Dis-Chem vs Clicks

The listing of Dis-Chem on the JSE this Friday seems to have captured retail investor attention in a way that few other recent market debuts have. One assumes that this is simply because we all understand the business: big box pharmacy and health (and most of us shop there!).

It is important to note, however, that the listing of Dis-Chem is not an offer to the public. It is placing shares with “selected institutional investors” in South Africa, “qualified institutional buyers” in the United States and selected institutions in other territories. This means that any retail investor will only be able to buy shares on the morning of listing (ie Friday). Generally, if demand is robust, this will mean the price will trade at a premium to the “offer price” at which institutions will have subscribed to the offer. This price, which will be disclosed tomorrow, is anticipated to be between R16.25 and R20.25 per share. So, for example, Dis-Chem could open on the market at >R20 per share, even if the offer price (which institutions bought at) was only ±R18.

¹ As at 29 February 2016

² As at 31 August 2016

³ Pharmacy equates to 27.3% of the ‘Health and Beauty’ business, comprising Clicks, The Body Shop, GNC and Claire’s.

⁴ As per disclosure by Dis-Chem in its pre-listing statement which relies on certain data from Clicks’ 2015 annual report.

Source: Dis-Chem, Clicks financial reports; author’s own research

With just under 20% of the pharmacy market each (for a total of <40%), there remains significant room to grow for both businesses.

Since the removal of restrictions on pharmacy ownership in 2003, corporate ownership became possible and consolidation followed. In the retail space, Dis-Chem and Clicks compete alongside The Local Choice (‘TLC’, in which Dis-Chem owns an indirect stake), Alpha Pharm, MediRite, Pick n Pay, Spar and independents.

Source: Author’s own research

Given the continuing trend towards consolidation, Dis-Chem says in its pre-listing statement that it has identified more than 100 opportunities for new stores from market research. Between August and end-February 2017, it will open eight stores (after opening three in the first-half of its financial year). This rate will accelerate, with “at least 18 stores” expected to be opened during its 2018 financial year (March 2017 to February 2018). It “intends to open 15 to 20 stores per year in the medium term” and has a stated “goal of doubling its store footprint over the next five to eight years”.

By comparison, Clicks aims to open between 20 to 25 new stores in the next 12 months (extending its footprint by around 4%), with a target of 30 to 35 new pharmacies (including conversions of existing stores).

In a research note on Dis-Chem published on October 31, Anchor Capital chief investment officer Sean Ashton says “the return on capital on new stores is exceptional. A typical store should cost R20 million (capex and initial working capital) and contribute ±R12 million in EBIT within four years (>60% ROCE), with break-even coming within one year. To put this into perspective, this means that each year the group is adding an extra 15% to 20% (>R100 million PAT) to group profit potential at store maturity from new openings alone. So, while new stores might initially lose money, the group also has previously new stores maturing every year (hence those losses are falling out of the base).”

He sees “further market share gains in the years ahead, driven by maturation of existing stores (1/3 are not yet mature) as well as a robust new-store pipeline”.

But, Anchor’s “key gripe with the business is its inferior cash-flow generation compared to Clicks… [but] Further scale could possibly resolve this issue… This may seem an unfair comparison given Clicks’ exceptional cash-conversion profile, but it is nonetheless worth pointing out that Dis-Chem appears to have a slower-moving stock cycle, and it also doesn’t have quite as favourable creditor terms as its peer.”

Source: Anchor Capital (from Clicks Group financials and Dis-Chem pre-listing statement)

¹ Calculated as average of last 3 financial years. Defined as EBITDA less working capital changes divided by EBITDA

“The above cash conversion profile highlights that it would be challenging for Dis-Chem to sustain a dividend payout significantly more generous than is currently mooted,” argues Ashton, “unless 1) working-capital days improve; and 2) the growth profile of new-store openings slows materially. It is also worth pointing out from [the table above] that, despite a higher gross profit margin, Dis-Chem’s retail division operating margin trails that of Clicks by more than 100bps”.

Anchor’s view is that the valuation of Dis-Chem “is rich at a 12-month forward 22x P/E multiple (26x to Feb 2017), but if growth plans come to fruition, investors could still do well from this initial heady valuation level. Assuming pricing at the mid-point of the guided range, we prefer Dis-Chem to Clicks and would advocate a switch.”

Source: Anchor Capital

* Hilton Tarrant works at immedia. He can still be contacted at hilton@moneyweb.co.za.

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