Jeronimo Martins (OTCPK:JRONY) (OTC:JRONF) runs the Biedronka supermarket and Hebe drugstore chains in Poland and the Pingo Doce supermarket and Recheio wholesale (and foodservice) chains in Portugal. In recent years the company has started a new expansion in Colombia as well with the Ara supermarket chain. Finally, the company also has a joint venture with Unilever for the production of personal care products and some other smaller businesses in Portugal. Historically the Portuguese operations were the heart of the company's operations but its excellent performance with the fast growing Biedronka chain has effectively tied the company's financial prospects more to the Polish retail market than the Portuguese one. This year the company has stumbled badly because of margin pressures caused by food price deflation. The deflationary environment in both Poland and Portugal has caused like-for-like sales declines in both countries, which has caused operating costs to rise faster than revenues. Investors in Jeronimo Martins have become accustomed to strong results over the years since the financial crisis and have in these past years valued the shares at a substantial premium to the food retail sector as a whole. Lower profits and a more cautious outlook have caused the share price to come down hard this year, effectively evaporating the share premium versus its peer group in the process. I believe that the company's hardships are largely due to external factors and will probably disappear in the medium term, making the share weakness an opportunity to accumulate a position in what I still consider to be a food retailer with an above average growth profile. Growth is unlikely to be as fast as it was during the past five years; it's now a moderate growth story combined with an attractive dividend. There are two primary reasons why I think the share is currently attractive.
First, although the company is well on its way to a mature footprint in its Polish operations I believe there's still meaningful room for growth. Biedronka probably still has about 20% traditional format unit growth ahead of it plus Jeronimo Martins has already embarked on expansion into the pharmacy retail sector with the Hebe chain. On top of that, the deflationary environment in Poland is very likely a temporary situation caused by the EU boycott of Russia. Putin has countered with a boycott of their own against all sorts of agricultural products from the EU. This has caused severe inflationary pressures in Russia while pushing down prices in the EU countries. Besides the fact that this sort of thing is utterly ridiculous in the 21st century, it doesn't seem likely to last very long, since both sides are suffering considerably (Russia a bit more perhaps). And even if the boycotts last I think it is very likely that Eastern European commodity foods will find different markets for consumption. The Polish economy has done very well over the past decade and a deflationary environment is not likely to persist in a country where wages are going up quite fast.
Secondly, while the new store expansion program in Colombia is still very modest in size it has significant potential for the future. Because this start-up operation will not become operating income positive for at least several years I consider this mostly a long-term story for investors in Jeronimo shares while the Polish business remains the real prize. Successfully exploiting a food retail operation in another country is no small feat and Jeronimo Martins has proven that it is able to do so where larger competitors such as Tesco (OTCPK:TSCDF) and Ahold (OTCPK:AHODD) have often struggled. If there's a business that can succeed in Colombia, Jeronimo's operation (based on its successful track record in Poland) should be it. The company certainly has a battalion of managers (both Poles and Portuguese) that have become specialists in retail expansion operations. Being an economic success story in a country plagued by the economic crisis has given Jeronimo Martins a strong recruitment advantage. It has created over 15,000 new jobs in its operations (all countries included) in the 2010-2012 period alone, while it hired 435 trainees in this period (from 57,000+ applicants!).
The margin situation
As stated the deflationary environment in Poland and Portugal has put pressure on Jeronimo Martins' margins. Let's take a look at the operating margin for Jeronimo Martins versus some of its peers. I have chosen a peer group of companies active in food retail on the European continent and have selected mostly multinational operators like Jeronimo itself is. The only exception to this rule is Colruyt (OTC:CUYTF) from Belgium which is active overwhelmingly in its domestic market (and for a small part in France). The other businesses are probably more known, with Ahold and Delhaize (DEG) both operating in the US and in their respective domestic markets of the Netherlands and Belgium (as well as some Eastern European territories). Casino-Guichard (OTC:CGUIF) and Carrefour (OTCPK:CRERF) are both from France with very extensive overseas businesses.
(Table above is the author's own work with all data from the companies' annual reports).
The table shows the operating margin for the past five fiscal years for the peer group and Jeronimo Martins itself. What becomes clear is that almost all of these companies have had trouble maintaining their operating margin levels. The period shown is of course characterized by the recession in several European countries, high unemployment and the government austerity programs. Delhaize, Ahold and Colruyt have seen strong downward trends in their operating margins, while underperformer Carrefour has seen a modest rebound from a low in 2011 near 2.8%. Historically food retail is a 4-5% operating margin industry, with price inflation and modest population growth enabling some like-for-like sales gains annually in this mature industry (in developed economies) to offset operating cost increases. In the past years all of these companies have struggled with higher costs combined with slowing revenue growth. Jeronimo Martins has bucked this challenge a little longer than most of its peers due to the strong like-for-like sales increases at its Biedronka chain. This year its Polish LFL sales dropped into negative territory which, combined with the fast-increasing costs associated with its store expansion program, deleveraged its fixed cost structure. I believe the underlying business in Poland is doing fine however, given that like-for-like volume is still up year-on-year. Therefore, price deflation caused by declining commodity prices generally and aggravated by the Russian boycott is the sole blame for this situation. This is nasty for current shareholders of Jeronimo but in my opinion a good opportunity for those looking for an attractive entry point. Even though the share has already rebounded some, I still think it's a relative steal at this moment. I will explain why in more detail below.
Growth in Poland
First of all the company still has room to expand the store network in Poland. Biedronka is currently the market leader in Polish food retail with 2527 stores in the discount segment. On top of the more than one thousand stores added during the past five year period Jeronimo thinks it can add 500-650 additional stores over time and has a target of +300 by fiscal year 2017. The strong annual sales growth achieved by Biedronka of 19% (past five years) will of course come down significantly but will still be superior versus most European food retail chains. I will take the year 2017 as a target year to model expectations for the company's financial future near the end of this article. I have chosen this year mostly because of the visibility management has provided for this period. All the other large players in the Polish food retail market have a store base significantly below a 1000 units, giving Biedronka very strong advantages of scale. Besides driving the highest sales average of any food retailer in Poland on a sales-per-square-feet metric Biedronka has also focused heavily on store-label brands to achieve attractive margins in their discount model. Their ebitda-margin of 7% (trailing 9M) is estimated to be over twice as high as that of the competition. The company already has a national distribution footprint with 15 distribution centers and over a 1000 trucks delivering every day. The additional stores will mostly fit into this existing structure making them more than accretive to operating earnings.
The Polish economy (population 38.5 mln) has done exceptionally well over the past decade or so and is one of the top performers of the former Eastern bloc countries. Current signs are that this is set to continue for the foreseeable future with estimated GDP growth over 3% annually in the period until 2017 and consumption growing slightly lower than this rate. Currently the country still trails Western European nations in per capita food expenditure (almost 50% lower on average than in the West). Combined with growth in disposable income the future for the food retail sector in Poland looks promising (growth of 3% predicted per annum up to 2017). Salaries are currently growing at rates around 3% per annum, which forms part of the equation that has caused Jeronimo's current predicament. With inflation rates dropping into negative territory in Q2 of this year generally and for food prices especially, the company is faced with increasing costs (for its personnel mostly) while the pricing level it achieves from its customers is impacted by deflation. This has created margin pressures for the company, but also for its peers. While the market has responded to lowered profit outlooks by sending the company's share price lower, it has failed to realize Biedronka will also benefit from its scale versus its peers.
Food retail growth is set to rise in future years despite the deflation now seen and will be captured mostly by the modern retail trade, which will continue to steal market share away from traditional retail ('mom and pop' shops). With average share of 54% in 2013 the modern retail sector's share in Poland still lags the general level it holds in Western Europe (75-80%) by a significant margin. The discount positioning of Biedronka in this sector makes it a likely winner in the future struggle for market share.
The discounter share of the market is currently at 21.4% (9M 2014) which is up from 15.1% in 2011, making it the fasting growing subsector of the food retail sector. In Western Europe the discount share is much larger (from 27% in Austria to 57% in Norway). Biedronka currently claims market share of 17.2% (July/Aug 14) which it has increased quite strongly over the years (as seen below).
(Table above: Biedronka's market share of the total Polish food retail category. From the company's Biedronka day 2014 presentation, November 13th 2014)
The company will address the current margin challenges by focusing on all the well-known pillars of a strong retail operation. First it will provide the customer with a stronger assortment, which includes driving higher sales in categories that were relatively unimportant until now (such as fresh and non-food). Secondly it will improve the customer experience by upping the engagement levels of its (until now) mostly efficiency focused stores. Both of these efforts will raise the value proposition it offers to customers. Secondly the company will invest in maintaining or widening its price leadership. This is achieved by its Everyday Low Prices image (learned from Wal-Mart) supplemented with promotional activity where appropriate. The planned expansion of its store base will increase the proximity to its average customer, again improving its service level (modern retail penetration still way below that of Western Europe in Poland). This also includes becoming a more urban focused operation with smaller stores in larger cities that have adjusted assortments. Finally, the company will increase focus on cost discipline made possible by the expansion of its store base slowing down.
Jeronimo thinks it can still achieve meaningful efficiencies by rationalizing distribution and store processes and by sharing best practices. I consider this a likely cost saving opportunity since the fast expansion pace of the past five years is bound to have created inefficiencies. Some of the initiatives above will affect margins in a negative way (price leadership) while others will benefit margins (cost discipline). Overall the company's margin is likely to come down somewhat over the next few years; EBITDA margin is targeted by management at a minimum of 6.5% in 2017 (versus 7% currently).
The Colombian Opportunity
Jeronimo Martins decided to enter the Colombian food retail market in October of 2011 after looking extensively for markets that suited its criteria for expansion. In the first quarter of 2013 it opened the first Ara stores and distribution center in this country and ended the year with a total of 36 stores (and 9M 2014 with 54 stores). The strategic plan 2014-2016 called for a minimum of 200 Ara stores in Colombia by year end 2016. It looks like that is quite an aggressive target which may not be achieved. It is however difficult to gain visibility on these operations since they are not yet reported separately. Jeronimo Martins currently reports it together with its new Hebe (117 stores - 9M 2014) drugstore chain in Poland which it started in 2011. Therefore I will look at these operations on a combined financial basis. The plan for Hebe is similar by the way: Jeronimo wants to have 200 of these stores in Poland by year end 2016. It also thinks the chain will become EBITDA positive around that time. For the Ara chain no EBITDA targets have been announced publicly. Together these operations will be negative contributors to operating income until at least 2017 in my opinion.
The Colombian expansion will be targeting separate regions one at a time and started in the Pereira and Santa Rosa cities which are situated in Colombia's coffee-growing region. The plan is to gradually expand into other regions as soon as the first one is scaled. The Ara stores are positioned as discounters that offer a significant level of private label products, which is relatively new in Colombia (162 private label articles out of total product assortment of 900). In the first year that Ara operated these combined chains achieved sales of €80 mln with EBITDA contribution of €-42 mln. This year the sales number had grown to €103 million for the first nine months of 2014. The Ara operation is probably the largest money loser of the two since it has to build from scratch while the Hebe stores can be leveraged on Biedronka's distribution network. I think the Ara development is quite a daring move, which probably would not have been undertaken had Jeronimo Martins not been a family controlled business (the Dos Santos family indirectly controls over 56% of the company's shares). While the expansion program is likely to pressure margins it also opens up a new growth opportunity to Jeronimo which is attractive considering the approaching maturity of their Polish store footprint. I think the uncertainty regarding operating losses and low visibility on progress have caused investors to be cautious on this undertaking, possibly underestimating the potential for future value creation.
The Portuguese Operations and my Scenario Model
In my opinion the Portuguese operations offer little room for organic growth and have delivered mostly stable to slightly declining results due to the depressed economic environment in Portugal. The company maintains an attractive market share leadership position in its two most important business activities however which contributed meaningfully to the overall economic results of the company during 2013. Combined sales contribution of the Recheio and Pingo Doce chains was slightly over 33% of company total, while providing 29.6% of total EBITDA. Given low possibilities for expansion the Portuguese business only consumed about 17% of the capital expenditures budget (2013) and has provided cash flows that have financed capital investments in the Polish operations for the past years. Biedronka consumed 74.4% of the 2013 CAPEX budget for example. So indirectly the Portuguese operations have provided substantial contributions to overall company growth. I have prognosticated slow growth for these operations in my Jeronimo Martins 2017 financial model (as seen below).
(Table above is the author's own work using data from the company's annual report 2013 and projections based on management plans as stated in the Biedronka Day 2014 Presentation and the Investor Day 2013 Presentation).
I have developed three different scenarios for Jeronimo Martins to unfold by fiscal end 2017. In the mediocre scenario the company will only achieve slow revenue growth of 2.7% combined with declining margins. This will result in a mediocre return for investors given the only marginal improvement in EPS. In the mediocre scenario the company will benefit mostly from stronger like-for-like sales growth in its Polish operations which will result in slightly higher margins versus the bad scenario. In this scenario investors would benefit from modest share price appreciation next to the dividend yield. If the good scenario unfolds investors would enjoy both a meaningful share price appreciation around 50% and an increasing dividend that will yield around 3% at the end (but 4.64% on current share price). I think the good scenario is the most likely to unfold given the historically strong performance of the Polish economy, the increasing possibility of improving economic circumstances in Europe (which will also show in Portugal), management's proven expansion abilities and the controlling family-enabled long term view. Based on the growth outlook that is enabled by the further Biedronka chain expansion in Poland and also by the Hebe (Poland) and Ara chains (Colombia) that are currently in start-up phase I think investors can consider Jeronimo Martins as a long term investment. The model above and its scenarios are based on quite moderate like-for-like growth rates in all three major territories. The current negative LFL growth rates in Poland and Portugal look quite scary and might cause some short term pain for the company and its shareholders. As stated I do not believe this situation to persist. Like-for-like sales in Poland have seen long periods of high single digits and even low double digit growth rates for example. I do not think it is likely that Biedronka will return to that kind of growth, but the current declining like-for-like sales seem like an anomaly to me, especially given the emerging character of the Polish economy.
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