SPAR’S FAILURE TO LAUNCH
It was once punted as an imminent hit for investors, but Spar’s inability to fix its overseas businesses quickly has hurt it. And since it cut its dividend by 50% last month, its share price has shed 14%. But, analysts say, this was the lesser of all evils
here may be a friendly Spar wherever you are, but there aren’t many happy investors in the supermarket group right now. To see why this is so, consider a cautionary tale, barely eight years old, of another retailer gone wrong.
Back in 2014, Woolworths CEO Ian Moir told shareholders that for R21.4bn, the board would “create a leading southern hemisphere retailer” and “become one of the top10 global department store operators”. All shareholders had to do was give their stamp of approval to the purchase of David Jones, an iconic Australian clothing retailer.
Unfortunately, excited shareholders voted overwhelmingly in favour of the deal.
It was a disaster. By 2019 Woolworths had been forced to write off almost R12bn of that purchase price, and a few months later Moir had been elbowed out.
But the ill-considered David Jones acquisition has ended up being about more than the loss of billions in investors’ funds. Eight years on, Woolworths is still distracted by the need to ring-fence the David Jones albatross.
It’s a nightmare scenario that haunts many a JSE executive team and its investors.
Only a few months after Moir made his big announcement in 2014, Spar’s then CEO, Graham O’Connor, revealed that his group had bought 80% of BWG Foods, which owns the Spar group in Ireland.
It was an announcement shorn of the razzmatazz of the Woolworths deal — appropriate, perhaps, given that it was valued at just over R4bn by comparison. And, as you’d expect from O’Connor’s less flamboyant
Spar team, there were no lofty promises of moving into a global league.
Spar has always been a little different from other retailers in SA. For a start, unlike Shoprite or Woolworths, Spar doesn’t own the stores bearing its name. It runs a whole
T
sale business, selling products from its six distribution centres to the 2,000 Spar, Tops and SaveMor franchise stores.
But that doesn’t mean Spar is any less ambitious than its peers.
In his 2014 annual report, O’Connor said that when the BWG opportunity came up, “the board and management quickly realised its potential, given that Spar had international expansion aspirations and was challenged by the tight retail operating environment in SA”.
He gushed that the Ireland business was “founded on similar values” and now that the Irish economic downturn was a thing of the past, BWG’s management was keen to “grow the business, improve efficiencies and optimise its financial performance”.
The pros of the deal, Spar said, were many: it diversified the revenue stream geographically, it gave Spar earnings in euros and it bulked up the scale of the company.
What wasn’t to love? It was 2014, after all, and SA investors were terrified of the havoc being wreaked on the country by then president Jacob Zuma. Shunting assets offshore, whatever the cost, seemed like a smart idea.
Fast forward to 2016. No doubt encouraged by the support of its investors, and sluggish trading in SA, Spar pulled off a similar foreign coup when it paid 44.5-million Swiss francs (CHf) for a 60% stake in Spar Holding AG in Switzerland.
O’Connor touted it as an “attractive investment opportunity in a familiar business with solid growth potential”.
The Swiss business had been struggling. But Spar’s investors bet that O’Connor’s team would have the financial muscle and nous to pull it right.
Three years later, in 2019, Spar SA reckoned it was time to try again. This time it was Poland that offered enticing macroeconomic stability “with ongoing government fiscal stimulus, a low unemployment rate and a positive consumption environment”.
So Spar bought Polish wholesaler Piotr i Pawel out of business rescue for €1 and took on its debt, which has grown to R1.3bn. It was sure it could haul it out of the sick bay.
This time, it miscalculated.
A debt straitjacket
It’s perhaps unsurprising, given SA retailers’ grim track record outside the country’s borders, that things have not gone quite according to plan for Spar.
CEO Brett Botten, who took over from O’Connor in March 2021 after 25 years in the business, will no doubt point to the fact
that Spar has seen its operating profit grow in Ireland and Switzerland, even if Poland is still in the red.
And unlike many of its peers who ventured offshore (think Woolworths, Pick n Pay, Truworths and Mr Price), Spar hasn’t been forced to take any major write-offs or flog assets at knockdown prices.
But Spar’s debt is now R8.7bn (R10bn if you add in overdrafts) — more than double its R3.39bn operating profit. While you might not describe this as “crippling”, it’s certainly a straitjacket, limiting the company’s operational flexibility.
At the best of times, it’s not a comfortable position to be in. But these are not the best of times. Spar SA is facing headaches at home beyond just rolling out an upgraded SAP system; its Polish acquisition has proven much harder to fix than it expected; and its Irish bankers are none too keen to lend the group any more money.
On February 16, it became clear just how fraught things really are.
Days after its AGM, Spar SA said it would slash its dividend payout by 50% over the next two years.
In November, the debt-strapped grocery wholesaler had warned shareholders it had to investigate “financing alternatives” to fund the rollout of the SAP software across the group, and to support its struggling Polish business.
As a result, it said, this “may include a possible adjustment to the current dividend policy”, since it “would not be appropriate to expose the group to higher levels of debt”.
Given Spar’s traditional commitment to paying generous dividends, it’s clear that slashing the dividend wasn’t plan A.
During the AGM, finance director Mark Godfrey said Spar had engaged with its SA banks and also “unofficially engaged” with its syndicate of banks in Ireland to get a sense of what level of debt covenants the bankers were willing to tolerate.
“[The banks are] not really showing the appetite to increase those [covenants] significantly,” said Godfrey. For those fluent in bank-speak, this suggested the Irish banks may be genuinely worried about Spar’s debt.
Maybe it was just that the Irish banks had finally drawn a line in the sand. They’d been tied to hefty levels of BWG debt since the
Celtic Tiger days back in 2006, when three Irish executives secured €400m funding to buy out the business from Pernod Ricard.
But those were the good old days for Irish borrowers. Banks fell over themselves to give loans, particularly when these were tied to property, as BWG’s portfolio was. But the financial crisis, a slump in property and an uninspiring performance from BWG led to a dramatic change in the banks’ risk appetite.
In 2013, the banks wrote off
€125m and demanded action. That was when Spar SA arrived on the scene, and paid R4bn for BWG — including providing a €220m guarantee to the Irish banks.
With Spar SA behind it, BWG figured it could roll out a five-year
€100m capital investment programme to expand in Ireland and southwest England. It began by buying Londis, an Ireland-based convenience retail chain, and soon swallowed the Gilletts Retail
Group, Corrib Foods and Heaney
Meats, and built extra distribution centres in the UK.
Despite reasonably good operating performances, debt has clung to the €200m mark. It didn’t help that BWG had to pay its executives a whopping €96.4m for their outstanding 20% stake in the business in 2020 and 2021. At the same time, Spar paid CHf56.3m for the outstanding 40% of the Swiss business too.
Buying out the minority shareholders boosted Spar’s share of the profit — but it also pushed debt to unprecedented levels.
Shareholders, who get a little twitchy at the sight of mountains of debt, can at least be comforted by the fact that Spar’s eye-watering debt of R10bn (including borrowings and overdrafts) is likely to be the peak, given the banks’ stance on lending more.
At the end of September 2021, almost 100% of Spar’s long-term debt was held in its overseas operations, with Ireland accounting for a hefty €195.8m (R3.4bn), Switzerland for €162.2m (R2.6bn) and
Poland for R1.5bn. SA, in comparison, had a “mere” R235.5m.
On this front, there’s good news and bad news. The good news is that the foreign debt is raised and serviced by the companies in those regions, which shelters Spar SA from foreign currency risk; the bad news is that Spar SA is on the hook for R3.6bn of BWG’s debt, R907m of Spar AG debt in Switzerland and R1.5bn of the Polish debt.
In all, it’s a fairly nerve-racking picture, and anybody not hooked on dividend payments should have reckoned it was long past time to rein in the generous payouts.
Remarkably, Spar’s dividend cut took many by surprise. You can see why: historically, no matter how tough the environment and how steep the debt, Spar’s board seemed set on paying a dividend that was just 1.3-1.4 times covered by earnings.
This dividend was already one of the most generous on the JSE. And the issue of an extra 9% in new shares in 2016, to settle two empowerment share schemes, didn’t halt the largesse.
Even in the 2020 financial year, despite Covid, Spar’s board thought it only right to hike the dividend to 855c a share — only marginally below its headline earnings of R11.35 a share.
In 2021, as debt pressures mounted, it still paid a generous 816c a share.
Paying out between 60% and 70% of earnings is not without precedent among retailers. But in the middle of a pandemic and
amid a debt-defying global expansion, it was an eye-catchingly gutsy strategy.
Evidently, Spar felt no need to follow many other JSE companies, which opted to hold back on dividends until the worst of the pandemic had passed.
Independent retail analyst Syd Vianello says it’s not just with the benefit of hindsight that the dividend policy looks inappropriately generous: “The dividend was always too high.” He says he can think of no other company that has had to cut its dividend to fund an SAP rollout.
It may not have been a coincidence, of course, that Spar’s executive bonuses hinged partly on “total shareholder return”. But whether this contributed to an overly generous dividend policy is something Spar’s remuneration committee will have to debate.
Investors cut and run
Either way, it spooked investors. Since its February 16 dividend-cut announcement, Spar’s stock has tumbled 14%, to its lowest level since 2017 — lower even than during the darkest days of Covid.
That the knock wasn’t more brutal had much to do with the forewarning provided by the company in November, when it released disappointing results for the year to September 2021. Revenue inched up 2.9% to R127.9bn, but operating profit fell 1.5% to R3.39bn.
It was then that O’Connor, now Spar’s chair, warned for the first time that to fund a new SAP system (the system being used is 25 years old) and finance the Polish business, the grocery chain “might” have to adjust the dividend policy.
But despite these signs, a number of analysts are still betting that Botten’s team can fix the business.
Keith McLachlan, investment officer at Integral Asset Management, dismisses any talk of parallels between Spar’s European adventures and Woolworths’ Australian ones.
“Australia has been a graveyard for SA retailers but Spar’s European situation is a little different,” he says, adding that Spar’s international expansion had gone pretty well until it bought the Polish business in 2020.
“They’ve struggled to implement their loyalty system in that country, but their track record suggests they will get it right within the next year or so.”
Analysts from Bank of America also say Spar deserves a premium rating to the sector because of its size, its above-average returns and its rand-hedge properties.
Analysts at SBG Securities, in a research report two weeks ago, described the dividend cut as the “lesser of all evils”.
Though SBG reckons investors will forgo R8 a share in dividends over the next two years, the dividend cut “dispels the possibility of a rights issue and attends to investors’ limited appetite for additional leverage”.
And SBG Securities upgraded its target for Spar, expecting the share price to hit R208 — 33% above its current level.
SBG isn’t even the most optimistic. Of the seven analysts who cover Spar, only one rates it a sell, and the average share price target is R204.71 — nearly a third above its current level.
A common sentiment, it seems, is that Spar just needs more time.
Sasfin’s Alec Abraham acknowledges the company is in a tricky situation. But he says that based on its track record, Botten’s team should be given more time “to get it right”.
Abraham points to the improved levels of service in Europe as an indication that the company is on the right track.
He says there was some concern when the struggling BWG business was bought in 2014, but the South Africans managed to turn the business around — as they did when they bought the Swiss business two years later.
Behind the improved levels of service Abraham talks about is Spar’s all-important metric: the “loyalty level”.
Spar management explains this is a measurement of the amount of goods Spar’s retailers buy from Spar. In SA it stands at above 80%; analysts estimate that in Ireland and Switzerland it’s an improved, if less impressive, 60%.
The problem is that in Poland, this stands at a grim 27% — considerably below management’s 40% target. Still, you’d have to say it’s an improvement from the 0% of a year earlier, when the Polish stores bought all their products elsewhere.
It’s useful to explain that Spar doesn’t operate a traditional franchise system. Its arrangement with individual store owners is based on a principle of “voluntary trading”, where owners can decide to buy products from someone else if they want to do so.
In other words, retailers are free to buy stock from anyone they choose. This is why loyalty is so critical, and why the quality of
the relationship is vital.
As Spar puts it: “The group’s performance relies on its ability to attract and retain retailers’ business by using our trading expertise to offer competitively priced products and superior warehousing and distribution capabilities.”
Zaid Paruk, a portfolio manager and analyst at Aeon Investment Management, lauds Spar management for acknowledging the concerns about the Polish division. Regaining loyalty, improving its range and pricing and addressing the distribution costs will lead to better profitability, says Paruk.
“[Spar’s] management has delivered similar outcomes in the past, such as a turnaround at BWG. The market appears to be confident that the management team tends to be cautious and underpromise.”
One way of looking at the below-par European “loyalty” figure is that it shows the potential for Spar to increase profits. But actually doing that is the trick — not just because of the increasingly tough competition in that region, but because of the nature of Spar’s relationship with its retailers.
Salmour Research’s Chris Gilmour says the voluntary dimension of the relationship is far more evident in Europe than in SA. “In SA there’s much more consistency in the quality and product range offered by Spar stores. In the UK and Ireland, some of the Spar stores can be quite unenticing, others very attractive,” he says.
This voluntary arrangement worked well for Spar many years ago, when its warehousing and distribution capabilities vastly outpaced those of its peers. Back then, grocery chains such as Pick n Pay and Shoprite were struggling to sort out their distribution, so Spar’s wholesale business thrived.
“Spar, which was unbundled out of Tiger Foods a few decades ago, was a master at centralised distribution from day one,” a now-retired retail executive tells the FM.
It gave Spar a significant advantage over its major competitors — and the stores bearing its name inevitably thrived.
“But all the retailers, led by Shoprite, have upped their distribution game,” says the former executive. “The industry is much more efficient now; even Pick n Pay has got on top of centralised distribution.”
This is great news for consumers, assuming that at least some of the benefits of increased efficiency are passed on. But it’s not such good news for Spar, which must now up its game. An upgraded SAP system should help, but it’s unlikely to be enough — even if the process of rolling out the new technology is a smooth one.
It comes at a time when the other large grocery chains are moving away from franchised stores thanks to improved IT and distribution systems, which have allowed for more efficient and centralised control. Spar can’t follow that trend. Of course, this could always be seen as an advantage as it continues to provide opportunities for entrepreneurs intent on owning their own stores to get into the retail business.
‘Economic profit’ on the wane
While Ireland and Switzerland dominate Spar SA’s debt profile, the Southern African business remains the most profitable by a country mile.
In 2021 Southern Africa accounted for 63% of group turnover and 73% of operating profit, Ireland chipped in with 23.7% of turnover and 28.5% of operating profit, and Switzerland contributed 11% of turnover and 12.2% of operating profit.
Poland provided R2.3bn of sales to the group, but it dented group operating profit when it clocked up a R477.2m loss.
All of this illustrates just how much of a whirlwind the past eight years have been for Spar’s investors.
Back in 2013, Spar was a formidable Southern African retailer, going head to head with heavyweights Shoprite, Pick n Pay and Woolworths. That year, it boasted revenue of just under R50bn and operating profit of R1.6bn, while its return on equity was 39.8% and return on net assets was 51.8%.
That was impressive and, since there was virtually no debt on the balance sheet, a generous dividend was easy to justify. Back then, Spar’s market value was R20.9bn.
Today, eight years later, Spar’s market cap has almost doubled to R37.8bn — though because of a few rights issues, its share price has only edged up 32%.
Revenue, now coming from Europe too, has more than doubled to R128bn, as has operating profit (now R3.4bn).
Its return on equity, at 27.9%, isn’t quite as good as it was, but that’s partly due to a rights issue for its empowerment deal.
Its return on net assets is still impressive, at 40.5%.
However, there were a few disturbing
While Ireland and Switzerland dominate Spar SA’s debt profile, the Southern African business remains the most profitable by a country mile
new features of its 2021 balance sheet. Its long-term debt is R7.3bn, its right-of-use assets are valued at R7.1bn and goodwill and intangible assets now account for R6.8bn.
David Holland, a director of Fractal Value Advisors, an expert in company valuation, sees Spar’s past eight years as rather troubling — a trajectory dominated by the hefty build-up of debt which makes return-onequity a specious indicator of performance.
Holland says the critical profitability ratios are going in the wrong direction. As it is, he says, retail in Europe is highly competitive, and many retailers — including Tesco and Carrefour — are generating returns that are below their cost of capital.
“Value-creating growth typically results in operating profit growth greater than revenue growth, and revenue growth greater than invested capital growth,” says Holland.
But this hasn’t been happening at Spar. The pace at which Spar has been investing capital has been outpacing the growth in revenue and operating profit since 2011. (Invested capital has shot up 9.7 times, while revenue has increased only 2.2 times and operating profit 1.4 times, says Holland.)
Even Spar’s hitherto impressive return on invested capital (which calculates how many rands are generated per rand of invested capital) has been falling since 2012. In part this is because the goodwill accumulated from its acquisitions has been so high.
Another way of looking at Spar’s longterm performance is through a lens of economic profit — essentially, what is left after deducting the opportunity cost of capital, debt and equity capital. It’s a useful barometer since it measures the amount of economic value a business generates.
Holland says Spar SA’s economic profit increased steadily until 2016, two years after the BWG acquisition and the same year as it moved into Switzerland.
Disturbingly, after stalling in 2016, economic profit has been declining.
This helps explain the relatively weak share price performance.
By the end of September 2016, Spar’s share price was R192 — nearly 19% above its current level of R155.
That’s far worse than Shoprite, whose stock has risen 18.3% over that time, but better than Pick n Pay (where shares have fallen 35%) and Woolworths (down 28%).
Either way, Holland says this is a red light, flagging the fact that Spar’s new investments are not generating economic value.
It will become clear in the next few years whether Holland’s pessimistic view turns out to be a more accurate indicator of Spar’s trajectory than that of most other analysts.
At this stage, the challenges look daunting on almost every front.
It will probably be months before the impact of Covid washes out of the system. In many regions, lockdowns helped boost sales at Spar’s more conveniently located outlets at the expense of the bigger retailers.
Spar may be able to hold on to some of this new business — but it will be a tough battle.
In SA, Spar is facing an economy that is more sluggish, yet far more competitive for retailers.
And, as O’Connor put it, chillingly, at the AGM, there “is a real risk of an uprising happening again”. In anticipation of more trouble, the company has put in place an “intelligence platform” to help the police, should there be a repeat of last July’s chaos.
Europe won’t be much easier — especially if the Russian war spills over into Western Europe. In Switzerland, it’ll be a struggle for Spar to keep the customers it gained during the lockdown.
In Ireland, the big five grocers — Dunnes, SuperValu, Tesco, Lidl and Aldi — are squeezing out smaller operators, even those offering “convenience” hot food. In this cutthroat environment, it’ll be tough to persuade Irish consumers to fall in with plans to lift Spar’s private label sales to 25% by 2025, from the current 18%.
As for Poland, even if it can bump up the loyalty level, Holland believes Spar will struggle to cover its cost of capital.
“The Polish business is losing money and strikes me as a negative [net present value] investment, even if the share price was low,” he says. “It’s also adding to a debt pile that needs to be reduced in the face of numerous business challenges.”
Trying to fix Poland is going to suck up money and resources that Spar can ill afford right now.
And, after a years-long spending spree, the executive teams across the enlarged Spar group must get used to operating with just the funds they generate. In other words, they need to start harvesting a lot more profits.
And don’t forget the SAP rollout — a oncein-25-years IT systems upgrade, which will stretch across SA and Europe. Ask Shoprite’s Pieter Engelbrecht or Pick n Pay’s Raymond Ackerman how easy that will be.
It could be that in the years to come, the expensive European assets will turn to account. If so, the decision to use comparatively cheap debt to bulk up the businesses will prove to have been a master stroke.
But right now, it’s clear the market isn’t betting this recovery is inevitable.