 2 R11 1 R9-1 R * Since managed by Warren Jervis R8-2 Aug-11 Nov-11 Feb-12 May-12 Aug-12 Nov-12 Feb-13 May-13 Aug-13 Nov-13 * Fund managed by Anwaar Wagner since its inception For more information on ELECTUS or to read previous editions of our Strategy Notes, visit Figures sourced from Morningstar, Old Mutual Investment Group and I-Net. Unit trusts are generally medium to long term investments. Past performance is no indication of future performance. Shorter term fluctuations can occur as your investment moves in line with the markets. Fluctuations or movements in exchange rates may cause the value of underlying international investments to go up or down. Unit trusts can engage in borrowing and scrip lending. The fund s TER reflects the percentage of the average Net Asset Value of the portfolio that was incurred as charges, levies and fees related to the management of the portfolio. A higher TER does not necessarily imply a poor return, nor does a low TER imply a good return. The current TER cannot be regarded as an indication of future TERs. A schedule of fees, charges and maximum commissions is available from the Old Mutual Unit Trust Manager Ltd (OMUT). Specialist equity funds may hold a greater risk as exposure limits to a single security may be higher. A feeder fund is a portfolio that, apart from assets in liquid form, consists solely of participatory interests in a single portfolio of a collective investment scheme. A fund of funds unit trust invests only in other collective investment schemes, which may levy their own charges. Certain funds may be capped to be managed in accordance with their mandates. Different classes of units apply to these portfolios and are subject to different fees and charges. Old Mutual Ltd is a member of the Association for Savings & Investment SA. Old Mutual Investment Group (Pty) Limited is a licensed financial services provider, FSP 64, approved by the Registrar of Financial Services Providers ( to provide intermediary and advisory services in terms of the Financial Advisory and Intermediary Services Act 37 of 22. Old Mutual Investment Group is a wholly owned subsidiary of Old Mutual South Africa Limited. Reg No 1993/323/7. November 213 ELECTUS MUTUALPARK, JAN SMUTS DRIVE, PINELANDS 74 PO BOX 878, CAPE TOWN 8, SOUTH AFRICA TEL +27 () , FAX +27 ()