What is Du Pont of it all?

When analysing the financial performance of retailers, it helps to know how to work with Return on Equity and other key metrics. Chris Gilmour gets the calculator out.

The Food and Drug and General Retailers listed on the JSE often trade at highly rarefied Price/Earnings (P/E) ratios. In the normal course of events, considering the less than stellar earnings performance of most of them over the past five years, one would intuitively expect to see these ratings decline.

But they haven’t.

They have largely stayed intact and in certain instances (as with Clicks and DisChem) they are trading on P/E ratios close to 30 times. In an attempt to discover whether or not there is a rational investment basis for these rarefied ratings, I have used a modified Du Pont analysis, which ranks each share by its sustainable growth rate (SGR) and then compares that to its P/E.

This throws up some interesting results.

Get the textbook out

In the equation below, I refer to Return on Equity (RoE) and the Payout Ratio, which is the percentage of profits paid out as distributions to shareholders.

As a refresher, the SGR = RoE * (1-Payout Ratio). In other words, the SGR is the Return on Equity times the retention ratio.

Return on Equity can be further broken down using the Du Pont formula:

RoE = Net Profit Margin * Asset Turnover * Leverage

How does this work, you ask?

It can be rewritten as RoE = (Net Profit/Sales) * (Sales/Assets) * (Assets/Equity)

If you remember your school maths, Sales and Assets cancel out in the formula and you are left with Net Profit / Equity, which is RoE!

The point of Du Pont is that you can properly assess the components of RoE.

Applying this to JSE retailers

I have taken the four most expensive retail shares on the JSE in terms of P/E ratio and calculated a SGR for each one:

Clicks vs. Dis-Chem

The first thing to notice is that Clicks has by far the highest RoE of any of these retailers at 48%. The second really interesting point is the vast differences in the payout ratios from just under 38% in the case of Dis-Chem to 85% in Pick n Pay.

One can reasonably argue that Clicks is especially generous to its shareholders, with a relatively high dividend payout ratio, and that it is one of the main reasons why it enjoys such a high rating. But even with such a high payout ratio, it still manages to achieve a decent SGR of 18.2%. Clicks also has an ongoing share buyback programme that enhances shareholder wealth.

Dis-Chem, too, has a relatively high RoE and combined with a relatively low payout ratio, ends up with the highest SGR in this exercise.

Pick n Pay vs. Shoprite

Contrast this with Pick n Pay, which also has a high RoE of 36.6%. It pays out such high dividends that SGR is left at a very low 5.5%. That was fine in the days when the company was being streamlined but now it’s in an investment phase with much greater capital requirements. This company has a number of options available to it when trying to improve its SGR.

Two elements stand out immediately, the first of which being that it can attempt to greatly improve its operating profit margin and in so doing boost its RoE. The group has been struggling with an exceptionally low operating profit margin for many years and it’s not immediately obvious how it can improve this metric substantially in the short term. At 3.1%, Pick n Pay’s operating margin is roughly half of Shoprite’s operating margin of 6%.

By greatly increasing the penetration of clothing in its portfolio, it can significantly improve its operating margin, but this won’t happen overnight.

As Pick n Pay’s Boxer chain grows in comparison with the rest of the group, it is likely that the profit margin will also improve. Discounters, perhaps somewhat counter-intuitively, have a somewhat higher profit margin than traditional supermarkets.   

The easier, second option would be to reduce the dividend payout ratio and apply the proceeds to debt reduction. Of course, this is easier said than done in a situation where the controlling family naturally wants a high payout ratio.

Debt/equity in Pick n Pay is high at 108%. That’s fine when interest rates are low and stable but once in an upwards trajectory, as they are now, this could come back with a vengeance.

Shoprite’s SGR is surprisingly low, at only 10.6%. Of course, its RoE was the smallest of the four to begin with. This in itself is also surprising, considering that Shoprite has a particularly high operating profit margin of 6%. It’s difficult to see how Shoprite can squeeze a higher operating margin out of the business, especially against such a difficult trading environment. And the operating profit margin does appear to have hit a ceiling of around 6% for the past few years now.

Unlike Pick n Pay, Shoprite doesn’t have a higher margin clothing chain to fall back on. But it does have Usave, the main rival to Boxer in the discounter arena. That could conceivably help to sweeten the overall group margin a bit as the penetration of Usave relative to the rest of the group increases.

Shoprite has an entirely different balance sheet structure to Pick n Pay. With total borrowings of R4.5 billion, its debt/equity is just under 18% and it has lower gearing than Pick n Pay. If it geared up to the same level as Pick n Pay, its SGR would rise considerably as this would drive a higher RoE.

But Shoprite has a culture of installing CAs as CEOs of the company. Current CEO Pieter Engelbrecht is a CA as was his predecessor James Wellwood “Whitey” Basson. CAs tend to be conservative individuals and don’t go looking for risk if they don’t feel it is warranted.

The bottom line

The bottom line in this exercise is that Pick n Pay appears to be trading on a P/E ratio that is way out of line with what can reasonably be expected in terms of its sustainable growth rate. Shoprite is not an awful lot better, though at least it has the balance sheet capability to change quickly if it so desired.

Both of the pharmacy chains, while expensive on PE basis, at least have sustainable growth rates that approximate to that type of rating.

This article reflects the independent views and opinions of Chris Gilmour, which are not necessarily the same as The Finance Ghost’s opinions on these stocks. For equity research on South African retail and other stocks, go to www.gilmour-research.co.za.