Financial Mail - Investors Monthly
HARSH PRESCRIPTION
A bitter pill for Dis-Chem shareholders
Pharmaceutical company DisChem’s failure to properly guide the market on its earnings did not sit well with investors — but that is not their only gripe.
They are also concerned about sales and earnings and the company’s growth outlook.
Dis-Chem does not have much room for missteps, given, as analysts put it, that it is “priced for perfection”, at a forward p:e upwards of 30.
In the past month DisChem’s share price lost more than 12%, while Clicks, DisChem’s more experienced and larger rival, gained 15%. At the moment, the smart money is definitely on Clicks.
This is not what investors had expected. Dis-Chem’s listing in 2016 was welcomed as a strong alternative investment in the sector, and its earnings and growth trajectory was most promising, hence the high rating. But its results for the year to February were a surprise, and not in a good way.
Dis-Chem’s share price fell from R37.50 prior to the release of its results to endFebruary to below R30, and has picked up only slightly since then to current levels of R31.80. The beginning of the fall prior to the results, which is under investigation, indicates that some investors were privy to just how far off consensus forecasts the company’s earnings were going to be.
Dis-Chem reported a 6.6% rise in headline earnings for the year to February, way off the 30%-plus most analysts expected.
The reason was largely the wholesale business, which dropped from a R93m operating loss in 2017 to a R169m operating loss in 2018, taking into account the effects of an upfront investment in distribution capacity. This is not necessarily all bad, as it is an investment for the future, but it is not the only concern.
Another is growth. Sasfin Securities senior equity analyst Alec Abraham says comparable sales and volume growth, while still positive, reflects a slowdown from last year, while a similar slowdown is not evident in comparable growth at Clicks. Given that Dis-Chem is coming off a smaller base, its growth should have been even higher.
Comparing products, Clicks has a narrow and shallow merchandise range whereas Dis-Chem’s is extensive, cov-
Independents still maintain at least a third of the market. For retailers, pharmacies are not a focus but rather an add-on for the convenience of customers
ering a far wider range of conditions, making it, essentially, a better store from the perspective of customers. Yet Clicks is growing more strongly.
Abraham attributes some of the problem to Dis-Chem’s expansion strategy. He is wary about the placement of some new stores, and cites store openings in the adjacent Sandton, Morningside, Woodmead and Sunninghill, saying he does not believe these were accretive to sales due to the stores’ close proximity.
Another issue, he says, is competitive strength. Clicks has many smaller stores in neighbourhood convenience centres, which are giving it an advantage. Dis-Chem has been trying to develop its smaller TLC format, but has only two TLC stores (which appeared to lose out on the absence of its association with the Dis-Chem brand, though that is now being addressed).
“Dis-Chem is opening 20 new stores this year, half in smaller format, and I don’t know if that’s enough,” says Abraham. “Clicks has about 490 stores and is still managing to open double the number of Dis-Chem. To me it seems they are not doing enough, while Clicks is not standing still, and is taking the fight to Dis-Chem and making it difficult for them.
“Clicks opens 20 to 25 stores a year, but is opening 40 this year, and unless Dis-Chem does more, I think Clicks may easily run over Dis-Chem.”
In the six months to February, Clicks lifted headline earnings by 14% and opened a net 24 stores to bring its total to 646 stores. A net 20 pharmacies were opened to bring the total to 493. Dis-Chem opened 21 in the financial year to bring its total to 129.
Damon Buss, equity analyst at Electus Fund Managers, says Dis-Chem had indicated strong growth in its listing document and the consensus for 2018 was around 36% headline earnings per share growth.
“When the market is expecting an earnings level like that, while the stock is on a high P:E and it delivers 7% and hasn’t guided to that at all, the market will punish the company quite quickly.”
The big surprise, he says, is in the wholesale division, where losses mounted to R169m as the company increased its investment in infrastructure. There were some one-off issues — a humidity problem in Durban and timing issues in the Western Cape — which will be sorted out, but Dis-Chem has invested in creating capacity to grow into, and now it needs to turn loss into profit, Buss says.
It is also making an acquisition in the distribution business where it is waiting for competition commission approval, and if this is not concluded, break-even at the end of 2019 won’t happen.
“While they are very good at running their business, the complexities of operating as a listed entity are often better served by transitioning to professional management, a challenge that most family-started businesses which list have. Investor engagement is where they struggle in our view and they need to guide the market better.”
Yet there is a lot of expectation in the share price. “We think it is overvalued and we don’t own it,” says Buss. “At its high valuation, if you miss on earnings the market will punish you.”
Clicks is a good, well-run business with a clear strategy, Buss says. It guides the market well and consistently delivers. Clicks’ guidance is for low-teen earnings growth over the next few years, which is reasonable, but at a 33 forward p:e it is incredibly expensive, and Electus is not buying at these levels.
Daniel Isaacs, analyst at 36One Asset Management, says he was surprised at the size of the distribution loss which caused the “big miss” on the earnings number.
Dis-Chem is a good business, but obviously surprised investors with this, and investors are not comfortable with surprises on highly rated stocks, Isaacs says.
It is not all bad. Dis-Chem has opened warehousing space and sunk the cost now, which is positive, Abraham says. While it is burdened with a higher stock-carrying level than Clicks, due to its wider range, it is bringing stock days down. A lot of its stores are new and haven’t reached maturity, he says. There is still a lot of goodwill in the share price — a market view that next year will be better, but this is not necessarily based on the company’s current reality.
The pharmaceutical market, however, is geared to ensuring Clicks and Dis-Chem thrive.
Though diminished in number, independent pharmacies continue to operate successfully. Supermarkets such as Checkers, Pick n Pay and Spar have rolled out pharmacies at their stores but analysts do not see these as a threat.
Isaacs says independents still maintain at least a third of the market. For retailers, pharmacies are not a focus but rather an add-on for the convenience of customers. “In terms of market penetration, they are not an issue.”
Buss says Clicks and DisChem have 45% market share between them, with the balance sitting largely with independents. Supermarkets’ share remains very small. He believes the costs of regulation and the buying power of the two big groups will continue to squeeze out independents.
Both have lots of space to grow, he says. “Both are great businesses”, and the threat of supermarkets will remain low. At Dis-Chem and Clicks, baskets are getting bigger, they will continue to benefit from the increased focus on healthy living and health products and their pricing is better than retailers can get.
Loyalty programmes are vital, with the amount of data they collect being a huge competitive advantage.
“I think the market is there for Clicks and Dis-Chem to share,” says Abraham, “and we will see others lose out to the two operators.” Both businesses are good and will continue to take market share, and that is why there is a premium in their valuations. But even by international standards, their valuations are high.”
Analysts agree Dis-Chem is a well-run business with some attractive competitive advantages, but it has not made the leap from family business to listed company and the responsibilities and challenges that go with it. Being “priced for perfection” and coming up short is the net result.
Dis-Chem will have to show its mettle if it wants to justify the investor faith it asked for.
Dis-Chem did not respond to requests for comment.