A bit­ter pill for Dis-Chem share­hold­ers

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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.


The large size of Dis-Chem stores and the range of their prod­ucts make them good for shop­pers

Clicks has more stores than Dis-Chem and trades well on their con­ve­nience fac­tor

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