Top-rated analyst gives his investment view on one of S.A's most anticipated listings: Dis-Chem

Dis-Chem is due to list on the JSE on 18 November 2016. While the group was founded in 1978 by the Saltzman family with their first pharmacy opening, its growth profile has taken off in recent years with the store base tripling since 2008 (28 stores). The group has ambitious growth plans yet, with identified opportunities for doubling the store base over the next 5-8 years. Despite Dis-Chem’s comparatively smaller store base (100 vs Clicks’ 500), the
group’s retail market share is similar to Clicks (which has smaller stores). We expect further market share gains in the years ahead, driven by maturation of existing stores (1/3 are not yet mature) as well as a robust new-store pipeline. Our key gripe with the business is its inferior cash-flow generation compared to Clicks, but further scale could possibly resolve this issue.
Dis-Chem plans to list at a price range of R16.25-R20.25/share. This implies a equity market value of R15.7bn at the mid-point of the range post listing, equating to a trailing EV/EBITDA multiple of 15.5x (12-month EBITDA to August 2016). Under the new capital structure (detailed below), we estimate the group is likely to earn 70cps of HEPS to February 2017, placing the stock on a 26x P/E to FY17 on the basis of the mid-point of the offer range. It is important to note, however, that the final placement price may be outside of this range – if this is the case, we believe it is likely to be above the guided range due to what is a well anticipated and sought-after new listing.
The offer
The group is offering 238.4m shares in the listing (27.5% of the total issued share capital at listing), raising R4.325bn in the process (the mid-point of the valuation range). This is to
be deployed as follows:
 R700m will be utilised to reduce debt (currently approximately R2.2bn).
 Acquisitions of CJ Group and minority interests in 9 partner pharmacies – R460m.
 A share repurchase totaling R3.575bn from existing shareholders prior to listing in order to achieve the required free-float of 28.3% on listing. Post-listing and repurchase, the Saltzman family will own 53% of the equity.
Strong earnings growth profile likely
We believe Dis-Chem is poised to sustain strong growth in earnings in the coming years.
 Not all existing stores have reached maturity (one-third of existing stores have been open for less than four years), so same-store sales should remain strong, driving margin
leverage on existing stores.
 The group is planning to open 100 stores over the next 5-8 years, and the return on capital on new stores is exceptional. A typical store should cost R20m (capex+initial working capital) and contribute ~R12m in EBIT within four years (>60% ROCE), with break-even coming within one year. To put this into perspective, this means that each year the group is adding an extra 15%-20% (R100m+ PAT) to group profit potential at store maturity from new openings alone. So, while new stores might initially lose money, the group also has previously new stores maturing every year (hence those losses are falling out of the base).
 The group already generates a 53% return on equity and given the rate of investment into new stores and a dividend policy of 40% payout, we expect earnings on a trend basis to grow by 25% per annum. This is provided that store-targets and trading densities are achieved.
Conclusion
Dis-Chem is clearly an exceptional business that has a unique opportunity to grow aggressively through a store roll-out plan that will see it gaining further share from independent pharmacy chains, and likely from Clicks too. The valuation is rich at a 12-month forward 22x P/E multiple (26x to Feb ’17), but if growth plans come to fruition, investors could still do well from this initial heady valuation level. Assuming pricing at the mid-point of the guided range, we prefer Dis-Chem to Clicks and would advocate a switch. We do, however, caution that demand is likely to be high and investors are unlikely to receive their full (or even partial) allocation.
What about the working capital?
We have one gripe with the business relative to its peer, Clicks, and this pertains to the level of cash generated by the group in recent years (per disclosure in the pre-listing
statement). This may seem an unfair comparison given Clicks’ exceptional cash-conversion profile, but it is nonetheless worth pointing out that Dis-Chem appears to have a slower-moving stock cycle, and it also doesn’t have quite as favourable creditor terms as its peer. Given the very high return on capital, this is only a problem to the extent that investors want dividends as investing into working capital at these rates of return is not a bad idea.
Furthermore, the high absorption of cash into working capital in recent years is also likely impacted by the fast pace of store openings relative to the installed base – while store openings will remain strong, they will likely slow relative to the size of the group.
Dischem1
The above cash conversion profile highlights that it would be challenging for Dis-Chem to sustain a dividend payout significantly more generous than is currently mooted unless 1) working-capital days improve; and 2) the growth profile of new-store openings slows materially. It is also worth pointing out from Figure 1 that, despite a higher GP margin, Dis-Chem’s retail division operating margin trails that of Clicks by more than 100bps. This is likely due to the lifecycle phase of their stores, and we would expect margin accretion as stores mature.
We note that Clicks currently maintains a dividend pay-out ratio of 70%, but will likely grow its EPS at a materially slower pace. In any event, when comparing the investment case of the two businesses, dividend yield is unlikely to be a material sway factor given that neither stock possesses very attractive yield – in the case of Clicks, due to a very high valuation (fwd 24x by our forecasts).
As demonstrated in Figure 2 below, we estimate that Dis-Chem is cheaper than Clicks Group on a forward P/E basis, but it also shows appreciably stronger growth potential.

 Dischem2

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