Description

Summary: PepCo Group NV (PCO) is a US$3.8B market cap (21% freefloat) European discount variety retailer in the middle innings of its store roll-out plan. PCO is an undervalued growth story whose near-term margins and earnings have been suppressed by cost and currency inflation. At PLN31.7 per share PCO trades at 13.6x FY23E (9/30/23) PE. Our target in two years is PLN65 per share.  

Background: PCO operates two banners, PEPCO and Poundland / Dealz. PEPCO is a pan- European discount variety retailer focused on women / children’s wear and home goods, offering multiple price points. Poundland is a UK discount retailer focused on FMCG which historically had a single price point. Dealz is an extension of Poundland operating in the EU.

The history of PCO is important to understand as it explains the convoluted structure. The PEPCO banner was founded in Poland in 2003 by the Pepkor Group, an established South African discounter. In 2014, Steinhoff International Holdings acquired Pepkor. In 2015, PCO’s former CEO, Andy Bond, joined Steinhoff with a mandate to roll-up the European discount segment. In 2016, Steinhoff acquired Poundland and PEPCO and Poundland were put under the PCO umbrella. PCO subsequently invested in Dealz to expand Poundland’s business to the EU. In 2019 Steinhoff succumbed to an accounting scandal and the Steinhoff estate is currently being wound down on behalf of its creditors - several US distressed funds. On May 26th, 2021, Steinhoff IPO’d 21% of PCO in a secondary sale. PCO is run independently of Steinhoff though Steinhoff has the right to appoint 3 of the 9 PCO board seats.

In March 2022, Bond retired and was replaced by PEPCO’s CEO Trevor Masters. At the same time, PCO changed its strategy to prioritize the PEPCO brand. In FY23, 90% of PCO’s new store openings will be PEPCO stores and PCO is trialing the conversion of Dealz stores to the PEPCO banner. This change is important as PEPCO is PCO’s highest returning asset and marks a shift from empire building to focused growth.

As of September 2022, PCO operated 3,961 stores (2,910 PEPCO / 1,051 Poundland). PCO believes there is white space for 20,000 stores in Europe (1 store per 22,350 persons). PCO cites Dollar General which operates ~18,000 stores in the US (1 store per 18,329 persons) with plans to grow to 30,000 stores. Additionally, PEPCO currently operates 1 store per ~31,500 persons in Poland. Since FY13, the PEPCO banner has grown its store count at a 23% CAGR. In FY23, PCO plans to open at least 500 PEPCO stores representing 17% YoY growth.

The below chart from PCO’s March 9th store opening seminar details PEPCO’s current footprint focused on Central and Eastern Europe (“CEE”) - where it has historically concentrated and has a dominant footprint - and the white space available in Western Europe (“WE”).

While PEPCO believes it has room for an additional 1,000+ stores in CEE, the majority of the white space is in WE. PEPCO began expanding into WE in 2020. PEPCO started with Southern Europe, which is closer in nature to CEE, and recently launched its first two stores in Germany. To date PCO has provided positive commentary overall and model financials based on its experience in Italy (which was the first WE market it entered). The continued adoption of PEPCO’s value proposition into WE is the crux of the PEPCO story and bears constant monitoring.

At its October 13, 2022 Capital Markets Day, PCO laid out the following new store economics.

PEPCO has many competitors. The closest are discounters KiK, NKD, Takko, Action and Primark. None is a perfect match as each has a different mix of clothing, general merchandise and FMCG products. At ~3,000 stores PEPCO has similar scale to all of them (KiK 4,000 stores, NKD 2,000 stores, Action 2,000 stores). All are present in CEE and compete against PEPCO already. KiK and Action are expanding in the reverse direction as PEPCO – from WE to CEE. 

Value Drivers

PCO has three primary value drivers: 1) store growth, 2) like-for-like (“LfL”) growth and 3) margin expansion.

PCO has provided the following FY23 guidance: 1) YoY store growth of 14% 2) overall LfL growth of mid-single digits and 3) EBITDA growth in line with historical rates (~14%-17%), implying slight margin compression. Factoring these items, consensus has PCO earning E.49/share in FY23. Beyond FY23, the sell-side has PCO growing by high-teens driven by continued store roll-outs and modest LfL growth.  

While PCO has significant white space, it is already aggressive in its store roll-out. This leaves PCO two drivers to accelerate its growth 1) LfL growth and 2) margin expansion:

1)   There are a couple of potential drivers of LfL growth. Near-term PCO has absorbed a significant amount of cost and currency inflation. Longer term, at its Capital Market Day, PCO outlined two pilot programs to accelerate its growth: 1) a store refresh program and 2) the addition of grocery products sourced from Dealz. PepCo trialed the store refresh program in 63 stores and realized an ~20% pick-up in sales. It is now rolling it out company wide in FY23 and FY24. PCO is in early stages of trialing the addition of groceries. Early commentary at its Capital Markets Day was promising.

2)   Consensus has PCO earning a 14.5% EBITDA margin in FY23. Prior to COVID, PCO earned closer to a 17% margin. PCO sources the majority of its products from Asia, where they are purchased in dollars, shipped and sold in Euros. Over the past two years the company has absorbed a significant amount of cost and currency inflation. Over a multi-year view PCO should recover this margin. PCO’s CFO discussed this at the Capital Markets Day.

“And clearly the focus is, doing this without impacting the customer. And in terms of the long-term, look, where the business has been typically seeking to target our pre-COVID ratios. We've always believed that the business that we had coming into COVID was strong and resilient. And the opportunity that we have absolutely, it would be in the same shape. I think the critical factor here at the moment is, the volatility in the environment means that we need to manage the business in a pretty proactive way. If you're thinking about the last year, what Trevor and team have had to deliver is, pulling the levers, accelerating things, slowing things down to ensure that we both manage the strategic delivery of the long term but also the short-term financial delivery.

The focus remains accelerating our clearly defined plans to deliver on our financial results. And I think that very important point, we will in no way make short-term decisions to enhance delivery one quarter or one year, this is about delivering on the business. And all of the plans that you heard about are recurring both in terms of CapEx, cash sales and items. So long term there is remains -- target the business to be pre-COVID or better. “

Valuation

PCO is often compared to fast growing retail names in Europe and a basket of dollar stores. Today PCO should likely trade somewhere between the two baskets. As a discounter it is less cyclical than its European fast fashion peers but given PEPCO’s focus on clothing and home goods it is likely not counter cyclical like a dollar store.

Our price target in two years is PLN65/share. This is 16x our FY25 EPS estimate, which factors in a modest rebound in PCO’s margins and implies a PEG of ~.8x.

Risks and Other Items

Beyond the well documented macro-economic challenges facing CEE, the primary risk is how well PEPCO’s value proposition translates to WE.

Both PCO’s CEO and CFO retired in the beginning of 2022 due to health issues. PEPCO’s CEO has taken over the role of Group CEO, which we view positively. The company is still conducting a search for a permanent CFO.

Steinhoff still owns 79% of PCO. At some point this will need to be monetized.  

63% of PEPCO’s products are sourced from China, with the remainder from Bangladesh (24%), India (10%), Myanmar, (2%) and Pakistan (1%)

The discount segment is competitive. PCO’s primary competitors are slowly expanding from WE to CEE. 

Catalyst

Continued updates on store expansion progress. 

Steinhoff continuing to sell down its stake.