March 2014 KESTREL CAPITAL Member of the Nairobi Securities Exchange Company update Uchumi Supermarkets Ltd Bloomberg Ticker : UCSP.KN Recommendation: LIGHTEN Reuters Ticker: UCHM.NR We issue a LIGHTEN recommendation on Uchumi Supermarkets Limited (Uchumi) based Share Statistics on a fair value of KES 10.50 implying a 29.3% downside from current market price. We are Fair Value (KES) 10.50 of the opinion that increased competition in the region has in the past year put pressure on Price (KES) 14.85 the company’s sales growth which we expect to remain subdued in the medium term (2 year Issued shares (m) 265.4 forward CAGR of 5.2% to KES 15.9bn in FY15F). Rising costs (2 year forward CAGR of Market cap (KES bn) 4.1 5.4%) as the company continues to expand both locally and regionally will continue to im- Market cap (USD m) 47.4 Year end June - pact bottom line performance, with the EPS estimated to record a 2 year forward CAGR of Free float (% ) 86.6 62.0% ( -85.1% y/y in FY14F and -3.1% y/y in FY15F). Uchumi is trading at forward P/E Av daily trading vol (USD) 38,422 and P/B multiples of 74.0x and 1.3x compared to its Africa and Middle East peer compara- ble medians of 21.2x and 4.7x respectively. Its forward ROE, at 1.8%, is also significantly Price Return lower than the peer comparable median of 23.8%. We therefore feel that the counter is over- Absolute Excess valued based on the above multiples and that its medium term prospects may not justify the 3m -22.8% -24.2% current high valuation. 6m -21.4% -26.3% • Rising competition to suppress revenue growth - 2 year forward CAGR of 5.2% com- 12m -28.1% -32.3% pared to 3 year historical CAGR of 14.4% Price Trend • Gross margin improvement as cost of sales rise slower than revenues - +40 bps over Source: NSE the next three years to 19.7% in FY16F Research Analyst • Rise in specialty income to support bottom line growth -Speciality income to increase 7.8% y/y and 10.3% y/y FY14F and FY15F respectively • Expansion drive to spur growth in operating expenses - EBITDA margin to ease 290bps y/y to 2.5% in FY14F and shed 10bps y/y to 2.4% in FY15F • Higher debt levels to drive finance costs upwards – Finance cost to rise 18.8% y/y to KES 19.1m in FY14F. • Rights Issue to be conducted in 2H14 - 100.0m shares to be offered possibly in 2H14 • Fair value gains on investment – we have not included any forward fair value gains on the 20 acre land that Uchumi owns which is revalued annually. • Lower earnings to suppress ROaA and ROaE - ROaA to ease 550bps y/y to 0.9% and ROaE to shed 1100bps y/y to 1.8% in FY14F • Inability to pay dividends in the medium term - Due to suppressed earnings growth, capex requirements and negative free cash flow position • Industry analysis -A look at the four major supermarkets in Kenya Joy D’Souza Key Statistics FY11 FY12 FY13 FY14F FY15F EPS(KES) 1.47 1.03 1.35 0.20 0.19 [email protected] Growth (%) -54.9 -29.8 30.3 -85.1 -3.1 +254 20 2251 758 DPS (KES) - - 0.30 - - P/E x 10.1 14.4 11.0 74.0 76.4 P/B x 1.7 1.5 1.3 1.3 1.3 Div yield (%) 0.0 0.0 2.0 0.0 0.0 ROaA 10.9 6.1 6.8 0.9 0.9 ROaE 20.5 11.1 12.8 1.8 1.7 Source: Company, Kestrel estimates Uchumi Supermarkets Limited KESTREL CAPITAL • Rising competition to suppress revenue growth – Rising competition has seen Uchumi lose its revenue market share (amongst the four major supermarkets) from 3rd position to 4th in the last two years, with the percentage easing 170bps to 12.5% in 2013. We expect the growth in revenue to be slower compared to the past in light of increasing competition in the region. The four major supermarkets in Kenya have been on an aggressive expansion plan with Nakumatt, Tuskys, Uchumi and Naivas increasing their stores regionally from 37, 37, 21 and 19 in March 2012 to 45, 46, 34 and 29 respectively currently. There’s also been in- creased interest by South African retailers who are said to be looking to enter the Kenyan market through buying local supermarkets. We estimate that sales will rise at a 2 year for- ward CAGR of 5.2% (compared to 3 year historical CAGR of 14.4%) driven by increased sales from new branches put up between last year (6 branches) and this year (4 branches already launched) and a rise in disposable incomes driven by economic advancement. Our forecasts suggest a 3.5% y/y rise in sales in FY14E ( -4.0% y/y in 1H14) and a subsequent 6.9% y/y rise in FY15F. FY11 FY12 FY13 FY14F FY15F Revenue (KES m) 10,841 13,919 14,369 14,872 15,898 % y/y ch 12.8 28.4 3.2 3.5 6.9 Number of stores 18 25 31 40 42 Average revenue per store (KES m) 602 557 464 372 379 Customer numbers (m) 20 22 24 28 Source: Company, Kestrel estimates • Gross margin improvement as cost of sales rise slower than revenues -Better supplier terms coupled with an improvement in the macroeconomic environment will drive gross margin improvement with cost of sales expected to grow at a 2 year forward CAGR of 5.0% compared to the 2 year forward CAGR of 5.2% in revenue. Our estimates are underpinned on stable inflation as well as better supplier terms coupled with economies of scale realised as the company continues to grow. We note that Uchumi has managed to surpass the 18.0% gross margin target set by management in 2011 when the company was re -listed on the NSE, achieving 19.3% in FY13 and 19.9% in 1H14. We expect gross profit margin improvement to support bottom line growth, especially, in light of growing costs attributable to upgrading of facilities and expansion. We highlight the historical gross margin performance and our estimates going forward below: FY11 FY12 FY13 FY14F FY15F Revenue (KES m) 10,841 13,919 14,369 14,872 15,898 % y/y ch 12.8% 28.4% 3.2% 3.5% 6.9% Cost of Sales (KES m) (8,944) (11,407) (11,600) (11,972) (12,782) % y/y ch 13.0% 27.5% 1.7% 3.2% 6.8% Gross margin 17.5% 18.0% 19.3% 19.5% 19.6% y/y bps ch -20 50 130 20 10 Source: Company, Kestrel estimates Uchumi Supermarkets Limited KESTREL CAPITAL • Notably, Uchumi introduced an electronic demand based system in 2012 with the aim of managing its inventory and reducing non movers. However, we are yet to see the benefits come through given that if anything, the inventory turnover has slightly deteriorated with the inventory days increasing from 34 days to 37 days. The company’s cash conversion cy- cle has however improved over the years from –0.02 in FY11 to –9.72 in FY13, mainly driv- en by an improvement in supplier credit terms which is currently at an average of 58 days (from 45 days in FY11) with management working towards growing the same to an average of 60days. Receivables turnover has remained stable with receivable days at 11 days. Uchumi, like its counterparts (Nakumatt, Tusky’s and Naivas) has introduced online shop- ping which is yet to catch up in the region. FY08 FY09 FY10 FY11 FY12 FY13 DSO (Receivables) 6.80 11.89 9.84 11.08 10.19 11.07 DSI (Inventory) 40.92 32.87 32.72 34.24 34.17 37.29 DPO (Payables) 56.93 61.93 50.30 45.34 52.20 58.08 Cash conversion cycle (9.21) (17.17) (7.73) (0.02) (7.84) (9.72) Source: Company, Kestrel estimates • Rise in specialty income to support bottom line growth - In line with the expected growth in the number of outlets, we estimate specialty income to grow 7.8% y/y and 10.3% y/y in FY14F and FY15F respectively. Our estimates are derived from the assumption that special- ty income will stand at 3.1% of total revenue in the next three years from 3.0% in FY13 and 2.7% in FY12. This will be driven by a rise in income collected from the sublet space in the new outlets (Uchumi sublets space to various outfits including jewellery stores, cosmetics stores, gift shops and mobile phone stores) as well as a rise in commissions generated from money transfer services including MPESA (Uchumi is the largest MPESA agent), transactions on other utility payment services including electricity, water and cable TV (DSTV) as well as till branding. • Expansion drive to spur growth in operating expenses – Uchumi has this year put up 4 Source: Company, Kestrel estimates new branches and plans to put up 5 more before the end of the year to support revenue growth in the face of growing competition. Additionally, Uchumi has embarked on an exer- Tanzania accounted for 4.4% of cise to upgrade its older establishments. Approximately KES 300m will be spent in FY14F total revenue in FY13 from 2.6% under the expansion plan. The company has been on a cautious expansion plan since 2011, in FY12 after an additional store with 3, 7, and 5 branches opened in 2011, 2012 and 2013 respectively.