Queue outside the Padini Concept Store Queensbay Mall, Penang.
(Source: Penang Kini, https://www.facebook.com/penangkini/posts/2726533110917490)
Disclaimer: My family may have positions in any company mentioned in this article.
Today we check out Padini Holdings Berhad ("PHB"), owner of the popular Brands Outlet ("BO") stores and Padini brands.
Summary
PHB is currently priced assuming a 25% permanent decline in revenues at 10% WACC. PHB is facing online competition, changing consumer habits and a negative economic outlook. We look to the UK fashion market to extract insights for how the Malaysian market will pan out.
Company overview
PHB sells clothes via the Vincci, Padini Authentics, PDI, Padini, Seed, Miki, and BO brands/stores. PHB generated revenues of RM1.78 bil in FY19 on an EBIT margin of 11.5%, with 95% of revenue generated in Malaysia.
As can be seen below, revenue growth has slowed since 2016 and EBIT margins have slowly come down from 13.6% in 2016.
From the annual reports, we see that Yee Fong Hung ("YFH") and Padini are the main revenue and profit generators, with YFH being the company behind BO and others.
This is also represented by the number of stores for each brand.
Given BO and Padini are so popular in Malaysia, this begs the question on whether PHB has found success in other countries, especially ASEAN. In fact, back in 2004, PHB spoke of having non-Malaysian sales being 50% of revenue. Unfortunately, PHB must have encountered serious obstacles when trying to expand overseas, as seen by the decreasing (!) number of stores overseas and non-Malaysia revenue contribution being stable at 5% for the past 5 years.
This may be attributable to PHB being a conservative company and overseas expansion must have yielded insufficient ROI to justify the risk: according to PHB executive director Benjamin Yong “PHB, throughout the years, has been a very conservative company and that is how we have managed to keep our cash flow healthy. We will look out for opportunities, whether it is in supply chain improvement or opening up in new malls. But we will not, for example, blindly open 20 stores to achieve a certain revenue growth only to see 15 of those stores fail.”
Group CFO Sharon Sung says, "We have always been in expansion mode, but the culture of the company is that we are very careful in our selection. Thus, we will be expanding in a cautious way."
Source: https://www.theedgemarkets.com/article/padini-tough-it-out-valueformoney-fashion; https://www.thestar.com.my/business/business-news/2004/05/27/padini-eyes-higher-overseas-sales
Industry overview
Even before Covid, the Malaysian bricks-and-mortar ("B&M") retail industry was struggling with structural headwinds. Factors such as e-commerce, technology, the rise of millennials and increase of online users are some of the disruptors to the retail industry. Why bother with dressing up, facing the notorious Malaysian traffic and weather and hunting for parking when you can buy from your armchair and have the goods delivered to your doorstep?
With Covid, the economy and consumer sentiment have been impacted negatively and the public is expected to stay home and avoid unnecessary outings, which encourages online retail and reduces the need to look fashionable.
We now attempt to look beyond Covid (which will end one day) and determine the impact of the aforementioned structural headwinds on PHB. I will draw comparisons from the UK fashion market, which I see as more developed than Malaysia’s. To assume that Malaysia’s fashion market will follow the UK’s is a big assumption, and I would have liked to review the fashion market of other countries such as China, USA and Europe for more clues as to how things will change. Nevertheless, let's dig in.
UK fashion market as an idea of how things will pan out in Malaysia
The list of B&M players in the UK include Primark, New Look, Next, H&M, Zara and Topshop, amongst many others. Online players include ASOS, Amazon, Boohoo and of course the online operations of the B&M players.
Brands Outlet strikes me as similar to Primark, although I feel Primark’s value-for-money proposition is stronger. I think BO needs to push this proposition harder and strive to be the cheapest in town for an acceptable level of quality to drive footfall; with this it can carve out a unique selling point to differentiate from other players. In the UK, the midmarket (consisting of the likes of Next and M&S) has failed, and PHB needs to avoid falling into this category.
As an example of failure, Next plc has moved from a growth story to one of managed decline. The explosion of choice has driven apparel spend away from mass-market propositions towards niche targeted brands (Source: Numis).
According to UBS, online cannot compete at Primark’s price points (e.g. GBP2 for a shirt). This is what still drives customers out of their homes to Primark’s stores. Affordability, good value for money and styles suiting the customer are the top 3 considerations when considering where to shop, per UBS's survey. Barclays’s own survey state fit, price and quality are the top 3 factors.
This provides an indication of where PHB should head, which I believe management is well aware of. “Instead of increasing prices, we want to increase the volume and quality of our products to keep our customers happy. We believe this is the best way forward, as customers today are price-sensitive and well-informed of product offerings in the market. Value-for-money fashion is what we want to offer,” says Benjamin.
Another consideration that PHB needs to take seriously is customers’ growing concern for environmental and social issues. According to Barclays, "the UK House of Commons Environmental Audit Committee released a report in February 2019 studying the environmental and social costs of the fashion industry, concluding that the fast-fashion business model is ‘encouraging over-consumption and generating excessive waste’. The fashion industry is the second most polluting industry on earth, right behind oil.
Fast fashion is increasingly criticized for its business model and practices, namely the low wages and bad conditions for workers employed in supplier factories in Asia (recall the collapse of the Rana Plaza clothing manufacturing complex in Bangladesh in 2013, killing 1,000 workers and injuring over 2,500), its footprint on the environment (the fashion industry produces 10% of the world emissions, which is more than the emissions of international flights and maritime shipping combined and c2,700 litres of water is used to make one cotton shirt), the excess inventory and waste, etc.
This leads consumers, especially younger generations, to gradually change their consumer behaviour with sustainability becoming an increasingly important buying criterion. According to a survey by fashion research engine Lyst, in 2018 searches for ‘sustainable fashion’ increased by 66%, while page views for ‘sustainable denim’ were up by 87%."
The impact of such ESG issues on consumer behavior is i) customers buying less, ii) they buy second hand (the fashion resale market has grown 21x faster than the retail market last year, according to GlobalData4. Buying one used item reduces its carbon footprint by 82%, reports research firm Green Story5) and iii) they buy from sustainable brands which focus on transparency and ethical trade and production (Source: Barclays).
Online - If you can’t beat 'em, why not join 'em?
As an indication of why PHB does not push the online proposition harder, we look at why Primark does not offer online at all. In FY18, Primark made an EBIT margin of 11.7%. UBS modelled online basket economics to include warehousing, distribution, marketing and other costs such as payment processing and customer service. Applying these costs to Primark’s average basket gives a -6% EBIT margin. SocGen did a similar exercise and found that click and collect yields an EBIT margin of 6%, and online EBIT margin assuming free delivery and returns is -4%. It is also notable that Primark conducted a 12-week trials with ASOS in 2013 and terminated it. Thus, it seems that Primark does not see online as EBIT-accretive.
Nonetheless, PHB management is aware of the need for an online presence and intends to strengthen its online presence through collaborations with e-commerce platforms. In November 2019, according to executive director Andrew Yong “Revenue contribution from the online channel is less than 1%. We need to merge between the brick-and-mortar channel and online platforms to provide a seamless customer experience. We have collaborated with Zalora Group and starting from last month, our products under the PDI label are available through Lazada. Now, we’re in talks with Shopee to widen our online reach. In the meantime, the traffic on Padini’s own website is still stronger as the full range of products is available there compared to what’s available on other online platforms."
The beauty of Online
Barclays lists the benefits that accrue to online players as below:
A focus on purely online with the ability to operate at a low margin and reinvest all the cash into the proposition: Brick-and-mortar retailers don’t have this type of funding luxury with rents to manage and a dual cost base to run. While pure online retailers have the freedom to use the latest technologies and create the most efficient, internet-driven inventory management systems, offline retailers are often encumbered by the layering of an online presence on top of existing infrastructure, effectively creating a separate company.
A flexible and personalised customer experience: Depending on its technical capabilities, online retailers can change the front page of their website depending on the time of the day and depending on the user. A traditional store-based retailer has no such luxury with a far more cumbersome process to change the layout of the store.
Less able to price dynamically: This is partly a problem of ability and partly overall strategy. Some online retailers can modify prices in a very dynamic manner: Boohoo has, for instance, a sell-through rate at full price of around 80%, which is much higher than the industry average of more like 60-65%.
Wider choice:A shop can’t change pricing or product availability in the same dynamic way as pure online retailers. While Boohoo, for instance, introduces 100 new styles a day, it is fairly difficult for brick-and-mortar retailers to compete with this type of turnover. Users can see around 85,000 product lines on ASOS, including c4,000 new styles each week, as well as an extra 100,000 products on the marketplace from small boutiques. Users on Zalando can see 200,000 items. Even Boohoo, which is entirely own-brand, has 20,000 styles on its site and 100 new styles a day. On the other hand, a typical fashion retail store might have around 5,000 SKUs on average. This represents a significant difference for a customer.
Tax: Online retailers tend to be less exposed to land and property taxes, owning less physical infrastructure. This lower cost structure represents a competitive advantage.
This is not to say offline retailers have zero defense against the assault of online retailers.
A strong established brand is a benefit over most pure online retailers, whose brands are recent in most cases. While the store network is part of building the brand, brand loyalty and a broad customer database are also meaningful when trying to build an online presence.
Being omnichannel is a benefit to those customers who are wary of shopping online or prefer an omnichannel experience for another reason. Traditional retailers allow customers to try on clothes ordered online in-store and return instantly, or a store can become a pick-up and drop-off point. That ability to create a full omnichannel experience is quite difficult for a pure online retailer to replicate, even though it is interesting to see that some online retailers are gradually going offline (Amazon is opening book stores and has taken over Whole Foods in the US, while Zalando purchased Kickz, the largest multi-channel basketball retailer in Germany).
A solid existing customer base, assuming commercial initiatives and marketing efforts are correctly directed towards offline shoppers, can create a very strong and loyal online customer base.
Valuation
With a basic understanding of PHB's playing field, we turn to our good friend the earnings power value method to determine the value of PHB. EPV assumes no growth, which is appropriate for PHB which has been unable to grow non-Malaysia revenues.
Valuation workings are as below:
I am slightly concerned that the discrepancy with actuals and can only attribute it to change in working capital. If someone could point out my errors, I would be really grateful. (I assume no investment in working capital since there is no growth.)
I set PPE capex moving forward to be equal to FY19 PPE capex, during which floor space only increased by 1%. This is consistent with the no-growth assumption (hence no-growth capex).
Since business is roughly back to normal (malls are open), I only assume 4 months of cash burn has been incurred since the March.
Thus, the business is priced assuming a 25% permanent decline in revenues at 10% WACC. I estimate the RNAV to be about RM1.00.
What is not priced in is growth, especially non-Malaysian growth (and which has been pretty non-existent since 2004). The dividend yield is about ~4.5%, so you are paid to wait, somewhat.
Thus, you can buy Padini assuming no growth with revenue permanently impaired 25%.
Peers comparison
Note: EV/EBIT of Associated British Foods, Primark owner, is used above. Multiples are as of respective FY19 cut off dates to reflect pre-Covid multiples.
P.S. Directors bought 4 mil shares at RM2.72 on 9 March 2020, and no more since then.
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