Retail sector: Into the trolley

Foreign investors have been on a shopping spree in SA retail. Interest is at a record high: foreign investors pumped R72bn into local equities last year, and another R18bn in the past six months. Massmart, Truworths, JD Group and Shoprite have become darlings of the foreign portfolio managers.

Ironically, their attention may drive away foreign retailers as they push up share prices. Foreign retailers, most visibly US giant Wal-Mart, are actively investigating SA’s retail environment. An acquisition, some say, is inevitable.

“SA equities, particularly retail equities, are on the radar screens of emerging market portfolio managers,” says Allan Gray director Delphine Govender. That’s because SA has crawled out of the global financial crisis as one of the best-looking emerging markets in the world.

“We have stable banks, a reasonable deficit, good governance and a tradable currency and we speak English,” says Massmart CEO Grant Pattison. SA may not have the growth story of China or Russia, he says, but the other factors count, too.
Another metric of stock analysis is the price: earnings ratio. Generally, the higher the p:e, the more investors are paying for a stock relative to its net earnings, and the more future earnings growth they are expecting.

Compared with global retailers, local p:e ratios are lower, which means that on a simplistic valuation basis, SA’s retail stocks look cheap to foreign investors. In SA, the average p:e for the retail sector this year is 17,2. In Russia, the average is 25,6 and in Latin America, 28.

“The p:e ratios may appear high to local investors, but not relative to other emerging markets,” says Cadiz portfolio manager Warren Buys. “Foreign investors thought our retail stocks were cheap; they couldn’t see why local SA equity holders were selling.”

The difference in view is better understood by examining the priorities of the different investors. Emerging market fund managers are looking for long-term value in emerging market equities across the globe. They identify a country and sector, and stocks are selected according to predefined investment criteria.
They gravitate towards liquid shares with a market cap above R10bn and a big free float. They avoid equities with unusual governance structures, like dual- class voting shares or pyramid schemes.

While SA is now firmly on the radar screen of emerging market investors, stocks that are well-known will gain a disproportionate share of the action. For instance Massmart and Truworths are included in all the international benchmark indices.
What is also clear is that the pricing of retail equities will be influenced by foreign funds — upwards.

Though small, the SA market could be attractive to foreign buyers. Pick n Pay chairman Gareth Ackerman commented at the company’s recent AGM: “Competition in SA’s retail environment will be changed by the possible entry … of leading international retailers. Their arrival on our shores would have profound implications for the retail landscape and the ways in which we do business.”

One often-cited attraction is SA’s position as a springboard into Africa. Companies like Shoprite and Massmart have expertise on Africa’s logistics, tax and regulatory complexities.

Another is that SA is a consolidated market with interesting demographics. “It’s the consolidation that is arguably enabling the impressive returns,” says Govender. Supermarket chains Shoprite, Spar and more recently Pick n Pay have expanded aggressively into peri-urban and township areas. This has come at the expense of independent retailers and spaza shops. Between 2008 and 2010 formal retail’s share of the food market increased from 62% to 68%, says Buys.

It is not just the defensive food stocks that survived and thrived in the recession. Clothing retailers have, too. Clothing retailers grew by acquisition, with Truworths, for instance, buying out independent brands like Uzzi.

The likes of Mr Price, Truworths and Foschini also gained market share through the recession, most likely from Edcon, which has not invested as aggressively in store expansion and upgrades, says Govender. “The recession slowed earnings growth, but not nearly as badly as expected.”

The introduction of the National Credit Act three years ago put the brakes on credit-driven spending. Social grants, which boosted food retailers’ sales, are now in the base. And high food inflation, which drove top-line earnings, is now virtually flat. “Volume growth is subdued,” says Absa Asset Management Private Clients’ Chris Gilmour. And, he adds, increased competition between food retailers for market share is eating into gross margins.

But the worst is over. SA recorded an economic growth rate of 4,6% in the first quarter of 2010. It is the third consecutive quarter of economic growth. “Don’t lose sight of the fact that SA has a consumer-driven economy — sustained growth will translate into more robust consumer spending,” says Gilmour.

For now, the real interest in SA retailers will be from international equity investors. If the economy is able to generate meaningful numbers of jobs, then the retail sector is well positioned for long-term sustained growth.

And that is a fact that no investors — be they foreign retailers or local investors — will miss.

This is an extract of a larger story from the Financial Mail. For the full story, click here.

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