Description

Pepco (PCO.PW) is a “moms-on-a-budget” European retailer. It was written up in October 2022 when the stock was at PLN32 with a price target of PLN65. Today the share trades at PLN25.50 recovering from a low of PLN16 a few months ago. (I recommend reading the earlier VIC write-up as it contains important background for this idea.) 

I agreed with the prior write-up. This is a great business. The stores are cheap to build and the payback on new stores is 18 months. At the time, there were 4000 stores with plans to grow to 20 000 stores filling in the white spaces accross Europe. Who would not be attracted to this idea?

What went wrong? Why did the share price get hit? The “growth at all costs” strategy was too fast, overextending the company. Core markets were neglected and suffered and the entry into “new” markets was rushed and not properly thought through.

The CEO resigned in September 2023, and Andy Bond, the previous CEO, was brought back to rescue the business. Rescue is the wrong word. The business was still doing well. Revenue and EBITDA were up 16% and 4% for the year ended September 2023 so we are not talking about a train smash implied by the dramatic decline in the share price. The problems should be easy to fix and the "misses" should be viewed as a minor setback or hiccup.

Today, the explosive concerns have long been forgotten. Pepco just reported its 1H2024 results. Revenues were up 14%, while EBITDA increased by 28%. Mr. Market reacted positively, shooting the share price up 16% in a single day.

Business Description

Andy Bond, the former CEO for 7 years, has returned and has determined that Pepco was overextended. His overriding strategy is to do “less to achieve more.”  

Before describing this strategy, I am going to briefly provide some information on the business and the money flows that are important for context. 

Pepco trades under the Pepco and Poundland/Dealz brands. 

• Pepco (selling mostly discounted clothing) operates 3 147 stores (1 317 stores in Poland) in the CEE and 518 stores in WE. 

• Poundland (think dollar store) operates 864 stores in UK+Ireland. 

• Dealz (an attempt to bring Poundland to Europe) operates 316 stores in Poland. 

A breakdown of the store footprint is shown below.

The 1H2024 revenues and EBITDA's for the brands and regions are shown below. 

Strategy

Store Footprint

While the “white space 20 000 store" opportunity is still alive, the aggressive store roll-out program has been curtailed. In the first half, 289 stores were opened largely because of earlier commitments. Openings will slow dramatically in the 2H with only 111 new stores.  

Most of the new stores will be rolled out in the higher ROI CEE. It’s back to the drawing board for WE. Pepco closed 72 stores in Austria and I would not be surprised if there is a shift in focus to Southern Europe, particularly Spain and Italy. 

The strategy for new stores openings is captured in this extract form 1H2024 results call. 

CEO (Andy Bond)

“I think the most important thing I can highlight as we think about CEE is it's not yet a saturated set of markets for us. We still see some very good runway for future growth. And therefore, the fact that we're focusing most of our capital there now does not constrain us in terms of our growth ambitions.

However, I think that within the next 12 to 18 months, we will have achieved the target of delivering a target operating model in Western Europe, particularly in Italy in Spain that will allow us to recommence store opening -- a significant store opening program in Western Europe, and that will be helped and facilitated by the distribution center opening later this calendar year in Spain.”

 (Note: Pepco’s distribution centres are located in the CEE (most in Poland). They are currently being used to service WE stores compromising the economic viability of these regions.)

Brands

Pepco wants to simplify and move to operating one business. Pepco clothes are being introduced into the Poundland stores which will gradually transform to look more and more like a Pepco. 

There are question marks about Dealz. The stores in Spain were closed leaving an isolated 316 stores in Poland. 

Restoring Profitability

GrossProfit margins in the Pepco stores have been under pressure since 2022. Good progress was made to restore margins in 1H2024 with Gross Profit jumping to 45.5%. Further, but a less dramatic, improvements are expected in H2.  (GPM’s were 46.8% and 47.2% in 2019 and 2021 respectively.)

LFL

LFL sales have turned negative. This is a particular issue in the Pepco stores.

The CEO is optimistic that LFL sales will turn positive in the H2.

Andy Bond, 1H2024 results call.

“First of all, it is worthwhile highlighting our negative like-for-likes have continued in the first few weeks of this half. However, I remain extremely confident that by the end of the year, we'll be exiting this year with a solid positive like-for-like growth that's sustainable in our core Pepco operating company. And I feel that's clear because we know the levers that we are pulling and making progress. Our price position is better. Over time, our inventory quality, which has been a major problem for the company is improving.

And finally, the fact that we are doing less just means that operationally, we're managing our business much in a much more disciplined manner. So I'm confident we'll see an improving like-for-like trend in the second half. And again, as we both already highlighted, we see the recovery in gross margins continuing in the second half, not necessarily the amazing improvement from Q1 to Q2, but definitely continued improvement.”

Capital Spend

The aggressive store expansion program has been curtailed and the expensive store refit program has been suspended. In general, there is a focus on lowering the capital intensity of the business model to help drive higher ROI’s.

The lower capex bill will obviously increase the Free Cash flows from the business and the prospect of a dividend is being tossed around.

Key Numbers

Pepco report in Euros. Stores have compounded at 15%, Sales at 17% and EBITDA at 20%. 

Valuation

I think it is obvious that 4 times is too cheap for a company that can easily double in size using very little capital, never mind the ROI that can be achieved when new investments have a 16 month payback.

Next to this ugly-duckling, comparatives, are highly rated businesses, trading at 4 times Pepco’s multiple. Deciding to list on the Polish market was a mistake that probably needs to be addressed.

Risks

Steinhoff (now IBX), currently controlled by bondholders, owns 72% of Pepco which does create the risk of a overhang. On the other hand, the bond holders have been very disciplined and have largely held on to this position. Selling at the current low multiple seems like a missed opportunity and the temptation for them to pull levers to get the share price up is very real. Selling to a highly rated competitor must be very tempting prospect.

Catalyst

Improving operational metrics. Management have guided that GPM’s will continue to improve and that LFL sales will turn positive in the 2H. 

Improved visibility on the strategy for WE will give investors a better feel for the potential runway for store openings.

Conclusion

Pepco’s share price jumped 16% on the 1H2024 result. "Jumps on news" are often an odds-on signal to buy to benefit from a rising share price as the "good news" is slowly reflected in the price. 

Catalyst

Continued improvement in operating metrics, gpm and lfl sales.

Clarity wrt the strategy for WE clarifying the potetial to open new stores.