27th August 2014
Pound shops may not offer value or at least not to equity investors with fierce competition environment and a struggle to increase margins due to their cost cutting measures argues Allianz Global Investors portfolio manager Matthew Hall.
Discount retailers have made huge inroads into the market share of traditional grocery and general merchandisers causing many retail stocks to fall out out of favour.
But Hall says investors are restricted in their choice of discount rivals with Aldi and Lidl in private hands. That leaves Poundland and B&M, both of which listed earlier this year, as the discount alternatives.
In a note today, Hall says: “When these companies listed earlier this year, I analysed the companies, and the sector they operate in, and whilst I too thought the structural growth trends could be attractive, I was surprised by a number of unattractive characteristics apparent in the GM discount market/companies.
“I was reminded of this fact last week when I read that Poundland and 99p store had started a price war in certain locations (officially labelled as ‘tactical marketing’). Whilst I found it amusing and slightly ironic that a fixed-price discounter finds it necessary to discount as a result of discounting by a rival discounter, it is also a serious issue given how low margins in these businesses are”.
Hall says the general merchandise retailers are increasingly finding themselves in direct competition and this competitive pressure may intensify as the number of stores grows.
“Between 2008 and 2013, the total number of GM discount stores doubled from 1154 to 2386. To put this into context, this is the same number of stores as HomeBase (323 stores), Argos (734 stores), WH Smith (615 high street stores), and Woolworths (800 before it went bankrupt) combined.
“Such expansion has been driven by low upfront store fit out costs, cheap space coming available from the bankruptcy of a number of traditional high street chains, and the attraction of lower unit costs as a result of better purchasing power.
“As a result, even though the GM discount store footprint is already well established, the sector continues to open stores at a high rate (Poundland and B&M plan on doubling their store base), which will only serve to increase the competitive intensity in the sector”.
He sees other aspects of fixed-priced GM discounters which make them lower quality companies. “Firstly, they can’t raise headline prices to offset cost inflation (e.g. wages/products), so they face the challenge every year of finding efficiency savings, or tweaking their product range, just to keep margins flat (it also means margin increases are unlikely). Secondly, although there is a structural trend towards discount shopping, sales per square foot in the GM discount sector have been flat for the past 6 years – which implies the main driver of growth in the sector is new space instead of pricing or like-for-like volume growth”.
Hall says that one way of quantitatively assessing the quality of a retailer is to look at the lease-adjusted, cash returns on invested capital (CROIC) that a retailer achieves.
“This shows the return a retailer might achieve on a new store, adjusting for the fact that some retailers choose to lease their stores, and others choose to own them. Retailers which generate high CROIC are more attractive because they can invest in growth projects which generate high returns for shareholders”.
He says Poundland generates a CROIC of around 10%, which is towards the bottom end of the UK midcap retail sector. He says the highest is Dunelm at around 30%.
“This takes some of the excitement out of the growth outlook for Poundland, because shareholder capital is being reinvested into low returning projects. This fact, and their high valuations, means the discounters might not be such a bargain after all”.