Disclaimer: I intend to soon purchase Pepco share, through a company I control, and I am likely to increase this position in the future. This article is for educational purposes only, please do your own diligence, as this does not constitute investment advice. Full disclaimer can be found HERE.
This blog is dedicated to identifying large market miscalculations and cycles, and profit from it. An obvious one was energy, and as a result, I ended talking about oil, gas, coal, and such a lot more than I initially expected.
Energy shortage and policy mistakes have been especially concerning in the EU. In Estonia, where I live, electricity prices have skyrocketed to the point of being essentially unaffordable for 10-30% of the population, while outside temperatures reach -20C (-4F). Just look at the hourly price a few days ago. Most of the prices are x15, and even x30 at peak consumption.
And it is not simply a spike one day. The monthly average power price is x2.8 higher year-to-year. It is likely to be x3-4 for December. New record prices are x4 higher than any other previous historical price.
Eesti Rahvusringhääling | ERRERR
This is simply not sustainable. Energy prices will need to go down or the economy will grind to a halt. Already, fertilizer production is paused all over the continent and this will have far-reaching consequences for the Eurozone inflation when it starts impacting agricultural yield and food prices. The 2 tend to correlate pretty closely, and food prices still have to catch up, while fertilizer prices take-off is not over yet.
I could not find a good graph of EUfertilizer prices, but if the North American one is there, I can guess how bad the EU prices are getting, with gas x5-4 higher than in the USA.
Beyond investing in energy companies, I struggled to figure how to benefit from it. Fertilizer companies unable to produce will not necessarily benefit from exploding fertilizer prices and shortage. Food producers with exploding costs and decreasing yield will not benefit either.
I imagine food production that requires no fertilizer can be an option. For example grass-fed cattle. But it is rather hard to find a publicly traded firm fitting this requirement. Most large agribusinesses tend to fatten their animals with grain and cultivate with large fertilizer needs. I am welcoming any stock suggestion that could be used in that context.
Second-order effects
So instead of focusing on the first-order effect, high cost for energy and fertilizer, I decided to look at the second-order effects. Â No matter how it plays out, a direct consequence will be a larger portion of Europeans' income going to necessities like food, power, and heating, instead of services and goods. This does not bode well for most EU retailers hoping to get more activities once the new wave of lockdown stops.
There is however a sector that is very likely to benefit from this trend. Discount retailers, or discounters. Already, discount retailers have been on an ascending trajectory for the last decade, with the likes of Lidl, Aldi, etc... taking growing market share. It is not any more "shameful" for middle-class buyers to shop there.
You can also see the share of food discounters in the German sector. Growth mostly flattened around 2009, but seem to rebound recently, in Germany and Europe in general. For example, UK discounters are expected to grow revenues by 6% next year.
Generalized inflation pressure combined with energy and food price shock will allow them to restart growing. The middle-class consumers will have to change purchases habit, and the lower class will shop exclusively at discounters.
Hard to find a target
Unfortunately for investors, both of the leading European companies in the sector, Lidl and Aldi are private companies. And their owners are happy to keep it that way.
When looking for a discounter, I also ideally wanted one that is still getting started. large enough to be a safe bet, but small enough to have a lot of growth potential. This would give me better chances to replicate what shareholders of the leading dollar store chain in the US have been doing, cashing on a 10x+ bagger in a little more than a decade.
As a side note, it is probably significant that the American dollar shops are giving up on keeping their good prices at 1 dollar and finally rising their price tag (by no less than 25%) for the first time in 35 years.
And this is when it hit me. I did know very well a discounter that was expanding very quickly but still had a lot of room to grow.
One where I and my family were very regular and very happy customers.
And also one that almost no one in the US or Western Europe is likely to have heard of. At least not yet.
I am speaking of the little-known clothing and family goods hard discounter called Pepco.
Pepco background
First I should clarify that I had already looked at Pepco as a possible investment something like 2 years ago. I was aiming to take a page from Peter Lynch's book and follow the "Buy what you know" advice.
Unfortunately, at the time the company was part of a conglomerate that looked mostly unprofitable, with several declining brands dragging the rest down. Its Pepcoholding was attractive but the rest was of much lower quality. I was not ready to also buy a lot of garbage just to hold onto Pepco, so I shelves the idea and forgot about it.
Luckily, and with the poor market timing you can expect from a poorly managed conglomerate, Pepco got recently IPOed. The Steinhoff International conglomerate is still owning 78.8% of the Pepco Group.
Frankly, if there is one black spot in Pepco it is that. So far, Steinhoff did not interfere with Pepco's growth, but I would like to see the links with the conglomerate totally severed if possible. Until then, poor decisions making or pressure by the majority shareholder will stay a risk. With some luck, Steinhoff will keep selling away its best holdings; it seems to be planning to also sell parts of its American MattressFIRM business. Â
For reference, here is a quick overview of the Steinhoff International holdings
Pepco since IPO
Pepco is now trading in the Warsaw stock exchange. I realize this might be an issue for many investors to find a broker offering the share. You can see more data here: https://www.marketscreener.com/quote/stock/PEPCO-GROUP-N-V-123219057/
At the same time, a less known stock exchange is often the occasion to find undervalued companies that were ignored by international analysts. I see Pepco as a buy-and-forget compounder, so I do not care about todays' market lack of attention. In 10-15 years, the growth of the business and cash flows will be what matters, not the market mood. Â
It seems the IPO price was a little enthusiastic, and the price quickly stabilized down at around 10 EUR. It is also climbing back up steadily for the last few weeks. I would not be surprised I am not the only one realizing the potential of a hard discounter with quick growth in this economic context.
The Pepco consumer experience
I will provide an overview of the business from its financial report and presentation and so on, but I wanted first to share how I, myself, shop at Pepco.
You see, I am 34, married, with a 3-year old boy. This means a few things:
permanent lack of time for shopping, between work and kindergarten trips
need to buy new kid clothes continuously
cheap price is valuable as the family budget is not infinite
So since it opened and we discovered it, Pepco has become my wife's favorite shop. She usually goes there 1-3 times per month and buys 20-50 EUR each time. This includes baby pajamas, toys, batteries, candles, etc... While she mostly goes there when we need something for the kid, she usually also comes back with some clothing for her or me as well. Usually at a 5-7 EUR price tag per item.
Ok so now you know I am cheap. Not so surprising for a value guy I guess... Â
But here the thing, according to my wife, the products' quality is not different from H&M, Zara and co. Kids' clothing might or might not have some Harry Potter branding or other licenses at no extra cost.
Overall the clothes last at the very least as much as the ones from more expensive shops and look as good. I suspect even a little better. And cost half or 1/3 compared to other shops.
Beyond the core of the shop, clothing, I mentioned toys and house items. Those are also good value, I would say -25% to -30% to the supermarket 100m away, in the same shopping mall. But mostly, because you are in such a good mood from the great price of what you were looking for, you are a little price-insensitive to the rest.
So when considering if we really actually need another plastic truck or candle for Christmas light, you decide that you can afford the extra 10 EUR spending. Or you remember you need batteries for all the toys, etc...
These extra items are something like just 25% of the shop space, but 43% of Pepco shops turnover. "Come for the clothes, leave with candles, batteries, and whatnot". Â
It is a great way to increase the average shopping cart with high turnover products. It also makes Pepco the shop you go to for sure, as you know you will get good deals on the stuff you kinda need or will need at some point. Essentially, if you don't go often enough, you will have to buy that stuff somewhere else, and it will cost you more. So you get into the habit to drop by every other week and buy in advance. Â
This kind of customer experience is great for 2 reasons.
First, cheaper than most if not all competitors is never going out of fashion. This is the same strategy Amazon used to dominate online retail, by focusing on what does NOT change, including customer preference for cheaper prices.
This is especially true if the shopping experience is still pleasant. The shops do not look like Costo but a regular cloth shop. Actually, until you pay more attention or look at the label, you wouldn't know it is a discounter.
Secondly, the extra cheap consumable items and the certitude of a good deal create a visiting habit. And make you compare every other shop in the country to Pepco. The reflex in my family when in another shop has become, in less than 1 year since we discovered the brand, "we should check if we can buy it at Pepco instead". Usually, we can, and it is indeed cheaper.
The branding is also right on point, and it's clear they know their ideal customer: a 30+ year-old woman, with kids likely below 10 years old. She can come to browse and buy without ever feeling it is stretching the family budget.
Or as the company itself express it "Mum on a budget".
Once again, with wallets depleted by stunning electric bills and soon groceries, this feels nice to be able to buy without worrying about the bill.
The Pepco group
I have put a strong emphasis on the Pepco shops, as it is the ones I know well and also in my opinion the best part of the group (and the biggest part of the group). The company has actually 3 different brands + a sourcing division.
Each of the brands has its own geographical area, with Poundland and Dealz in the UK+ Ireland+Spain, while Pepco dominates eastern Europe. The core of Pepco is in Poland, and the core of Poundland in the UK
Poundland shops are larger (400-1000 m2) than Pepco's (350-550 m2). The main offers are:
snacks/tea/coffee/soft drink
cosmetic /haircare
cleaning
pets
small electronics (headphones, cables, etc...)
They also offer a "Pep&Co" clothing section (basically an integrated mini Pepco in the Poundland shop).
The difference between Poundland and Dealz is that Dealz is a Poundland shop with an adapted offer to the local taste and pre-known brands, bringing the UK formula to Spanish and Polish consumers. Â
PGS: The sourcing department
With operation in China and the Indian subcontinent, this department is the reason why Pepco can afford cheaper prices. Not only the shops are relatively small and aim for quick turnover and frequent visits, but they get supplied without any middlemen taking a cut.
Notably, PGS provides 3/4 of the clothing of the Pepco shops and Pep&Co section of Poundland and Dealz. I imagine the last fourth is the Harry Potter and other branded pieces of clothing. PGS is also starting to investigate sourcing closer to its shops, in Turkey and Europe. The PGS department claim to keep tight control over its suppliers, having conducted 2000 factory audit since 2017.
This lead Pepco to claim a 50% gross margin, compared to the usual 25% of its competitors using a third-party sourcing model. I expect this lead to a slightly less flexible product line, which is not a problem considering Pepco's positioning on price, and not regular change in fashion.
On a side note, I haven't myself noticed supply chain issues at Pepco shops so far. Nor does the company give a warning about it. I suspect the 200,000 m2 of warehouses in Europe have been useful to stockpile ahead of the Christmas season. Direct shipment to store, eliminating carrier from the equation contributed too.
The only comment made by management was about rising shipping costs, that should be compensated by internal cost-saving. So Pepco product prices will not increase next year, in the context of generalized inflation. This will help grow the business and reinforce the competitiveness of the brand.
The company is also aiming to entirely remove all air freighting by 2021, both to reduce carbon footprint and cut costs. For the same reasons, all lightning will switch to LEDs this year. I have not seen ESG initiatives that could hurt margin, only the opposite, so it is good to see that management still have a keen eye on the main positioning of the company, cheap prices.
The company results so far
The company operates 3,200+ shops, with a total of 50 million customers/month. This makes 520+ customers/shop/day.
The total employee count is 37,000, with 600 at the headquarter. The headquarter seems to be large enough to support the operations but not bloated either. At 3000 shops, the group has the critical mass to invest and share the cost of the IT systems and supply chain. Both the CEO and CFO have done most of their career in retail, notably Walmart.
The solid gross margin and smaller shops are allowing a great payback time for new investment. In all markets, it takes less than 2 years for Pepco to get back its investment in new shops. ROIC is generally great, with still some improvement needed in some countries, notably Hungary.
As they are bigger, Dealz shops take longer, around 3 years to pay back. Still not bad, but I prefer the Pepco stand-alone shop metrics better.
Total revenues were at 3.5 billion euros, and EBITDA at 229 million euros. Revenue only grew at 3% in 2020, as Covid lockdowns closed up to 20% of the shops at one point. Managing to maintain some growth despite lockdown and a general offline retail carnage is damn impressive.
The company is also accumulating cash, with 400 million euros at the end of 2020, up from 247 million euros in 2019. Cash generated from operation jumped at 628 million euros, from 236 in 2019.
With any retail operation, I am always warry of excessive debt that could take down the ship in a downturn. Net debt is standing at 328 million euros and has been reduced by 133 million since 2019.
Again, impressive considering this was in the midst of the Covid pandemic and lockdown. At the same, I know I or my wife only went shopping there more during that period, so maybe not so surprising.
The accelerating growth
What I am looking for with growth
When it comes to growth companies, I require at least 3 elements:
A proven and durable competitive advantage.
A growing existing market.
Another growing, larger addressable market.
A maybe not cheap, but at least reasonable stock price.
Point 1 is obvious, as it is what makes the company able to perform well.
Point 2 is there to help the company grow regardless of its competitive advantage. This way if I got the competitive picture wrong, it might still be able to grow its revenue and income without growing its market share. This gives me some extra margin of safety beyond the business quality and its current price.
Point 3 is where most of the money can be made when investing in growth. If everything goes right and the business grows solidly in its existing market, it will also be able to expand in the broader, larger market, which is also growing.
Point 4 is obvious if you overpay for an investment, returns are going to be lackluster. Price matters, always. Quality and fast-growing companies are valued at a premium and it is okay, but this premium should still be rational.
Pepco Group today
Pepco's market position perfectly fits my criterion, and even better, the company has already realized it. It now considers the whole of Europe as its addressable market, and aims for the "8,000 new store opportunities identified". The existing markets are the ones growing the fastest but represent just a quarter of the whole addressable European markets. Â
For now, the growth is mostly coming from Pepco shop, with Dealz/Poundland essentially stagnating. The company is opening 400 net new shops this year, with 310 new Pepco, 70 new Delaz in Poland and Spain, and 25-30 Poundland and Dealz in the UK + Ireland. So the relative stagnation of the previous years for Dealz/Poundland is ending. Â
Pepco store growth is going to accelerate, with the recent entry in Serbia, Austria and Spain, and the incoming entry in Italy. The recent bankruptcy of several higher-priced retailers from Covid is also giving the Pepco group cheaper, previously unavailable mall spaces to open new shops. Â
Revenue growth is doing great and the Group is playing catch up after the missed the year of 2020. "In the year to September 30 the group saw revenue jump 19.4% at €4.122 billion year-on-year, led by the Pepco chain with 29.2% growth."
Expansion strategy
The group growth is clearly on an exponential trend. You can see each of the steps of the Group growth here, but what stands out to me is the accelerating shop count:
2004: first 13 shops in Poland
2007: the 100th shop opened
2014: the 500th shop opened
2016: the 1000th shop opened
2020: the 3000th shop opened
So I actually find credible management targeting 8000 shops in the medium term. They have clearly demonstrated their ability to scale up, and that was before a strong presence in the most populated countries in Europe, including the richer Western Europe ones. Â
The group expansion strategy is nevertheless remarkably disciplined. Only 1-3 new markets at a time, and consolidating the position before going after a new one. It also so far concentrated on the European periphery, leaving out the French and German market. Actually, with the UK, Spain, Italy, and Eastern Europe, the French and German markets are getting a little surrounded from the West, South, and East all at once.
I think this was a very sensible approach, as these markets have already a heavy presence of local and international discounters. So shops there are likely to be more expensive, less profitable, and take a longer payback period.
Nevertheless, I suspect the discounter segment of French and German retail is going to boom. Have you looked at French electricity baseload power prices recently? This is the price curve since 2008! There is no way this will not hurt consumers' wallets.
And the company's management took notice of the opportunity, with the recent surprise announcement of entry in the German market next year. I expect the Austrian entry also demonstrated the viability of the business model in "rich" german-speaking countries.
The future milestones
Here is what I expect regarding the group growth:
In the next 3 years:
Densification of the Eastern European market
Quick growth in the hard-hit by the pandemic Italy and Spain
Entry in the German market
A restart of the growth in the UK + Ireland
Tentative expansion in Portugal, Scandinavia, the Benelux region, Switzerland, or maybe even France
After 2025:
Aggressive entry in France, with Dealz in large urban center, Pepco in the rest of the country
Densification of Spain + Italy shop network
Densification of Germany shop network
Beginning of stagnation of Pepco growth in Eastern Europe
Extension of Dealz shops in new Eastern Europe capitals and urban centers.
Maybe expansion out of EU/Europe, either to North America or Russia.
Financials
For the long term compounders with a very large runway of unaddressed markets, competitiveness, profitability and an ability to scale quickly are the most important factor. But of course, the price of the stock still matters as well.
The company P/E ratio is pricey at 34. Even the expected results of 2022 would put the P/E at 24, a lot less expensive but still not cheap.
I mentioned it before, but debt is not a problem and the company will likely keep deleveraging quickly. I am nevertheless confident that the company is now reaching "escape velocity", with a critical mass of old and profitable shops to keep financing its expansion.
A good indication of that is the net profit, positive is 2019, and that managed to stay at 0 even with Covid lockdown and aggressive expansion-related investments. Even without any extra tailwinds for the discounter's business model, the growth in profitability would have been attractive.
Is the stock still a good buy at this price?
So am I still interested even at that price?
Yes.
I generally prefer deep value situations, like the Transocean/RIG I covered last month. With Pepco I am ready to adopt a different strategy for the following reasons:
Very good personal understanding of the brand.
Pre-existing quick growth.
Validated and simple business model.
Space for growing main active markets.
Large consumer market still unadressed (France + Germany + Benelux + Scandinavia is roughly 200+ million people).
Growth and demand of discounters supercharged by the ongoing European energy crisis (and soon, food prices rise).
Normally, I would have kept a stock like Pepco on my watchlist, waiting for a cheaper entry point. In my opinion, this is unlikely to happen as the rising European inflation will boost all discounter businesses, and make them a new investors darling very soon. The recent stabilization of the price stock post-IPO and its quite rapid rise might indicate this is already happening.
So to me, this is similar to buying Amazon at some "pricey" point, counting on the strong quality of the business to justify the price. I am skeptical of such a strategy for large-cap stocks that might not have 5-10 years of aggressive growth left in them.
In comparison, Pepco is still a relatively small-cap (6 billion EUR) listed in an obscure/out-of-favor stock exchange (Warsaw), and a business operating mostly in Eastern Europe. Each of these is a good reason to assume it is still out of the radar of larger institutional investors. Once the expansion in Germany, Austria, Spain, and Italy is more advanced, I expect a lot more institutional interest in Pepco.
Of course, remember this is just my opinion. You need to determine if a company like Pepco would fit in your strategy and portfolio.
I also expect that in the shorter term, there is a risk that inflation nimble at the profit margin. So some volatility is to be expected. Pepco is definitely a buy-and-forget long-term compounder, which I would not try to hold for less than 5 years, ideally 10-20 years.
But overall, I expect Pepco's competitors to suffer much more from rising prices and declining customer buying power. The decrease in margin should be compensated by an increase in sales volume and a strengthening brand. It is also likely that customer habits will change durably after they get used to hunting for cheaper prices, and this should benefit discounters in the long term.