Description

At the time of high valuations one of the rare pockets of value comes from turnaround stories. This is one of those.

Carrefour is one of the world’s largest retailers with €80 billion in net sales. Yet, the company is trading at a fraction of the price of other large global retailers or, for that matter, it former self. I believe that is poised for change. With a new and proven management in charge, the company is going through serious and thorough restructuring that will lead to the stock appreciation.

Once upon a time, Carrefour used to be the second largest retailer in the world in terms of sales, but years of underperformance and strong competitive pressures in the domestic market are the cause of decades long stagnation.   After a series of disappointments, dismal results and many, many CEOs,   the Carrefour board decided it was time for a new management team led by Alexandre Bompard. Alexandre Bompard  joined Carrefour coming from Fnac-Darty and brought Mathieu Malige with him, as CFO. This time the board has chosen wisely since Alexandre Bompard is a big corporate star in France with a brilliant track record. His past performance tells us he is perfectly suited for the CEO position at Carrefour. He became CEO of Fnac, a French books, music and electronics retailer in 2010. At the time Fnac was under immense pressure from competitors, most notably Amazon. He managed to stop the bleeding with the cost-cutting plan that included layoffs and reduction of logistics and stores costs as well as putting in charge a new and talented management team, formed between new external hires and internal appointment. Sales stopped falling, competitiveness was restored, margins increased and after 2013 IPO, stock price tripled. On top of that he was the brain behind successful Fnac-Darty merger.  Surely, his appointment was a clear winner for Fnac shareholders.

Carrefour is a global food retailer with a network of 11947 stores in 30 countries. It has close to 380 thousand employees and serves more than 100 million customers. With 46% of total sales, France is Carrefour’s largest and most important market. About 27% of sales comes from other European countries of which Spanish is the largest, followed by Italy, Belgium, Poland and Romania. Latin America is the fastest growing market for Carrefour and it represented close to 19% of sales in the first half of 2018. It consists of two countries: Brazil and Argentina. The rest of the sales comes from Asia – China and Taiwan.  Alongside its directly operated stores in those 10 countries, Carrefour operates a network of franchised stores in many other countries: Indonesia, Saudi Arabia, and Algeria, just to name a few.

Despite being the largest, France is not the most profitable market for Carrefour due to fierce competition going on there. The most profitable market with the largest margins is actually Latin America, more precisely Brazil, where Carrefour owns 71.8% shares of local retailer Atacadao, after 2017 IPO. For years, Carrefour has been losing share in very competitive French retail market. It was so competitive that even German discounters Aldi and Lidl had a hard time gaining share. After years of presence in the French market, German discounters hold a much smaller share than in comparable European markets. The price leader in France is Leclerc. It is gaining share for years and is now the market leader in groceries. Its business model is simple – everyday cheap price. Hypermarkets which represent half of the sales in France for Carrefour have a price gap of approx. 400 bps to Leclerc.

On January 27 this year, after 6 months at the helm of the company, the new management presented a comprehensive transformation plan “Carrefour 2022”. At the core of the plan is a massive cost reduction of €2 billion on a full year basis as of 2020. Over the years, Carrefour has created layers and layers of bureaucrats, consultants and managers(unlike Leclerc where its members occupy top management positions) who besides adding to the costs, also slow the decision making process. To reduce Leclerc’s competitive advantage, Alexandre Bompard and his management team have decided to cut 2400 jobs of 10.5 thousand at its HQ in France. And they didn’t leave it there. Similar layoffs were planned for Belgium and Argentina. As well as divesting (selling or closing) 273  ex-DIA stores. But actually the vast majority of the €2bn cost reduction comes from the a) optimization of direct purchasing like reducing assortments by more than 10% and using global scale at negotiation table with international suppliers b) rationalization of indirect purchasing ( strict management of expenditures and renegotiation of historical contracts) c) reduction of logistics costs. A big part of that savings would be used to gain price competitiveness vs. Leclerc. In addition, the focus of their plan is on massive investments in digital – €2.8 billion over the next five years or 6 times more than current investments and to take at least 20% of French food e-commerce market or €5bn in sales by 2022.   On top of that, they have planned to reduce the sales area of hypermarkets in France by at least 100 thousand m² to match their catchment areas, to form purchasing and selling alliances, to dispose of 500 million of non-strategic assets, to selectively choose investment projects and cap them to €2bn per year and to increase the share of Carrefour branded products to 1/3 by 2022.

It is an ambitious plan, no doubt. As far as I was concerned, already the experience and success with Fnac implied that the management was able to carry out such plan. H1 results published a week ago made me almost certain of that. In the first half of 2018 they achieved €520 million or a quarter of annual savings planned for 2020. The workforce reduction in France, Argentina and Belgium have been made, and Carrefour made an exit of 273 ex-DIA stores. Also, Carrefour signed important strategic partnerships with Systeme U, Google, Tencent and Tesco. With Systeme U and Tesco it was purchasing partnership with a goal to negotiate lower prices with suppliers.  In December of 2017, Carrefour signed a similar agreement with Fnac Darty regarding purchasing partnership for household domestic appliances and consumer electronics in France. The goal of the strategic partnership with Tencent was to boost Carrefour’s loss-making Chinese business, especially by improving Carrefour’s online visibility there, but also using Tencent digital and tech expertise in offline retail like, for example,  in newly  opened La Marche “smart store” that uses facial recognition technology. The partnership with Tencent will also include buying a smaller stake in Carrefour China. In France, Carrefour has formed a similar digital partnership with Google since Carrefour has been lagging behind its peers in e-commerce over the years with only 9% of market share. How will this partnership look like? From 2019 Carrefour customers will be able to buy Carrefour products through Google platforms such as Google Home, Google Assistant and Google Shopping. Furthermore, Carrefour will open an innovation lab in Paris with Google Cloud to work on developing services based on AI.  

On other fronts, assortments have been reduced by 4% in France (mainly on non-food) in the first 6 months of this year, inventory management was improved and capex significantly decreased in management’s attempt to be more selective as far as investments are concerned. It is also worth mentioning that fall in operating margins has been stopped  and net debt is now €1.5 billion lower than a year ago( but higher than 6 months ago due to significant seasonal fluctuations; working capital requirement rise sharply in the first 6 months of the year). Operating income finally increased (at constant exchange rates) in H1. It was a small rise, by 36 million or 6%, but considering fall of 21.5% in H1 2017 it is an important turn.  Another improvement was in e-commerce: 50% growth was achieved in H12018 vs. same time last year.

So unlike some former managers who set the bar really high and never came even close to reaching it (in 2010 Lars Olofsson forecast that the operating income would double by 2015, from €3.1 bn to €6.4bn and that operating margins would rise from 3.7% to 5.3%) the first half of the year shows  that the management is on the right track and that their goals will be achieved. The most demanding will certainly be the French market where taken measures will take longer to materialize than in other geographies. France is going to need more investments in prices as well. Some cost reduction already taken won’t be seen there until the second half of the year or even 2019. Notably, first gains related to job cuts in French headquarters will take place in H2.

Risks

Due to its relatively low price to replacement value, risks are not big. The management is certainly going to deliver most of what have they promised. The only question that still remains as a cause of some concern is the level of competition in the French retail market over the years ahead. It is the only factor that is hard to predict and which the management has little influence upon. Industries sometimes could be very self-destructive. Even so, I believe that the magnitude of cost cutting is such that it would most certainly lead to significant operating margin improvements for Carrefour as well as sales and market share growth. Furthermore, the level of strategic alliances between retailers has risen in recent years and it is essentially a sort of market consolidation that should somewhat reduce the very high level of price competition.

The stake in Atacadao, a Brazilian listed subsidiary, is worth more than 5 billion euros and 36% stake in Carmilla, Real Estate Company is €1.2bn. On top of that there is a lot of valuable real estate since 65% of all hypermarkets and 50% of supermarkets is company owned.  By some calculations they are worth around €15bn.

Valuation

How much is this company worth? I believe that it is reasonable to expect operating margins north of 3% as a result of aggressive cost cutting and higher sales, which should translate to at least €2.5bn in operating income in 2019 and more than 3 bn euros afterwards. 12x EBIT and it is already a nice return on investment.  And the downside is pretty much protected due to valuable assets the company owns.

Catalyst

improvement in operating margins