Introduction
The South African food & grocery sector is dominated by four major players; Pick n Pay, Woolworths, Shoprite and Spar. If you’ve discussed any of these retailers with your friends around a braai recently you would know that Shoprite (in green below) is the clear sector darling, rising an impressive 46% in the last 12 months.
Its well-deserved too, Shoprite management has taken the fight to Woolworths with reimagined Checkers stores targeting upper LSMs and set the standard in food delivery apps with Sixty60. However, Shoprite is now trading on a PE of 22, while the broader food and staples sector trades on a pricey PE of 25. There’s one outlier though, and that’s Spar (in orange), trading on a far more reasonable PE of 13,5. So is Spar the ideal opportunity for a contrarian investor looking for value or is this business cheap for a reason?
About Spar
The Spar Group Ltd was founded in 1932 and operates as a wholesale warehousing and distribution business. Through their voluntary trading model Spar services both corporate operated and independent retailer stores, both of which are branded as Spar stores or various other group retail outlets. Their retail outlets span Southern Africa, Ireland, Switzerland and more recently Poland. The company offers products ranging from fresh produce and ready-to-eat meals all the way to building and hardware products. They currently operate 4 459 stores with a variety of formats such as their one-stop bulk shopping outlet “SUPERSPAR”, “Spar Express” petrol station convenience stores, “Tops!” liquor stores or even “Build it” home building supply stores to name a few.
Earnings
In 2021 Spar generated R127m in revenue, up 3% year-on-year from 2020’s R124m. This growth is a continuation, albeit at a lower rate, of the consistent topline growth Spar has been able to demonstrate over the last 5 years with a CAGR of 6%. Net income performance has been even more impressive, growing 13% in the last year to R2,2m and continuing a 5-year CAGR of 4%. The one blemish on this impressive track record was 2020, which saw profit after tax fall 10% YoY. This was somewhat understandable given the Covid-19 lockdown regulations which meant Tops liquor stores were unable to trade. However, what was avoidable was the acquisition of Spar Poland which contributed a further R153m in after tax losses.
Nevertheless, Spar has demonstrated their ability to generate reliable earnings growth over an extended period. In his book The Intelligent Investor, Benjamin Graham points out the importance of comparing a company’s earnings yield to that of an AA rated corporate bond yield. The intention is to ensure that the yield an investor earns is at least as high as what could be achieved by investing in a bond, a less risky asset class. Spar has an earnings yield of 7,3%, lower than the current AA bond yield of 9,9% and especially concerning in a rising interest rate environment that will see bond yields climb. In essence you’d be both earning a higher return and taking less risk if you invested in the AA rated bond.
An important component that affects the profitability of any business is the Degree of Operating Leverage (DOL). The higher the operating leverage, the greater the level of sales a business must generate to overcome fixed costs. Spar operates as a warehousing and distribution business in the food retail sector, meaning their level of capital-intensive equipment and machinery is relatively low. Spar’s DOL of 0,86 means that if they were to experience a 10% YoY decline in sales, net income would only drop by 8,4%. In effect decreasing the volatility of their earnings and the risk of investing in Spar. This is especially important as Spar is operating in an environment with slowing economic growth and falling consumer confidence due to rising inflation and interest rates.
Spar’s primary input costs are food, staff, storage and delivery costs. The invasion of Ukraine, a country referred to as the breadbasket of Europe, has left a global supply gap in sunflower oil, wheat and other key ingredients in food production. The disruption has led to food prices rising sharply around the world, and Spar is no exception. Food price inflation in South Africa is currently 6,2%, up from 4% pre-Covid. Arguably even more challenging is the rising fuel prices that impact Spar’s delivery operations. Brent crude oil futures are currently trading around $114 per barrel, up 70% from $67 a year ago.
Spar has maintained a stable 11% gross profit margin over the last 5 years. While not very high, this does provide Spar with some degree of pricing power and allows them to pass on a portion of their rising input costs to the consumer. In their half year results Spar reported internally measured price inflation of 4,4%, while their grocery sales only climbed 3,7%. This sort of margin compression indicates that they are struggling to pass on the full extent of rising input costs in this highly competitive sector with constrained consumer spending.
Business Cycle
The food retail sector is naturally defensive as the majority of goods sold are everyday household consumables. This is positive for any business operating in an inflationary environment and especially so in the South African context where unemployment is high, and consumer discretionary income is low. However, an element of cyclicality does exist due to Spar’s premium pricing relative to peers (Shoprite and Pick n Pay) which would see consumers switching to save even at the expense of a convenient shopping experience.
Industry Landscape
The South African retail food industry is highly concentrated among the four largest retailers, Shoprite, Pick n Pay, Woolworths, Spar and Massmart. Together they account for 80% of retail sales, with the remainder being contributed by the informal sector. Competition between the retailers is fierce, with consistent improvement to the instore experience, ready-made meals and recently a push to online shopping brought about by Covid-19 restrictions.
The introduction and rapid adoption of online shopping is a cause for concern for Spar. Their competitors Woolworths Dash, Pick n Pay ASAP and Checkers Sixty60 launched on average two years ago and have already impacted consumer behavior with many customers shifting their purchasing habits to Checkers Sixty60, a result of the superior experience. Meanwhile Spar has been held back by their independent retailer business model which has meant they have only just launched their app “Spar 2U” which is available in specific areas for now. The danger is that this may be a case of too little too late.
Finally, for many decades South Africa’s largest supermarket chains have prevented one another and smaller grocers from opening stores in the same shopping malls through exclusive lease agreements with landlords. In 2020, the South African Competition Commission eliminated the use of this practice on the grounds that it is anti-competitive. This ruling is likely to lower the barriers to entry for SMMEs and further increase the level of competition and vulnerability of large retailers such as Spar.
Moat Trajectory
Spars best defense to this growing threat is their focus on convenience. Spar has the most stores in urban residential areas in South Africa, nearly twice as many as their nearest competitor. Spar specifically targets customers that require quick shopping, such as those on their way home from work.
The second largest contributor to their economic moat is the flexibility that their voluntary trading model provides store owners. Retailers can stock their store to meet the specific needs of their community, which unlocks added value for customers and breeds improved customer loyalty. In addition, because stores are typically owner managed there should be a greater focus on the success of their store and emphasis on increasing sales at a store level.
An important consideration when discussing economic moats is whether that advantage is growing. In the case of Spar there is no evidence that their moat is becoming more entrenched, if anything the introduction of competitor delivery apps may be diminishing the convenience factor offered by Spar.
Cash Flow
Cash flow is key to any business as cash is required to settle debts, reinvest in the business and return money to shareholders. Spar has grown its cash flow from operations by 5% CAGR over the last 5-years and generated R1,7bn in 2021. The company generated a cash flow from operations to net income ratio of 0,8. Indicating that earnings are not especially cash flow generative and not as high quality as that of their competitors.
Balance Sheet
Spar’s balance sheet is highly leveraged, with R52bn in assets and R43bn in liabilities. Their debt-to-equity ratio of 2,89 is far above what many value investors would consider an acceptable level of risk. Spar has recently committed to implementing a new SAP system to optimize their supply chain and replace aging systems. This project comes at a R1,8bn cost and could run over budget. Spar management has commented that the project would be funded with debt, which would further elevate their D/E to 3,1 and lower their interest coverage to 3,04 times. Higher debt levels increase the risk of a business being unable to pay their debts should difficult trading periods arise.
The quality of Spar as business is also doubtful given their ROIC of 10,1%, which is just barely higher than their WACC of 8,3%. This highlights that management has not been effective in putting the capital under their control towards profitable projects that will generate a return greater than the cost of capital. In other words, Spar creates just 2c of value for every R1 invested, indicating that this business may be a value trap. Its important to note that ROIC has declined from historic levels with the introduction of IFRS 16 required finance leases to be included as a liability and this as invested capital in ROIC.
Dividend
Key to many value investors is assessing a company’s ability to pay dividends. Spar paid a dividend of R8,16 in the most recent year, providing a reasonable dividend yield of 5,1%. To put that in perspective the JSE average is closer to 2%. However, management has indicated that in the coming two years the dividend paid will be halved to provide the necessary cash to fund the SAP upgrade and expansion in Poland.
Management
The importance of evaluating the quality of management may seem of little importance when a business is performing well. However, when a business is in a difficult situation, it’s much easier to have confidence in the long-term prospects of the business if its clear management are the right team for the job. One important aspect to inform this opinion is the level of management turnover. Spar recently appointed a new CEO, Brett Botten, who has 27 years of experience at Spar and was previously the MD of Spar South Rand. However, time will tell whether he is the right person to lead the company and any appointment of a new CEO raises some questions around their suitability. Group CFO, Mark Godfrey has held his position since 2010 and joined Spar in 1996, providing additional stability at the top.
Another key measure of management is their ability to guide a business through periods of adversity. In Spar’s case Covid would certainly prove to be a period of adversity which management did well to respond and adapt to. However, the greatest adversity they face is likely their current expansion into Poland and efforts to turnaround those operations. If Spar is successful in this endeavor they would have displayed impressive capability in overcoming adversity.
Valuation
As mentioned in the introduction Spar is currently trading on a relatively speaking reasonable PE of 13.5, especially when compared to peers which fluctuate closer to 20. However, what is potentially a more insightful comparison is Spar’s PE over the last 5 years. On this basis Spar has a long run average PE of 18, which declined in the most recent period to today’s PE of 13. However, in my view this share has rerated to this lower multiple as a result of their heavy debt burden.
To gain a better understanding of Spar’s true intrinsic value a DCF has been performed based on the following assumptions:
Revenue Assumptions
South Africa
Stores
Store openings in 2021 were low due to store closures in response to the KZN riots. Excluding 2021 year, the historic average growth rate has been 4%, which has been used to project the rate of store openings over the next five years with some tapering as store saturation rises. Management has confirmed they have a strong pipeline of new stores.
Price Inflation
Historically food price inflation is around 4%, now in 2022 it is materially higher at 6%. Fuel prices are also high in the short term, and as Spar is mainly wholesale business this has a material impact on transport costs. Price inflation is expected to return to long term average by 2024.
Same Store Sales
Historic same store sales have been negative. In 2020 this was due to Covid regulations limiting liquor store sales. In 2021, 180 stores were closed for several months due to damage form KZN riots.
Spar will likely lose market share in the short term until the Spar 2U delivery app is available. Food retail is a defensive product but as Shoprite offers more affordable pricing than Spar inflation will lead to a short-term decline in demand as customers move down market.
In the long term this will revert, and Spar could grow with the SA population growth rate of 1,3%. However, adding further stores will lead to some cannibalization and act as a drag on the same store sales growth rate.
Ireland (BWG)
Stores
Little management guidance was provided. Therefore, store growth rate is expected to continue at the historic long term average growth rate of 1,4%.
Price Inflation
UK food inflation is on average 2%. In the short term a sharp increase to 6% is expected due to the impact of the Russia-Ukraine war on the ability for Ukraine, a major grain exporter (20% of global wheat supply) to continue production. In the long term I suspect other producers will reduce this deficit and normalize inflation to 2%.
Same Store Sales
Inflation and transport cost headwinds (a result of limited truck driver availability) saw sales drop in 2021. This will lead to slower revenue growth in the short term, reported at 7% in the half year results. However, the long-term average growth rate in same store sales has been 6%, which can be expected to continue.
Switzerland
Stores
Good growth in stores in the most recent year due to 60 new petro-convenience stores "Spar Express" opened. Management has indicated continued expansion of store footprint through EUROSPAR. I conservatively expect future store opening at the 3-year average rate of 3,5% which excludes the 2021 outlier year.
Price Inflation
Historic trends indicate that food price inflation is generally low at 1%. In the short term a food price inflation spike is expected due to the war in Ukraine and supply chain shortages. Long term inflation is expected to normalize at 1%.
Same Store Sales
A temporary decline in same store sales is expected as Covid restrictions created a momentary increase in customers shopping at local convenience stores during 2020. However, with lifting of restrictions customers are now returning to larger stores such as Coop & Migros. In the long-term same store sales growth will continue to be impacted by cross border shopping, a result of the high cost of living in Switzerland. Thus, the retail market continues to experience low economic growth estimated at 0,3%.
Poland
Stores
Total revenue growth reported in 2022H1 results was 4,8%. Of this store growth contributed 2,8% with 4 new petro-stores being opened, and full year opening conservatively estimated at 6 stores. Despite this management has stated they are targeting 30% more stores in 2022. Assuming management can achieve just half of this target the store growth rate is estimated at 15% a year.
Price Inflation
Trading economics, his indicated that Poland is facing high food inflation right now. However, Poland has a historical base of 4%, which I will assume for the long-term starting in 2024.
Same Store Sales
Spar Poland has struggled, with pandemic related setbacks. Looking forward they have required independent retailers to improve loyalty and grow their Spar supplied purchases with a target of 50%, current loyalty is 30%. However, the high price inflation will result in decreased sales as clients go to larger, lower cost warehouse stores and avoid convenience in the short term. Nevertheless, improved loyalty should see same store sales grow at least at 3% until 50% loyalty is reached.
IFRS 16 Adjustments
Capital Expenditure was forecast by splitting Spar’s historic capex between maintenance capex and growth capex. Both of which were projected using an average of the past % of revenue that they constituted. However, the maintenance capex only used the last 2 year average as this takes into account the IFRS 16 impact on depreciation.
The change in Net Working Capital was forecast using Spar’s cash conversion cycle components to determine the expected accounts receivable, inventory and accounts payables. While other current assets and liability components were again based on their % of revenue over a 5-year average.
Intrinsic Value
After concluding the above-mentioned assumptions, as well as a WACC of 8,3% (which uses a Bloomberg sourced 5-year Beta for Spar of 0,46) and an expected long term growth rate of 1,5%, conservatively below the South African expected GDP growth rate of 2,1%. The intrinsic value that this DCF arrives at is R102, 54% below that of Spar’s R158 market price. As a value investor I look for a margin of safety normally in the region of 30%, in this case that is not possible and thus Spar is not a buy at these levels, especially given their high level of debt.
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