Description

Dino Polska

DNP.WA PLN 406.8

June 20, 2024

An Exceptional Compounder with a Long Runway of Growth

Summary

Dino Polska is an operator of medium-sized grocery supermarkets in Poland that has been rapidly expanding using a simple, yet differentiated, strategy focused on rural and small-town markets where 73% of Poles reside. 

Dino’s strategy is designed around developing owned stores in a standardized format with a modest 400 sqm footprint selling fresh groceries, meat, and staples at competitive prices. The efficiency of their store model allows the stores to be supported by a population of just 2,500 people within a 2km radius. Dino has opened 2,438 stores since 1999 at a fast rate of 20%+ per year and has not closed any stores. 

Dino has further differentiated itself by owning and developing all of its stores in a standardized fashion and vertically integrated by owning its meat processing operations allowing it to provide fresh meat counters in each store, a key differentiator versus its competition and a valued offering by its customer base.

Dino has substantial room to grow within Poland without entering urban areas. I estimate that the theoretical ceiling on stores is around 11,000, almost 5x the current footprint. In addition, expansion into neighboring countries including Eastern Germany, Slovakia, Lithuania, and the Czech Republic create future optionality as does the possibility of expanding into adjacent verticals like pharmacy and petrol.

The primary risks to the bullish Dino investment thesis include competition and execution, both of which Dino has a strong record of managing successfully.

To invest in Dino today, an investor must simply believe that they can continue to execute on their proven strategy. Dino is controlled 51% by its founding Chairman and actions to date indicate the behavior of a highly aligned owner-operator.

Dino’s business model is driven by fully reinvesting all free cash flow into developing new stores. It does not pay dividends and it has not repurchased shares. I estimate that Dino achieves a ROCE of 40% at the store level and the firm generates ROIC of 20%.

Dino is reasonably priced today with a normalized FCF yield 50 – 100bps above 10-year treasuries after backing out growth capital expenditures. The investment opportunity lies not in a repricing, but in the continued execution of a successful business model by a competent and well-aligned management. It is reasonable to project that Dino could compound its intrinsic value by 15% - 20% p.a. over the next decade.

Company Overview

Dino is an operator of medium-sized grocery supermarkets in Poland. 

Poland is unique in that only 27% of the population lives in cities compared to 78% for Germany. Dino does not operate in urban locations.

Operations are concentrated in small towns and villages where the stores offer proximity to their customers’ residences. Dino’s slogan “najbliżej ciebie” translates as “closest to you.”

Dino was founded by Tomasz Biernacki in 1999 who retains the Chairman role today.

In 2010, he sold 49% to a private equity firm for roughly USD 200 million and used the proceeds to purchase rural land plots across Poland to support future store growth. In 2017, the investors wanted to exit, which culminated in an IPO where the only shares offered were the entirety of the outside investor’s stake. Dino received no proceeds in the IPO and Biernacki has never sold shares and owns 51% of the equity.

Dino has grown rapidly to 2,340 stores as of September 2023 from 639 at its IPO in 2017.

Dino started in the more populous western part of Poland and as it has grown it has both filled in density and expanded eastward, adding owned distribution centers along the way. 

There are no secrets in retail and a structural competitive advantage is usually achieved only by a distinct business model and culture that focuses on executing consistently well on a great number of things over time to create value for the customer. Dino shares many of the characteristics that have established competitive moats for retailers like Costco and Walmart.

Dino’s business model is simple, yet it’s distinct from most of its competitors, like Biedronka.

Dino owns the land and buildings for its stores outright.

While this requires a greater initial capital cost versus renting, it offers several long-term benefits. Long-term store costs will be lower for owned stores, the company retains full control of its property designed for its needs.

Dino operates a standardized store model.

Owning the land and building the store to their specifications affords the opportunity to design a standardized store model which creates efficiencies in the construction process including procuring materials, fixtures, and equipment. It also creates operating efficiencies and helps maintain a consistent brand identity.

Stores are around 400 square meters and contain 5,000 SKUs. Dino has opened over 2,300 stores since 1999 and has not closed a single store.

Dino has focused on rural markets.

Avoiding urban markets allows Dino more control over their destiny. It allows them to be a lower cost operator, own their stores and land, and avoid competing directly against larger competitors.

A typical Dino store is located near a rural road junction and is situated in an area where there are at least 2,500 people within a 2 km radius. Dino’s efficient store model allows it to operate in areas where larger competitors would be at a disadvantage as their larger stores and overhead require a greater population density to be economically attractive.

Rural Polish homes are not large and do not have much storage. In addition, while Poland is a great success story since the fall of Communist rule in 1990, rural incomes are modest. Most customers shop at Dino several times a week, often commuting on foot, and the average ticket is around USD 10.

Dino offers a selection of merchandise tailored to its customer base.

Dino offers both international and Polish branded products, fresh fruit, vegetables, and bakery delivered daily, and notably, a staffed meat counter. Having a meat counter is significant as it represents a sizeable investment in both staffing and infrastructure. The Polish diet consumes a good amount of meat, and the perception is that counter meat cut and packed in front of the customer is fresher and higher quality than the packaged meat found in most competitors’ stores.

Dino has achieved scale economies that it shares with its customers.

Dino has vertically integrated into meat processing plants which gives it a cost advantage on a significant food item. The rapid growth in stores creates scale that allows Dino to receive suppliers’ discounts. The absence of rental expenses creates additional savings in operating costs. Since they own their stores, Dino has installed solar panels on 1,700 of its stores, reducing their electrical consumption. These small items executed well and consistently have built a significant competitive advantage for Dino and it has shared the cost benefits of scale with its customers by keeping prices low.

Current Opportunity

In 2022, food inflation spiked in Poland, rising from 8.7% in Q122 to peak at 22.9% in Q123. This created significant distortions in the market. Food inflation has fallen steadily since the Q123 peak to 2.6% in Q124.

As food inflation tapered off in 2023, Biedronka and Aldi commenced a price war and Dino Polska has been impacted, but to a far lesser degree.

Biedronka’s Q124 LFL sales came in at 4.6%, 200bps above food inflation and sharply below the low 20s it generated in Q222 – Q123.

Dino’s LFL sales were 11.9% in Q124, 930bps above food inflation, yet well below the high 20s – low 30s it delivered in Q222 – Q123. Dino continues to take share in the markets it competes in.

While Dino’s sales growth has not been noticeably impaired by the price war between two larger competitors, it has suffered margin compression resulting from Dino price matching a competitive basket of goods to Biedronka.

The gross margin compression should abate over time as Biedronka and Aldi are unlikely to maintain their price war indefinitely. Most notably, Dino continues to take share in this competitive marketplace with LFL sales over 2x Biedronka and Dino has a better business model with far superior economics. Their competitive advantage should continue to expand over time.

My thoughts:

Dino delivered impressive results for 2023 with 250 new stores opened (+12%). LFL sales increased 17.2%, compared to food inflation of 15.1%. However, the margin between LFL sales and food inflation was the lowest in over a decade.

There are two questions worth examining: is Dino’s competitive position eroding and will the current concerns of investors matter in five years.

Dino’s competitive position does not appear to be eroding. Biedronka’s parent Jeronimo Martins reported 2023 results earlier in March and their results and commentary is helpful in understanding the competitive dynamics of the current market.

Biedronka’s LFL sales increased 14.2%, below the 15.1% increase in food inflation. Biedronka specifically calls out a shift in the competitive environment. Specifically, food prices rose sharply in Q2 2022 through Q1 2023 after which prices were increasing at a slower rate until January 2024 when prices started declining and Biedronka is now experiencing a deflationary environment on revenues. At the same time, inflation continues to increase on the cost line, primarily for wages, rent, and electricity. Falling prices and rising costs are continuing to pressure margins and Biedronka is expecting a challenging 2024 as their primary competitors Lidl, Carrefour, and Auchan compete primarily with price and Biedronka has articulated its strategy is to maintain price leadership. Biedronka was asked several times about competitors and never mentioned Dino.

In 2024, the Polish minimum wage rose by 17.8% in January and will rise another 1.4% in July. Over time, this increase in purchasing power should translate into sales growth.

Dino is not immune from these macro factors impacting the Polish consumer and the grocery market. However, I believe they are better positioned than Biedronka for two main reasons. First, Dino operates exclusively in smaller towns in suburban and rural markets. While Biedronka is its strongest competitor, it has primarily gained share at the expense of small independent grocers. Price competition is likely less intense than in the more competitive urban markets. Biedronka calls out the discounters as increasing pricing pressure in a fight to retain share. This is less of a factor for Dino. Second, Dino owns their stores, avoiding rent increases that Biedronka mentions are pressuring margins. Dino has also installed solar panels on its stores helping offset electricity cost increases which have been pressuring Biedronka’s margins.

In summary, while the operating environment is challenging with deflation of revenues and inflation of costs, Dino is in a stronger competitive position than Biedronka and other competitors because of its superior business model of operating in smaller, less fiercely competitive geographies, owned stores vs rented, and vertically integrating its meat offerings provide significant competitive advantages that are likely to increase during challenging environments. Furthermore, Dino’s business model generates high returns on incremental invested capital of 24% vs. 5% for Jeronimo Martins over the last five years. In a challenging operating environment, Dino can continue to expand given its strong economics. Biedronka may find itself in a more challenged position as deploying capital at unattractive returns eventually becomes problematic. Biedronka has also fully committed itself to be a price leader and is willing to sacrifice further margin to do so. It is likely that Biedronka will have to be more aggressive on price in the urban markets it concentrates on due to other competitors with a similar mindset. It may well be less aggressive in smaller markets against Dino where there is a somewhat lesser competitive intensity on price.

Finally, will this matter in five years? Whenever there is a sharp change in pricing, there is often a rebound effect until the market stabilizes. Food prices rose very sharply in 2022 before slowing down in 2023. In 2024, prices are actually declining, but off of a very high base. As Polish consumers feel the wealth effect of rising wages, their consumption should increase, and grocery stores are selling essential, non-discretionary items. Similarly, costs should ultimately stabilize as well, helping margins. This might take the remainder of 2024, but it’s not likely to matter in five years.

What could matter in five years is more interesting. Weak companies fail in hard times, good companies survive, and great companies thrive. While Dino shareholders may be concerned about the near-term outlook, I’d argue that this may be a tremendous opportunity for Dino to further solidify it’s competitive advantage. Biedronka and the discounters appear to be in a fight to be the low-cost leader. It’s likely in the process that some operators might fail and exit the market (not likely to be Biedronka). This could ultimately improve the competitive landscape for the remaining players including Dino – and that would matter in five years.

Dino has the best balance sheet and the best underlying unit economics in the market. It should be able to continue to grow and take share in its markets – the independents are going to have a very tough year – while not exposed to the cage fight among the discounters in the urban markets. Note that Biedronka does not mention preserving ROIC in their commentary, only a myopic focus on maintaining price leadership, regardless of the margin impact.

I think that barring any data that would indicate that Dino’s competitive position is weakening, the falling stock price creates an attractive opportunity for long-term shareholders.

I’ve attached selections from Jeronimo Martins’ conference call below:

Pedro Dos Santos, CEO

This was true also in 2023. Inflation did help sales on one hand, but also further pushed costs up, namely personnel and rents. When looking at the last 5 years, we see both an consistent trends of cost increase and price investments pressuring EBITDA margin. Since the end of 2023, a dangerous combination of persistent cost inflation and rapid decrease of food inflation has presented itself. Our main food retail business are already operating with deflation in their baskets, which makes comparatives with the previous year even tougher.

We also experienced an increase of competition, particularly in Poland, and of the fight for volumes and market, particularly in Poland and for the Polish market, we share again that let me share again. This necessarily means more cost, and therefore, further pressure on margin as we will not put our price leadership at risk. We will also not compromise on the remuneration package of our people. In 2023, all our companies increased salaries, and we invest nearly EUR 360 million in bonus and their incentives and also in social responsibility and well-being measured targets at our employees. In January of 2024, our biggest companies rose their minimum salaries again, and will also have nearly EUR 100 million more in bonuses payments to our operational teams and in the 3 countries with regard to 2023.

Ana Virgínia, CFO

In the current geopolitical context, marked by instability and complexity, it is very difficult and premature to anticipate how the leading economies will perform in 2024 and how that will influence the market in which we operate. With our food retail businesses operating with deflation in the main category since the end of last year, the group faces a severe combination of rapid decrease in food prices with high cost inflation. Also, deflation will lead to tougher competition in the food retail market as all players strive for sales growth. To this context, which will put further pressure on margins, one must add the contrast with the previous year, which presents demanding comparatives, particularly in the first 6 months due to the outstanding performance and the high price increases registered in those months. On the other hand, the increase in real household income could drive an important -- an improvement in consumer behavior.

In Poland, together with reinforced social support measures, there was a 17.8% increase in the minimum wage in January, which will be followed by a further increase of 1.4% in July. It is expected that this will contribute to a recovery in purchasing power. However, for now, the consumer remains extremely price oriented.

And in January, food retail prices in the market continued to register negative volumes. In this context, Biedronka will stick with price leadership and remains focused on sales growth, leveraging its commercial strength to raise the bar on the creation of saving opportunities for the Polish consumers. In an extremely competitive and tough market, as we have today in Poland, this is currently driving price deflation in our basket. In our view, protecting sales growth is of strategic importance to reap the benefits of a potential improvement in the consumer environment, to protect profitability in a high cost inflation scenario and to sustainably protect market position. However, having in mind the context, we cannot exclude that this strategic focus, combined with the substantial investment to increase our teams' wages may pressure EBITDA margins more than the impact registered in 2023.

It will not be the main cost lines increasing. I think that as we expect growth in sales, that line, we believe, it will be further allowances. Where we see a high cost really is, of course, on our major heading is everything that has to do with salaries and wages, and it's the rents, that really follow not the year's inflation, but the prior year's one, which was in Poland above 10%.

So prices are going down compared with the prior year prices. So what happened in 2023 is that we -- prices went up quite significantly in the beginning of the year still and peaked in the first quarter, then there was disinflation. And what we saw in the last months of the year in 2023, so the exit in terms of prices was already deflation in the main categories. Now in the first months of the year, we are having decreases in prices versus the prior year. So it's really deflation in the market.

And it's not just in Poland. We are also seeing that in Portugal and in Colombia. Because, of course, you have, first of all commodities prices are going down, and this is overall. And then, of course, you have all the players also wanting to fight for volumes and reacting and wanting to grab a piece of the market share in a market that is getting lower than it was before. On the margin pressure, I think that's the worst case scenario, of course, is if the consumer does not react to the fact that it has more available income, at least in Poland.

I think that is the most possible scenario for at least the first half of the year, definitely. And even so, you have to take into consideration that even with deflation, prices are still high. So considering what they have increased in the last 2 years, so we are not -- prices are lowering, but it comes from a very high level, and that is also part why or partially why the consumers remain quite cautious.

And also on how PPI -- so the inflation even and the willingness of the suppliers to invest to further recover their market shares will be willing to invest with us to really drive the market. So on that, I think that we cannot commit on any guidance on gross margin. And as for high competition, what we believe -- so this is now more visible in Poland, but we expect really a rise in competition in all food retail markets. As I mentioned, the food inflation will no longer be a driver of growth. The delay in high cost inflation, so the fact that wages are increased the following year, rents are increased the following year will put further pressure not only, of course, in Biedronka, but in all players in the market.

And so the only way to protect profitability is continuing to fight for them. And so what we will think it will happen is what is already happening is, in a very competitive market competition is getting tougher. Of course, there are some players that are a little bit more tough than others because they have also or they play exactly on the same growth drivers, which is price. So basically, the ones that we are seeing more aggressive are the discounters and Lidl. But this is a normal reaction to, let's say, all the food retail dynamic in the last years where Biedronka really gained a lot of market share.

And now as the market is being pressured with deflation at the top line and inflation at the cost line, this will put pressure and puts pressure also to be more aggressive to get sales. So what we are seeing is really is a raise in the communication of price by all players. As for the working capital, it was 4 days. As for the future, it really will depend, Jose. Because, in fact, you have part -- one thing is, of course, the terms of payments.

And what we are planning is really that we will have to invest on that, definitely. We are seeing some of our suppliers and curiously, even some big suppliers wanting to decrease price terms even, because otherwise, they will have getting into trouble with the kind of constraints in funding really from the banks and from other sources. And of course, the level of -- so interest rates that are demanded. But it's not just interest rates, it's really a constraint in funding. And on the other hand, you really have in -- the fact that inflation and the level of growth really influences also the way that the working capital evolves.

So if you have -- even if you have the suppliers investing more with us, the cost of goods sold will go down. And so even working capital, when growth tends to slow down, being it for deflation or being because of volume, this will have the opposite effect that it has, for instance, in 2022 when the inflation trajectory was going up. So the level of suppliers at year-end was quite significant compared with the prior year. So this really will depend and will depend also on the level of assets.

But I think that all of them will have to turn to also look at prices, even the ones that have in large assortments, et cetera. So in fact, I would say that currently, even Carrefour, Auchan all the players are really communicating price, because this has become really even more as a drive to -- or more important KPI to drive that. And so what we expect is that every player will have to go and communicate price more aggressively -- in a very aggressive way.

A Brief Primer on Poland

Poland has been the most successful post-communist state since liberation in 1990. It adopted the German and French legal systems and pursued economic liberation policies that enabled it to attract foreign investment. Since 1990, GDP per capital has increased from $6,200 to $37,000 in 2021 - a six-fold increase over 30 years.

Poland is now the sixth-largest economy in the European Union and ranks 21st worldwide and it is predicted that it could surpass the United Kingdom in GDP per capita over the next decade.

Among its neighbors, Poland compares is roughly comparable to Lithuania, the Czech Republic, and Slovakia, well ahead of Belarus and Ukraine, and trails Germany by a good margin.

Industry Analysis

Grocery retail is a very competitive industry with many players and several strategies, each with relative strengths and weaknesses. Megastores like Walmart draw from a large radius in the US, effectively subsidized by high car ownership and low gas prices. Similar models in Poland have been tried and not fared as well as gas prices are roughly $10/gal. Discounters generally have done well because Poles are very price conscious. Biedronka is a discounter with larger format stores of around 600-700 sqm. They lease their stores, so each looks somewhat different. Dino is in the category of proximity discount stores, operating smaller stores of 400 sqm near residences. Dino’s stores can operate effectively in areas with only 2,500 persons within a 2km radius. The radius is important because a) many shoppers walk to and from the store and b) they make several trips per week (average ticket USD 10) in part because their homes lack the storage capacity to purchase and hold greater quantities and in part because of habit.

Industry Structure

Poland has a population of 38 million, comparable in size to California. 27% are in cities/urban areas, 40% are in rural areas, and 33% are in towns and semi-dense areas (source: OECD).

The Polish grocery retail market is estimated at PLN 368b in 2022 (source: PMR). Dino recorded revenues of PLN 20b in 2022, for 5.4% share of the national grocery market. If we assume that prices in the large cities – where 27% of the population resides – are 125% of the prices in rural areas, the value of the retail market is split 34/66 between urban and rural areas (0.27 * 1.25). This implies that Dino’s market share in rural markets is 8.2%. I believe there are greater greenfield growth opportunities available to Dino because it is competing against weaker independents (Mom & Pops) in underserved rural communities.

Dino’s addressable market is the 73% of Poles who live outside urban cities. That’s 28 million people at present (not factoring in the estimated 1.5 – 2.0 million Ukrainians who have taken refuge in Poland since the onset of the Russian invasion in February 2022). Dino’s stores target a catchment area of 2,500 persons within a 2km radius. This implies a ceiling level of 11,100 stores at the current population and rural/urban distribution. The recent trends have Poles exiting the cities for the countryside for cost and lifestyle reasons and it would be reasonable to assume that immigration might also concentrate in the rural areas for cost reasons. Compared to the current store count of 2,340, Dino could grow its store base by 4.7x. If Dino were to expand its store count at 20% p.a., it would take just over 8 years for it to saturate its current market opportunity. 

International opportunities would include eastern Germany and Slovakia. Biedronka recently announced that it will expand into Slovakia. Czech Republic is also a possible expansion opportunity, but Slovakia’s demographics are closer to Poland’s than those of the Czech Republic. 

Competitive Dynamics

Dino’s closest competitor is Biedronka, owned by Jeronimo Martins (JMT PT) which operates 3,596 stores in Poland and has approximately 22% market share in comparison to Dino’s 5% market share.

Biedronka is a strong competitor with scale. Their stores tend to be larger and primarily located in urban areas where grocery prices are higher than in the rural markets that Dino concentrates on. Dino matches Biedronka on EBITDA margin under IFRS 16 which shifts store rents out of operating income and into interest and depreciation expense. The fact that Dino can match Biedronka on operating margin excluding rents at less than a third the scale of Biedronka is impressive given that scale confers significant COGS leverage driven by increased vendor discounts. Excluding IFRS 16 and returning rental expense into operating income, drops 

Biedronka’s EBITDA margin by 200bps and recognizes Dino’s competitive advantage. Dino’s EBITDA margin should continue to expand as the business scales.

While Dino and Biedronka are competitors, they appear to coexist well due to two primary factors. First, Biedronka has a greater presence in urban areas where Dino is absent, eliminating direct competition. Second, there is plenty of market share being gained at the expense of independent operators. In addition, some of the larger international grocery chains have found it challenging to thrive in Poland, reducing the competitive threats.

Here are maps of Poznań, the fifth largest city in Poland with a city population of 500,000 and a MTA population of 1.1 million.

Biedronka’s stores are mostly clustered in urban areas within the city limits.

Dino does not have a presence inside the city but is active in the countryside, where Biedronka is largely absent.

What are emerging trends? Threats?

There are recent indications that Biedronka is waking up to the competitive threat posed by Dino. Consider Pełczyce, a town in northwestern Poland of 2,700 inhabitants. 

There are two Dino’s in the town, the first near the center and the second in the far southwest corner on the road in and out of the town. Next to the latter store is a new Biedronka store that contains a staffed meat counter!

There are several observations to be made here. On the positive side, Biedronka’s competitive actions indicates that it is waking up to the effectiveness of Dino’s strategy of rural areas and features like a staffed meat counter. This both validates Dino’s strategy and also means that competition going forward could intensify. It is known that Biedronka had about 150 meat counters in its 3,500 store count. It is unclear how Biedronka is operating the meat counter (internally managed or subcontracted) and it is unclear if there’s been a shift in strategy to incorporate meat counters in most or all new stores in rural areas where it would be competing with Dino.

Biedronka is a strong competitor, yet it has a less efficient business model of reinvesting a smaller percentage of earnings at lower returns than Dino. Biedronka is expanding at a much slower rate than Dino. In the last 12 months, Biedronka added 192 net stores for 6% growth in store count while Dino added 228 stores for 10% growth in store count. If these trends were to continue, Dino would exceed Biedronka’s store count by 2029 and surpass it in revenues a few years prior.

Biedronka recently announced that it would be expanding into Slovakia. Slovakia is perhaps the best international expansion opportunity for Biedronka and Dino along with eastern Germany. It’s unclear what prompted Biedronka to act now. It may be to either curtail Dino from moving into Slovakia later or perhaps to draw Dino into entering the Slovakian market now and taking away their focus from Poland. I think the likelihood of Dino entering Slovakia now is slim given the effectiveness of their business model and the greenfield opportunities they have to potentially quadruple to quintuple their store footprint in Poland alone.

There is a real possibility that Biedronka ends up spreading themselves too thin as they appear to be increasingly chasing Dino in the countryside and now are entering a new country.

Financial Summary

How does the company make money?

Grocery retail is a straightforward business. Dino sells groceries, consumer staples like soap, liquor, etc. The customer pays via cash or credit card giving the retailer funds at the time of sale, while it can extract favorable payment terms from its suppliers that increase with scale, creating a virtuous negative working capital cycle to effectively self-finance operations.

What are the drivers of growth? And how have they evolved over time?

The primary driver of growth is new stores. Dino stands out among its competition for continually being able to reinvest large amounts of capital at high returns, driving revenue growth and compounding intrinsic value at high rates. Dino’s ROIIC over the last 5 years was 24.4% and it reinvested 114% of income at these returns, driving revenues up 35% and compounding intrinsic value at 27.8%. These are truly exceptional numbers and it’s not surprising that the stock price has compounded at 37% over this period.

Biedronka’s parent, Jeronimo Martins (which operates three concepts in three countries) has grown through reinvesting 179% of income but at a ROIIC of only 5%. Other operators in Poland are highlighted including Carrefour and Eurocash. 

What is the runway for growth?

Dino had been growing store count at 20% - 25% over the last several years but slowed down the pace in 2022 following the Russian invasion of Ukraine due first to uncertainty and more recently, due to the inflationary spike both for food inflation as well as impacting construction. The y/y growth rate of stores has progressively slowed from 23% in Q1 22 to 14% in Q1 24. Conservatively assuming that store growth is 11% going forward, Dino’s store count would grow from 2,438 in Q1 24 to 4,054

 at the end of 2028, representing less than half of the maximum store footprint I calculated at 11,100 – using the current population. 

How does management allocate capital?

The beauty of Dino’s business is evident in the capital allocation model. Dino is effectively self-financing. It reinvests 100% of cash flow into the growth of new stores at an ROCE of 40%+ on a store level.

The capital efficiency of Dino’s business model is an exceptional flywheel. Untethered to a reliance on capital markets to finance growth and the resultant burden of ballooning interest expense that accompanies debt-financed growth, Dino is free to grow at a pace of its choosing with the unique attribute that faster growth enables faster growth.

Dino has slowed the pace of new store openings over the last year from low to mid 20%s down to 13% in response to the uncertainty caused by both the Russian invasion of Ukraine and the resultant spike in inflation. It is reasonable to expect that growth will reaccelerate once things normalize and inflation has come down for both food and construction costs in the last six months.

Dino has not issued any shares since the IPO – and the shares offered then were entirely owned by the selling private equity fund. It is likely that had the fund not wanted an exit, that Dino would have remained private.

Dino pays no dividends. Executives receive no equity incentives, just cash. Chairman Biernacki has not sold any shares and does not draw a salary or any other equity incentives.

The alignment of interests with shareholders is exceptional as is the track record of capital allocation.

Risk Analysis

What are the key threats to the business? How might these risks be mitigated?

The primary threats to this business are competition and execution. It is likely that Dino will face increasing competition over time, particularly as the market evolves. To date, Dino has taken share largely from independent mom & pop grocery stores that simply can’t compete effectively with Dino. 

As the market matures, it’s likely that Dino will be increasingly going head-to-head with Biedronka as evidenced by the example shown in Pełczyce above. Given Dino’s superior business model, its track record of exceptional execution, and an owner-operator mindset and incentives, I am confident that Dino will endure these competitive attacks.

Valuation

How do you value this business today?

Dino’s rapid growth distorts its financial reports, so a few adjustments need to be made to reveal normalized earnings power.

New stores take 3 years to reach maturity with the expectation that they reach 60% maturity at the end of year 1, 80% at the end of year 2, and are 100% mature at the end of year 3. Given that stores have been added at a pace of 5-7 per week, I calculate a weighted average seasoning schedule to get a sense of what the normalized revenue run rate per store is.

At the end of Q124, Dino had 2,438 stores open versus 1,532 in Q121. 348 stores open 2-3 years are assumed to be running at 75% maturity. 330 stores open 1-2 years are assumed to be running at 50% maturity and 228 stores open 0-1 year are assumed to be running at 25% maturity. This reduces the actual ending store count of 2,438 to an effective store count at maturity of 2,015 stores (-17%), which are delivering revenues per store of PLN 12.2 million versus the reported revenues per store of PLN 11.5 million.

Applying the normalized revenues/store of PLN 12.2 million to the full store count at Q124 of 2,438 gives a normalized revenue run rate of PLN 29 billion. With Normalized EBITDA margins of 8.5% - 10.5%, and assuming maintenance capital expenditures run at 40bps of revenues versus recorded depreciation of 2.5% of Gross PP&E (40-year depreciation) and we get a pre-tax ‘FCF’ yield of 6.0% - 7.5% and an after-tax FCF (assuming no working capital changes in a normalized state) of 4.8% - 6.0% assuming no further growth of the business. This compares favorably to the 10-year US Treasury yield of 4.2%.

Dino is by no means priced as a 50-cent dollar under this hypothetical exercise of the current business in a normalized state with zero growth, but that shouldn’t be expected given its growth profile. Even this hypothetical steady state would be likely to see some real growth as the stores continue to take share from independents. Perhaps the steady state is then viewed as a bond priced at 50-100bps above treasuries but with a coupon that could still grow a couple percent a year in real terms. That’s certainly not the investment thesis for Dino, but it should give investors comfort that the current business is reasonably priced before considering the value of the growth option. 

An additional margin of safety exists because of the durability of Dino’s model. Stores and distribution centers are owned providing hard asset value on the balance sheet that may well be worth half the current enterprise value if marked to market. Dino operates with minimal leverage, has a very lean cost structure, and has vertically integrated in owning its meat processing facilities which extend from owning everything from the cattle to the meat counter. The stores are small and efficient and are said to be able to break even at a very low sales rate, providing a buffer against unexpected events. There are no dividends or stock grants sending capital out of the company.

Dino had been growing store count at 20% - 25% over the last several years but slowed down the pace in 2022 following the Russian invasion of Ukraine due first to uncertainty and more recently, due to the inflationary spike both for food inflation as well as impacting construction. The y/y growth rate of stores has progressively slowed from 23% in Q1 22 to 14% in Q1 24. Conservatively assuming that store growth is 11% going forward, Dino’s store count would grow from 2,438 in Q1 24 to 4,500 at the end of 2029, representing less than half of the maximum store footprint I calculated at 11,100 – using the current population. 

Using the same assumptions as before on a store count of 4,500 and assuming the market applies a similar valuation of 6.0% - 7.5% to normalized store performance in 2029, implies a future valuation of PLN 758/share for a CAGR of 13% over the next 5 years. Yet there’s still over 6,000 stores left to grow domestically alone!

Extending this analysis to 2035, 12 years in the future, Dino will be closer to the target of 11k stores with an ending store count of 8,417. Again, I think it’s a very conservative assumption that Dino will maintain its store growth at only 13% and expect that high teens is more reasonable while still being conservative. At this point, the steady state valuation rises to PLN 1,419/share and the CAGR at 11% tracks the growth in stores of 13%.

This model is simplistic and conservative as it incorporates no margin expansion for a firm that doubles and then doubles again, it appropriately tracks Dino’s business model. Adjusting the model to expand EBITDA margins from 8.5% - 10.5% to 11.5% - 12.5% raises the value in 2035 to over PLN 1,944/share, for a CAGR of 13% over 11 years.

Free cash flow has historically been reinvested into store growth, making a model of Dino’s intrinsic value to consist of no interim owner’s earnings payments until the business is fully mature. In practice, there will be a point where the cash thrown off by the business will exceed the cash needed for reinvestment, particularly if they maintain the reduced growth rate of new stores at 13%, versus 20%+ historically. I would expect that is one reason that Dino’s store growth is likely to rise above its current run rate as inflation continues to subside.

There is also the likelihood that Dino expands its current store format beyond Poland, with Eastern Germany and Slovakia being the most likely targets. In addition, Dino could expand into other verticals adjacent to groceries including gasoline, pharmaceuticals, etc. that could provide further growth and consume the excess cash thrown off as the grocery business matures. No credit for this optionality is made in the valuation model. Given the alignment of interests with the Chairman, I have low concern that they will do something foolish with capital allocation.

This analysis implies that Dino, purchased at the current price, has the potential to be a 5 bagger over the next 9 years.

How might your perception of fair value change over time?

The three most important factors will be the competitive environment, the maturing of the Polish market opportunity, and how they allocate capital beyond that opportunity.

What return can we generate over a 5+ year time horizon?

Dino should grow intrinsic value along with store count, somewhere between 15% - 20% CAGR over the next decade.

At what prices would you recommend the purchase of Dino’s equity in order to achieve said return?

I believe 13-15% returns over 5+ years can be achieved at the current price of PLN 406. Prices below PLN 310 make 20%+ returns achievable.

Catalyst

Dino is a long-term compounder. Continued execution of their superior business model is both necessary and sufficient. An end to the price war between Biedronka and Aldi (which neither can sustain indefinitely) would be a bonus positive catalyst.