Matas (Matas DC) – Buy DKK140

Investment Thesis
Matas is the largest health and beauty retailer in Denmark with a powerful brand, strong market share, stable free cash flow, high quality management and a cheap valuation, trading at 11.2x our 2015 (CY) earnings. Matas is substantially undervalued given its consistent mid-single digits top-line growth, 15% annual EPS growth, 100%+ return on tangible invested capital and two free options that could substantially add to its earning power.

Business Overview
With 295 stores across Denmark (266 owned/operated and 29 associate stores), Matas is the dominant retailer of health and beauty products. For the American audience, Matas is a high quality drug store (think Walgreens) without pharmaceuticals or food but with a stronger focus on cosmetics (think a more affordable Sephora). Matas has been around for 64 years and is known by every Dane. Revenue mix is heavily weighted toward cosmetics with 41% of revenue from mass beauty (make-up, hair-care, skincare and toiletries) and 33% from high-end beauty (selective fragrances/skincare/etc from brand names such as Chanel), 10% from vitamins, 9% from household goods and 6% from OTC drugs.

Industry Overview
Matas commands 38% share of the total beauty market in Denmark and 62% share in high-end beauty. In Vitamins and OTC drugs, Matas commands 26% and 15% market share, respectively. Matas has more than twice the share of its next biggest competitor in mass beauty, and more than 3x the share of its nearest competitor in vitamins. Its private label “Stripes” brand accounts for 17% of revenue and is the #1 beauty/personal care brand in Denmark. Matas has continued to take market share with an incremental 900bps gain in the total beauty market over the last decade. Matas has consistently outperformed the broader health and beauty market, which grew at a CAGR of 3.6% over the last ten years while Matas grew at a 5.8% CAGR. Over the next four years, the overall H&B market is projected to grow at a 3.0%-4.0% CAGR and we believe that Matas will continue to outperform the market growth by 1-2% annually. Our proprietary survey of ~500 Danish women proves the strength of the business. 45% of Danish women visit a Matas store at least once per month, making it the second most frequently visited store after Netto (a large grocer); 93% would recommend that a friend shop there; and Matas has the highest overall score of any retailer in Denmark.40

Management
Since CVC’s buy-out in late 2006, the Matas management team has successfully transformed Matas from a cooperative structure with 180 store owners, each of whom owned/operated their own stores but used the Matas name, into a professionally managed and cohesive company. Our reference checks revealed that CEO, Terje List, is a world-class leader, salesman and operator with one of his biggest supplier stating that “you couldn’t find anyone better than Terje [to run Matas]”. We calculate that the CEO has over $4mm of equity value (stock and options) in Matas which equates to over 5x his base salary and a significant portion of his net worth. This is definitely on the higher end of management ownership in Europe. When we met with Terje, his passion about the business was evident and he jokingly explained that if he is not successful in continuing to build Matas, he will be forced to leave Denmark as the entire business community associates him with the company.

Key Investment Factors:
Market leader in attractive industry with great unit economics:
As stated above, Matas is the market leader in an attractive and growing industry. This understates its strong unit economics with over $1,000 sales per sq-ft (in US terms), 17% EBIT margins and low capex (~1.5% of sales). Operating margins are partially higher than most retail peers due to the nearly 50% gross margins in the beauty category as well as leveraging rental and labor expenses due to its outstanding sales productivity. Additionally, lease agreements are attractively structured because rent is indexed to inflation and only Matas (not the landlord) has the right to terminate a lease. Matas also leverages marketing expenses across the country (very homogenous population) and receives substantial marketing subsidies (>1.5% of sales) due to co-sponsoring by suppliers, such as L’Oreal, who aim to promote certain products through Matas’ leaflets and stores.

Proven competitive advantage as numerous foreign players have tried and failed to take market share from Matas:
Over the last ten years, three foreign competitor chains (German market leader Douglas, German discount drugstore Scheker, and Norwegian beauty retailer Esthetique) all entered the Danish market with plans to take significant share of this attractive market. All failed miserably as Douglas closed is last store in 2010, 6 years after it first entered, Scheker closed its last store in 2009, 5 years after it first entered, and Esthetique sold its final 9 locations to Matas in 2013 after having as many as 20 locations at its peak. We believe there are numerous reasons as to why Matas has thrived, including its structurally advantaged retail locations, national advertising scale (75% of all Danish households receive Matas’ bimonthly leaflet) and captive Danish consumer mindshare that would be impossible for any entrant to replicate. A former Matas employee explained to us that “it’s all about location in this business and Matas has the best locations in small towns and brilliant locations in the big cities.”

Consolidating the retail network and optimizing new central warehouse:
Matas plans to continue to expand its operated retail square footage by opening a very select number of new retail stores and by buying associate stores. This allows Matas to optimize best-in-class practices, product assortments and capture incremental retail margin (17% wholesale gross margins vs. 48.5% retail gross margins). There are 29 associate stores today and management believes that 10-15 would be attractive acquisitions candidates. Matas has the right of first refusal and recently bought in 6 stores at a valuation of 1.0x revenue, which translates to 7-8x pro-forma earnings. Matas has also recently transitioned to a new central warehouse for high-end beauty products which we estimate will have a long-term positive impact on overall gross margins by 50-100bps.

Full roll-out of loyalty program and growing online sales:
Launched in August 2010, Club Matas is already the second largest loyalty program in Denmark. Its 1.35mm members include over 60% of all Danish women aged 18 to 65. Around 60% of revenue is generated from Club Matas members as they visit stores roughly 50% more than non-club members. Members earn points on each transaction that then can be used for purchases at Matas’ online Pointshop. For the first time ever, targeted marketing programs are set to begin soon and we believe could boost SSS by 1%. A large current supplier told us that they are very excited about the use of data and “understand the value of working with Club Matas to really focus on their target audience.” Although, not a big part of sales (<1% of total), Matas is also the leading health and beauty website with DKK 30mm of online sales that is growing 50% so far this year.

Benefiting from a macroeconomic recovery:
Recent 3% like-for-like growth has come even as the overall Danish economy has not yet recovered from the financial crisis. In 2012, Danish real GDP growth was negative 0.35% and total retail spend declined 2% YoY. Recently, we have observed that Danish Consumer Confidence has massively turned positive (June-Nov 2013) and is back to pre-crisis levels after years of negative to flat readings. While total retail sales and GDP are still stagnating, we believe that the worst is over and the Danish consumer is recovering.

Discussion of Two Free Options
StyleBox Option:
Matas is planning to leverage its extensive market and consumer knowledge to open StyleBox, a Danish retail chain concept combining hair, nail and make-up treatments with the sale of selective beauty products. Stores will be located in large cities and in shopping malls. The new concept will sell a selection of high-end products that are unavailable in Matas stores. Matas has launched five stores and will end the year with 7 locations in prime areas. Management believes that Matas could open up to 50 stores if the concept is successful. Our proprietary survey suggests that over a third of Danish women would be interested in shopping at StyleBox. We believe that StyleBox could add DKK 1.00-2.00 in EPS (10-20% increase from current year consensus EPS).

Pharmacy Option:
Denmark is the only remaining Scandinavian country that has yet to liberalize the sale of prescription drugs. Currently, Danish law dictates that only pharmacists can own and operate pharmacy stores and these owner/operators currently have a monopoly on prescriptions sales to the general public. No dominant incumbents exist because pharmacists can only own a maximum of 4 pharmacy stores (of the 314 national pharmacies). The Danish Competition Authority and Danish Productivity Commission have both recommended the liberalization of prescription drugs and the government is scheduled to discuss this matter in March 2014. Matas management has explicitly stated that it’s prepared to act if the law changes as its larger stores could easily add a prescription counter without expanding square footage. Although the low gross margins on prescription (Danish pharmacy gross margins are 22.9%) would be a negative mix shift for Matas, it would be very positive on gross profit dollars, which is what really counts. Basically, this would drive higher profits per store and the increased traffic would also be beneficial to core health and beauty sales. Our survey revealed that almost 40% of women would be interested in buying prescriptions from Matas. If liberalized, we expect that Matas could gain 10%-20% share of the pharmacy market (has 15% share in the OTC market) which would translate into an additional DKK 2.25-5.75 in EPS (23%-60% increase current year consensus EPS).

Valuation and Why It’s Cheap
Absolute valuation:
On our numbers, Matas trades at 11.2x 2015CY earnings with no credit given for either of the two significant options outlined above. We expect revenue and earnings growth of 4-6% and 15% per year, respectively. Management has committed to paying out 60% of Adj. Earnings through dividends or share buyback until it de-levers to 2.0x Net Debt / EBITDA from 2.8x today. We believe that Matas will institute a healthy dividend and then use incremental cash flow, especially after it reaches its target leverage ratio, for buybacks. The tremendous stability of the company’s cash flows makes it a perfect business to leverage (under CVC ownership it had >6.0x leverage during the financial crisis) such that management could easily maintain a 2.0x leverage ratio and uses the incremental cash flow for buybacks and special dividends much like DSV A/S, another great Danish company.

Relative valuation:
Matas trades at 11.2x our 2015CY earnings estimates versus comps that trade at a median of 15.7x EPS for 2015:
• Nordic retailers (Axfood, H&M, Mekonomen): 14x-20x
• Global cosmetic (Bonjour, L’occitane, Sa Sa): 14x-18x
• US beauty retailers and pharmacies (CVS, Walgreen, Sally Beauty): 13-15x
• Beauty and personal care (Estee Lauder and L’Oreal): 20-21x

Indiscriminant selling:
Prior to the IPO, CVC (private equity firm) and former store owners (“M Invest”) collectively owned 69% and 30%, respectively, and now own 19.4% and 8.5%, respectively. CVC has recently moved to exit Denmark entirely as a result of a recent change in tax law that eliminates the interest tax shield on highly levered companies, impairing the ability to do LBOs. Danish pension and retail investors have also been far less interested in the private equity backed IPOs since the epic failures of Pandora and TDC in late 2010, which have both massively underperformed in the year following their IPOs. Additionally, Matas will not be paying a dividend until mid-2014 so many dividend-seeking investors are on hold until then.

Illiquidity from small float:
Since the IPO, average daily volume has averaged just $7.5m/day and about half of that in the last 2-3 months. The lockup on CVC’s and M Invest’s remaining stake expires in December 11th and a sale of all their shares could free up a significant amount of liquidity, potentially increasing the current float by 45%+.

• Increased liquidity after CVC completely exits enabling larger institutional investors to participate– this could theoretically happen in the next few weeks after the lockup expires.
• Continued earnings beats on SSS sales growth and operating leverage – just reported 3.9% SSS growth versus 3.3% expectations last quarter.
• Pharmaceutical market moves towards liberalization in 2014.
• StyleBox early success in 2014.
• Dividend payments in 2014 attract yield seeking investors.