Steinhoff International Holdings N.V. - Strategic Analysis: Back On The Comeback Trail?

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About: STEINHOFF INTL HLDGS NEW (SNHFF), SNHFY, STHHF, STNHY
by: Sarel Oberholster
Summary

The events of 2017 as well as the restructuring during 2018 are now history and, Steinhoff has navigated the storm.

Core businesses are performing better than expected and were not affected by the negative events. Debt servicing and repayment is supported by trading performance.

Underperforming units, particularly Mattress Firm, have been subjected to intensive restructuring to return all business units to profitability in the short term.

Sustainable EBITDA is expected to range between EUR1.021bn and EUR 1.372bn for 2019 with detailed analysis provided.

Sustainable EBITDA is expected to range between EUR 1.234bn and EUR 1.503bn for 2020 with detailed analysis provided.

“It’s not whether you get knocked down, it’s whether you get up.” -Vince Lombardi

Steinhoff on the comeback trail Photograph by SJ Oberholster.

Introduction

Steinhoff (OTC:SNHFF) is a holding company for a number of subsidiary and associate companies, some listed separately, engaged in non-food retail trading. The businesses cater mostly for the price sensitive retail sector with a focus on affordability and convenience. The business activities are divided into two main sections, “Household Goods” and “General Merchandise” where they trade in over 30 countries across more than 40 brands. Household Goods are traded in more than 5,800 stores, using 5.9million square meters of retail store space and employing about 66,000 employees.

“Product categories include: furniture, mattresses, household goods, appliances, home accessories, consumer electronics and technology goods, building materials and DIY products and accessories.”

General Merchandise is traded in more than 6,000 stores, using 2.7million square meters of retail store space and employing about 62,000 employees.

“Product categories include: clothing, footwear, personal accessories, cellular products, selected financial services and fast-moving consumer goods.”

Major geographical trading areas are Central Europe, Eastern Europe, the United Kingdom, South and Southern Africa and the United States. The largest business units are Conforama (Central Europe & the Balkans), Mattress Firm (USA), Pepkor Europe (Eastern Europe with Poundlands in the UK), Bensons for Beds and Harveys (UK) and Pepkor Holdings Ltd (South Africa).

Steinhoff is primarily listed on the Frankfurt Stock Exchange with a secondary listing on the Johannesburg Stock Exchange. It also trades in the USA OTC market as SNHFF. It has 4.31bn shares in issue for a market capitalization of USD526mil (ZAR7.327bn and EUR459mil) as at 7 January 2019. Net debt was reported at EUR9.36bn as at 31 March 2018 and an update on the debt position is expected when Annual Financial Statements are published. Net Asset Value on the Balance Sheet as at 31 March 2018 was EUR0.54 (USD0.62 and ZAR8.61 at current exchange rates). The share closed at a price level of USD0.13, EUR0.11 and ZAR170 on 7 Jan. 2019.

Troubles and investor concerns over the past 18 months

The Steinhoff share price reached a high of EUR6.16 (for a market capitalization of about EUR24.5bn, $27.8bn, and ZAR386.7bn) in August 2016 but then came under increasing pressure for a number of reasons. Balance sheet valuations, reported revenue and profitability were being questioned by analysts. Acquisition prices and the propensity for acquisitions also made investors uneasy. The acquisition of Mattress Firm at what was viewed as an excessive price in particular came in for heavy criticism. The share price trended down from late 2016 right through to August 2017 when Steinhoff had to publicly refute an article by Manager Magazin alleging dishonesty and incorrect accounting treatment of certain transactions. The investigation by German authorities into Steinhoff Europe Group Services GmbH reported on by Steinhoff in December 2015 resurfaced and regained prominence. On 4 December 2017, Steinhoff announced that the 2017 Annual Financial Statements will be published in unaudited form. On 6 December 2017, Steinhoff made a shock announcement that its CEO has resigned with immediate effect, it has launched an investigation into “accounting irregularities”, and that PwC has been appointed to perform an independent investigation. The share price collapsed. The credit rating agencies downgraded Steinhoff debt to junk status, and Steinhoff went into an immediate liquidity crisis. No audited financial statements could be produced until the completion of the PwC investigation, creating a financial reporting vacuum which encouraged short selling with an expectation that Steinhoff would not survive the liquidity crises or the PwC investigation. We do not know as yet exactly what the “accounting irregularities” were or what the full effect on the 2018 Annual Financial Statement will be. We do however know from the trading updates and Half-year unaudited financial information that Steinhoff is solvent with a positive NAV and trading successfully (trading data is referenced in the trading estimates later in this article).

A number of attorney groupings have filed for a class action or instituted litigation against Steinhoff which I have previously discussed here.

Managing the crisis

The crisis was managed on five fronts simultaneously (liquidity, debt, tainted management, stabilizing group trading activities and restructuring the group to address under-performing units and to rid itself of problem units). The liquidity crisis was addressed through a sale of a small portion of liquid investments to cater for immediate liquidity needs while instituting group wide cash management and entering into negotiations with creditors. Creditors had to be reassured that the company can service and repay its debt if given sufficient time to pay, a process which took some eight months to negotiate and resulted in a three-year credit lock-up agreement for the majority of interest bearing debt, while all the South African debt was repaid. Management tainted by the “accounting irregularities” resigned or were pushed out. New top management was employed with an emphasis on gaining expertise in managing the unfolding crises. Group companies were encouraged to operate independently from the holding company, to focus on their relative trading performance and to access their own finance for their own liquidity needs. Group companies achieved independent financing and Pepkor Holdings Ltd (formerly STAR) actually arranged a full independent refinancing of its debt to repay the holding company in full, assisting the group with liquidity management. Steinhoff has managed its business units as independent, each with its own management and business strategies which were now further strengthened to ensure that the units which were strategically important perform unrestrained by the crises. The trading updates indicate that this was a very successful development and business units have actually performed above normal expectations. The most significant restructuring occurred at Mattress Firm. Steinhoff announced in early October 2018 that it would file for voluntary Chapter 11 protection in order to close under-performing stores and exit the lease agreements on those stores as well as renegotiate other leases where appropriate. It also advised that it aimed to exit Chapter 11 protection within 45-60 days and that it would secure exit financing for Mattress Firm once the process is complete. The Chapter 11 process was completed successfully and exit financing was obtained, but at a cost of relinquishing 49% of the shares in Mattress Firm to the financiers. Non-core assets and the troublesome Austrian businesses (POKO & Kika-Leiner) were sold off.

Financial information remains scarce with Steinhoff reporting unaudited Half-year Results and Trading Updates over the course of 2018 (for linked references see estimated trading tables later). The share price reached a low of EUR0.08c during June 2018 and is currently trading at EUR0.11c. At EUR0.11c, it is only 20% of the restated NAV of EUR0.54c and given the trading results expected (see hereunder), the share price should be undervalued even at EUR0.54c, in my opinion. The share price of a retailer such as Steinhoff should reference value from trading results rather than from a NAV as it relies on its trading results rather than on a return on assets and balance sheet for its continued existence. Compare for instance the previously (now disowned by Steinhoff) reported revenue at EUR16.44bn and Profit before taxation at EUR1.685bn as at 30 September 2016 with the trading updates for 2018. Not much different from the current trading numbers, yet the share price was trading at around EUR6.00 with that trading performance vs the share now trading at EUR0.11c against a near similar trading performance. The comparison demonstrates the principle of share price valuation vs trading results and reaffirm the view that the current extremely low share price is irreconcilable with current available trading information.

Trading estimates and EBITDA

Steinhoff recently announced a delay in the release of annual financial statements for 2017 and 2018 due to the PwC investigation not being concluded as yet and the share price dropped substantially even though the delay is not likely to have any material impact on the value of the shares. The PwC investigation is now expected to be concluded by the end of February 2019. The Q1 2019 Trading Update is also expected in February 2019, while the now mostly historical annual financial statements for 2017 and 2018 are expected to become available by the middle of April 2019.

The annual financial information for 2017 and 2018 are important. These statements will however not be representative of the actual current state of the company due to the extensive restructuring and the myriad of changes, impairments and unusual events which will be reflected in those statements.

The Steinhoff group is at its core a retailer which means trading results are more important than balance sheet items, and looking at the company’s recent past can confuse a futuristic assessment. We still only have partial trading results, but a picture of the trading position without extrapolating the costs of restructuring, the impairments and the unusual events, is emerging. A reasoned estimate of the trading results and EBITDA before extraordinary events, currency adjustments and impairments can be constructed (described by Steinhoff as “Sustainable EBITDA”). The “new” Steinhoff’s future is of greater interest than the “old” pre-restructuring Steinhoff’s disastrous recent history.

The first step is to construct trading results and EBITDA for 2018 from available information, which is almost complete and estimate for the final quarter trading results of unreported and unlisted divisions/subsidiaries. Using that information as a base, one can on a detailed basis make reasoned estimates of the expected results for 2019 and 2020 by analyzing the micro trends, the effects of restructuring and taking into account the micro and macro-economic environment of each of the businesses. It is also prudent to frame the assessment as scenarios given the nature of the estimates. I have chosen to express the expected EBITDA results as “Conservative” with a “Positive” and “Negative” scenario for each of 2019 and 2020.

Estimated trading results and EBITDA for Steinhoff International N.V. for the financial year ending September 2019

Steinhoff International estimates of EBIT and trading results for 2019 The Estimated Revenue Table for 2019 constructed by SJ Oberholster with reference to the following publications by Steinhoff: UNAUDITED QUARTERLY UPDATE FOR THE THREE MONTHS ENDED 31 DECEMBER 2017, UNAUDITED HALF-YEAR RESULTS FOR THE SIX MONTHS ENDED 31 MARCH 2018, UNAUDITED QUARTERLY UPDATE FOR THE NINE MONTHS ENDED 30 JUNE 2018, the published 2018 full year financial results of Pepkor Holdings Ltd and full year financial results released for Pepkor Europe together with Poundland.

Estimated trading results and EBITDA for Steinhoff International N.V. for the financial year ending September 2020

Steinhoff International estimates of EBIT and trading results for 2019 and 2020 The Estimated Revenue Table for 2020 constructed by SJ Oberholster with reference to the following publications by Steinhoff: UNAUDITED QUARTERLY UPDATE FOR THE THREE MONTHS ENDED 31 DECEMBER 2017, UNAUDITED HALF-YEAR RESULTS FOR THE SIX MONTHS ENDED 31 MARCH 2018, UNAUDITED QUARTERLY UPDATE FOR THE NINE MONTHS ENDED 30 JUNE 2018, the published 2018 full year financial results of Pepkor Holdings Ltd and full year financial results released for Pepkor Europe together with Poundland.

As mentioned above, Steinhoff trades across 30 jurisdictions and across over 40 brands. A detailed discussion and description of each are available on Steinhoff’s website and in the trading updates both referenced above. The important businesses for the above estimates are discussed here under together with the descriptions of each as given by Steinhoff on its website.

Conforama

Conforama operates an extensive network across Europe, with stores in France, Spain, Portugal, Italy, Switzerland and Serbia. Conforama’s core product lines comprise furniture, decoration, and a range of homeware appliances and electronic goods, employing a multi-style product strategy.”

Conforama operates in competitive and mature markets facing increasing competition from digital stores. It has been developing its own digital footprint while appointing an e-commerce Deputy CEO tasked specifically with rolling out its own e-commerce offering. They had increased marketing and brand building expenditure during the run-up and play at the 2018 FIFA Soccer World Cup which directly impacted 2018 expenditure levels but will not be repeated in 2019. The business is relatively stable, locked in a low growth low profitability mature market environment with a high level of predictability. It is expected that e-commerce will help unlock new potential at Conforama.

UK – Bensons for Beds & Harveys

Bensons for Beds is a leading sleep solution destination, offering both classic and contemporary bedroom furniture. It sells a comprehensive assortment of leading bed brands, including the Sleepmasters range manufactured exclusively by Relyon.”

Bensons for Beds is trading profitably since its restructuring. The Half-year report describes it as a “strong performance”. They maintained margin, in-store customer conversion and has an established on-line presence.

"Harveys is a leading home retail specialist in the United Kingdom, focusing on lounge and dining room furniture at value prices. It was also one of the first furniture retailers to give its customers an online shopping alternative."

Harvey’s is loss making and the trend has not yet turned positive. Management initiatives to produce a revenue-led return to profitability includes targeted marketing and renewed focus on in-store conversion rates.

Pepkor Europe

The businesses categorized under Pepkor include the following:

PEPCO is one of the largest non-food retail chains in Central and Eastern Europe, with stores in Poland, the Czech Republic, Romania, Hungary, Slovakia and Croatia. PEPCO offers clothing, footwear and accessories for the whole family, as well as household goods and toys at the lowest prices.”

PEP&CO has national coverage with its first 50 stores located in secondary towns across the United Kingdom. The chain offers a mix of women’s wear, children’s wear and babywear to the value-conscious consumer, with 95% of its products priced at under £10.”

Poundland and its subsidiary, Dealz, offers a variety of household, personal and FMCG (fast moving consumer goods) items at discount prices.”

Pepkor Europe businesses are targeting cost conscious and price sensitive customers providing low cost, affordable and downright cheap clothing, footwear, accessories, household goods, toys and fast moving consumer goods. These businesses are very successful and operate in economic environments where their product mix is on target. Growth is phenomenal even though it is slowing as market penetration increases. The performance of this business has not been affected by the Steinhoff crises and continued excellence is expected.

Pepkor Holdings Ltd (South Africa and Africa)

Pepkor Holdings operate more than 5,100 stores in 12 African countries, the majority of which are in South Africa. Their product mix includes clothing, footwear and homeware, furniture, electronics and appliances, consumer goods, DIY, hardware, mobile phone handsets, airtime and data. Their pricing strategy is to be the low cost price leaders in the product ranges which they carry.

The company is separately listed on the Johannesburg Stock Exchange and Steinhoff holds 71% of the shares after selling 6% as part of managing the liquidity crises.

Pepkor Holdings is managed independently from Steinhoff and is another excellent investment held by Steinhoff. Pepkor Holdings recently reported outstanding results for the 2018 financial year with 10.9% revenue growth and 10.7% operating profit growth before once-off costs.

Mattress Firm (USA)

Mattress Firm is the leading specialty bedding retailer with the largest geographic footprint in the United States. The company offers a broad selection of both traditional and specialty mattresses, bedding accessories and other related products.”

Revenue at Mattress Firm has been solid but lack of profitability was an area which needed some direct management intervention. The historical growth-at-all-costs objectives left Mattress Firm with significant over-representation in many cities, often with 3-4 stores visible in the same area. The accounting crises and subsequent developments at Steinhoff removed any latitude which Steinhoff thought it had to address the problems at Mattress Firm and forced the decision upon them to remove the over-supply and excess expenditure through a voluntary Chapter11 restructuring. Revenue has been sacrificed over the past two years to restore profit margins and to cut the costs associated with under-performing stores. The result is that Mattress Firm is expected to return to profitability much sooner than it was otherwise expected to achieve.

Comment on some estimates

Each of the businesses matter but the under-performing businesses of Conforama, the UK’s Bensons for Beds & particularly Harveys and the USA’s Mattress Firm have the greatest potential to impact the EBITDA positively.

Conforama is a substantial business but locked in a structural low profitability culture. It needs to be shaken up, and hopefully, the events since Dec. 2017 would generate the business will to address its low profitability. Fortunately, it does not contribute to losses. The estimate for revenue for 2019 is basically unchanged, and profitability is expected to return to the same level, pre-soccer world cup advertising expenditure levels. The estimates for 2020 move revenue up by less than 4% and increase EBITDA margin slightly in line with the view that changing this business’s profitability may be challenging even though the company has implemented steps to address profitability. It would be very pleasing if the management of Conforama were to prove me wrong.

The UK businesses (other than Poundland, which is grouped with Pepkor Europe) will probably suffer some fallout from Brexit and a generally muted economic environment in the UK. As a result, both revenue and profitability estimates are lowered for 2019. The estimates for 2020 take into account the steps announced by Steinhoff to restore profitability to the UK businesses for a return to the 2018 revenue level and a break-even for the UK businesses combined.

Mattress Firm assessed on a still consolidated basis, which may well change to equity accounting going forward, is expected to benefit substantially in the short term from the extensive restructuring undertaken. The closure of 660 underperforming stores is expected to have a less than pro rata reduction in revenue impact. Revenue has also been on a rising trend generally at Mattress Firm. To remain conservative, the revenue estimate for Mattress Firm is reduced by slightly less than 10% for 2019 compared to 2018. Mattress Firm will have most of 2019 to benefit from the material cost reductions as a result of the restructuring and together with all measures taken to address profit margins, allow for an EBITDA break-even estimate, if slightly positive, for the 2019 financial year. The impact of not being a drain on profitability is important. Revenue for 2020 is estimated to improve but not yet to fully return to the 2018 levels, while profitability is expected to return to about 50% of what it should be. The estimates have been cautious, and it is fair to say that the results from Mattress Firm may surprise on the upside.

Every estimate for every component whether labeled conservative, positive or negative in the above two tables have been considered and modeled separately to be objective, realistic and contextual fully cognizant of the fact that only limited or partial information is available. Having considered each data point separately rather than just working with the main components provides for a more realistic range of outcomes against which to assess Steinhoff’s trading position given the absence of published and comprehensive current financial information. There is a much greater likelihood of the positive scenario materializing rather than the negative in both 2019 and 2020. My approach has been conservative in estimating EBITDA for both years probably more so for 2019. My expectation is closer aligned to the positive scenarios rather than the conservative scenarios. The negative scenarios are not expected outcomes.

The February 2019 Trading Update will be an important addition to the available financial data. However, the real tests for progress by Steinhoff will be at the 2019 Half-Year Reporting stage, the Q3 Trading Update and the release of the 2019 Annual Financial Statements. These will be the share price discovery events, not the PwC report, or the 2017, or 2018 Annual Financial Statements which all deal with bygones.

Debt, interest, and debt repayment

A simplified argument is often made to say that Steinhoff has EUR10bn in debt which at 10% pa interest capitalized annually will grow to more than EUR13bn by September 2021. I am unable to subscribe to this approach given the absence of detailed financial information. Here, I need to see the net debt as opposed to gross debt. I need to know the net interest paid and the interest percentage on gross debt, which I suspect is less than 10%. There is also the matter of offsetting interest income and investment income. I further do not believe that the debt can be viewed in isolation ignoring revenue growth or the restoration to general profitability.

There is a substantial negative shift between trade credit and interest bearing debt when a company experiences a liquidity crisis such as Steinhoff had, increasing the interest paying debt burden. That shift turns positive as the position normalize and trade credit insurance becomes available once again at reasonable cost, which will contribute to Steinhoff’s ability to reduce interest bearing debt levels. All of these factors will be in play over the next three years, while the majority of interest bearing debt is locked up but repayable.

An interest rate of 10% is also an aberration and would normalize to around 6-7% (all things being equal) as Steinhoff makes progress towards stabilizing the group while returning profitability to all its business components. Historically Steinhoff’s average interest cost was around 5% of gross debt. There is adequate proof that it has the management skills to achieve its strategic objectives.

The events of 4 and 6 Dec. 2017 and the crises which followed as described above were a serious wake-up call and a harsh lesson to management, the message; ~“get your house in order or perish”. Look closely at what has been done to manage the company through a very serious crises, to stabilize the group and to restructure comprehensively, look at the revenue and EBITDA estimates, test them and judge them against available information as referenced, and it must be clear that Steinhoff is already on the comeback trail. The tough choices and decisions have already been made and is now baked into the cake.

The revenue and EBITDA estimates provided above suggests that Steinhoff can sustain the debt levels that it has at this stage even though the debt is high and a burden. It also is clear that interest cover can return to around 3 times EBITDA by 2021 at normalized interest rates, at current debt levels which means that there is scope to reduce debt going forward. Add normalization of trade credit and the debt picture is not nearly as bleak as the over-simplified EUR10bn@10% narrative would have it, yet even that scenario can be sustained if need be.

Conclusion

The storm around Steinhoff has subsided. The threat of liquidation has been averted and the group has been substantially streamlined in a major restructuring. The resilience of the core businesses with diverse branding has proven to be a bulwark against the extreme negative events since Dec. 2017 as described above. It is time to look towards the future rather than to dwell on the past. Steinhoff has not only survived during a crisis which, in most cases, would have sunk a company but has restructured successfully, did a courageous C11 clean-out of Mattress Firm in an incredibly efficient 48 calendar days, and re-established a strong top management structure. All of this was achieved in spite of a very hostile press where Steinhoff’s ability to defend itself was severely hampered by the PwC investigation. Steinhoff did not go bust as predicted or hinted at by most in the media who portrayed Steinhoff as a perpetrator of wrongs while in fact it was a victim. It is now extremely unlikely to fail given its trading performance, its proven resilience during 2018 and its significant successful restructuring. The events reported since Dec 2017 has certainly tested the viability, liquidity and solvability of Steinhoff as well as the competence of the management teams to the nth degree in real time and both have proven its naysayers wrong.

The 2017 and 2018 Annual Financial Statements are more important as the basis from which Steinhoff will move forward rather than the newsworthiness of the tragedy. The 2018 Annual Financial Statements will be loaded with restructuring costs, distress costs, asset revaluations and impairments which will not be repeated in 2019. Steinhoff has already survived the 2018 financial year so the negativity which will be part of the 2018 financial statements and whatever the PwC investigation reveals are all history which has already been successfully navigated and will not be repeated. As such, it has little direct value for investment decision making going forward, indirectly it is a positive which has distress tested and reaffirmed the Steinhoff business case.

Investment decisions must not be driven by emotion, and the hysteria around Steinhoff will surely emerge in the future as a case study of investor panicky group behavior rather than calm and considered assessment even when visibility is low. Much still needs to be done at Steinhoff, and the house-cleaning, cost reduction, profitability and debt reduction strategies will need to be fully and successfully implemented. The heavy lifting has been done, now comes the fine-tuning phase. The framework structure is in place. The profit potential is visible. Steinhoff is on the comeback trail. It is up to investors to identify deep value investment opportunities in a market where most asset are overvalued rather than undervalued. Every investor has his own risk profile, but waiting for certainty and perfect visibility will certainly ensure a missed opportunity to capture profits from this deeply undervalued share.

Disclosure: I am/we are long SNHFY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.