Weighing up Massmart

Its recent poor trading update does not bode well for the retail and wholesale sectors, writes Marcia Klein

Massmart’s May 24 trading update, when the share fell 18% in a day and contributed to its decline from R165 in mid-April to R116 now, is not just of concern to its own shareholders.

It is also a sign of things to come from the consumer-facing retail and wholesale sectors this year.

Deflation, economic contraction, higher Vat and escalating petrol prices and an increasingly competitive and saturated market will affect retail and wholesale results — and share prices — for the remainder of the year at least.

Without meaningful sales increases, companies have been left with cost reduction as their only viable response, and that can go only so far.

Massmart’s hopes for improved sales momentum in 2018, expressed earlier this year, have not materialised, as improved confidence after Jacob Zuma’s resignation has not translated into more spending by lower- and middle-income consumers.

For the first 19 weeks of the 2018 financial year, Massmart’s sales grew just 0.8% to R31.4bn while comparable sales were down 0.5%. Geographic diversity made little difference, with sales growth in SA at 0.8% and sales outside SA dropping marginally.

The problem was largely in food sales, where deflation played a significant role in the 2.3% decline. Deflation, as well as customers prioritising food, clothing and transport over big-ticket items, also bit into durable goods sales, which increased just 0.2%.

Liquor (6.9%) and home improvement (6.1%) recorded relatively strong sales.

Massmart’s biggest problem appears to be in its Massdiscounters division (Game and DionWired), where sales dropped 6.2%, and it is this area of its business which worries analysts most.

Massmart is relocating most of the Game head office from Durban to Johannesburg this year and will cut staff, costing it R116m. This division’s earnings before interest and tax loss will be R150m-R170m in June.

Masscash (the wholesale division and retail including CBW, Jumbo Cash & Carry, Trident, Shield, Cambridge Food and Rhino Cash & Carry) sales were marginally negative, and similar rehabilitative actions to Massdiscounters will cost this division R50m and result in a small loss to June.

Among the group’s better performers, Masswarehouse (Makro and The Fruitspot) sales grew 5.6% and Massbuild (Builders Warehouse) 6.1%.

The biggest concern, according to analysts, is a structural issue, where these performances look set to be dragged down largely by Game, which cannot seem to find its place in SA’s retail landscape.

The bottom line is investors can expect a 36%-46% decline in Massmart’s headline earnings, or a 58%-68% decline in restated earnings, including restructuring costs of R112m.

The problem, says Sasfin senior equity analyst Alec Abraham, is that for close on a decade the economic environment has not been supportive of a business model premised on high volumes and low margins in an environment of steadily rising inflation.

Given these circumstances, there’s not much it can do except control costs, which Abraham says it has done well. He was previously forecasting 3% revenue growth for this financial year, translated into bottom-line earnings growth of 5%. The trading update’s turnover increase of 0.8% takes the bottom line to minus 17%, says Abraham. “This speaks to how the business is structured for high volumes.”

The reality, he says, is that management runs the business well, is tight on costs and has taken defensive steps, but none of this is enough given the economic environment of the past few years — and possibly the next year or two at least.

“Bottom line, we need jobs, and as long as GDP is growing at less than the population growth rate, we are becoming poorer, and the retailers are going to be under pressure.”

Electus Fund Managers equity analyst Damon Buss says Massmart is relatively

Management runs the business well, is tight on costs and has taken defensive steps, but none of this is enough

exposed to commodity food products, and with deflation volumes haven’t recovered nearly enough, which affects businesses in the retail sector, where costs are relatively fixed and escalate due to inflation.

In 2017, Massmart did well to take costs out of the system quite quickly.

“If the tough sales environment persists and Massmart cannot pull more costs out, the razor-thin margins in some divisions . . . could easily go negative, resulting in a larger decrease in headline earnings per share than is currently expected.”

Massmart is also dealing with changing consumer behaviour. An increasing number of people research and order goods online, and while Massmart increased online sales by 66% it remains a smaller player online. Big retailers are finding it difficult to compete with their largeformat stores that many people no longer need to go to to make their purchases.

Buss is not convinced the food offering in Game stores works. “Game is not where people go to do a grocery shop, and it is giving up floor space to low-margin products.”

Massmart may also struggle because informal traders are getting bigger with better buying power, and increasingly going directly to manufacturers to get good deals on products while they do not have large retailers’ costs like head offices and other legacy cost centres.

Evan Walker, fund manager at 36One Asset Management, says Massmart has two excellent formats — Makro and Builders — which are virtually unchallenged in the market, with a definitive customer base and a good price offering.

“With Game, however, I don’t know if it even has a place in SA.”

Walker says a large proportion of its product range can be bought in a supermarket as big retailers have been overspaced and expanded their general merchandise ranges.

“Game has done the opposite — it has increased food and shrunk general merchandise and has struggled to find a definitive space in the retail market. It has never been a destination shop you had to go to for half your shopping requirements, but rather for things you only get every few years, and it is difficult to see how it can fix that.”

Walker says the cash and carry market is saturated and competitive, with cut-throat pricing. Established retailers have moved into cash and carry while independent wholesalers are semi-retailers. “It has all become quite hybrid and those markets have become efficient — now it is all about price.”

Without an obvious solution for Game, or for any immediate or meaningful change in consumer spending, Abraham expects the group to continue focusing on costs, on trying to make Game more relevant, and on continuing to expand into Africa outside SA, where it remains a relatively small player, with about 40 stores.

“There’s not much else they can do but try work around an environment of lower volumes. SA businesses have been geared largely to work only in inflationary environments, so deflation is a curve ball.”

The problem with Massmart’s update is what its situation indicates for the retail and wholesale sectors in general.

Walker has been negative on the retail sector for the past three years.

“The market is utterly saturated, and there has been an onslaught of new shopping centres, strip malls and standalone stores.”

He says retailers have been aggressively increasing space for years, even decades, and now they are all competing on price to grow sales in a lowvolume environment.

Given the economic backdrop, most have done well to cut costs.

“On global comparative margins, they have done a remarkably good job up until the end of last year, but now that’s over,” Walker says. “They have done most of what they can on costs in this very saturated consumer environment, but now there is upward pressure on costs.

“If their costs increase 5% or 6%, they are going to need sales growth far north of that, and the market is just not strong enough to keep supporting that in perpetuity.

“In fact, they are still expanding space on the premise that the consumer environment is going to turn, but we are just not creating jobs and consumers are still distressed.” There are some signs, like debt levels coming down, which make it look like things are improving for consumers, but there are others, like the fuel price, which indicate otherwise.

Buss says food retailers are moving past deflation, and any inflation should be good for them, but it depends on the retailer. Apparel remains tough, with Truworths seeing no improvement in sales since its December interims. DIY market sales appear to be holding up, while liquor sales continue to exceed expectations.

Buss says Electus has Massmart on hold. “There are still downside risks and we don’t see enough upside to change our view. We are happy to sit and watch at the moment.”

Massmart’s earnings have been “flattish for years”, says Walker. 36One is not invested.

“It hasn’t really grown, and from here on out, does it have the ability to grow earnings at a better rate? I don’t think so.”

He says the group has two very good businesses and two that were dragging on the bigger group. “I cannot see a way out for them. If they spun out Makro and Builders tomorrow we would buy.”

*Massmart declined to comment.

Massmart has two excellent formats — Makro and Builders — which are virtually unchallenged in the market, with a definitive customer base and a good price offering.