The share price of holding company Brait (BAT) has appreciated strongly this year to a price that implies that Brait management has created R40 billion in value over the past four months through the execution of two transactions. While Brait has an exceptional track record of capital allocation decisions, and its recent transactions have been well executed, we believe that the current share price is reflecting an unrealistic view.
At close of trade on August 4 the BAT share price was up nearly 100% on the previous year and trading at a 98% premium to its latest published NAV of R80.34. Why should BAT be trading at such a large premium to the value of its underlying holdings and what does this imply about the value of these holdings?
Brait’s main investments are in Steinhoff, Premier Foods, Virgin Active and New Look, a UK based clothing retailer. The recent rise in the share price seems to be mainly due to excitement about the acquisition of New Look. If we use the current market price for Brait and the company’s own valuations of the remaining holdings, we can see what the current Brait share price implies about the valuation of New Look. Based on this approach, a BAT share price of R155 implies that New Look is worth R54 billion, or a 2015 EV/EBITDA multiple of 20.2x. This is almost three and a half times the R14.5 billion that Brait paid for New Look just over a month ago. It also places New Look at a premium relative to other comparable listed clothing retailers, including the highly rated Mr Price and Inditex, the owner of Zara.
While it certainly seems that Brait did purchase New Look at an attractive price, it is difficult to see that it was able to buy the business at such a large discount to the fair value implied by the market. The majority of the stake that BAT purchased was sold by two private equity companies, APAX partners and Permira, and it is hard to imagine professional investors selling an asset at a fraction of its fair market price, if they could have rather listed the business at the higher valuation.
Of course the Brait share price may not only be pricing in a revaluation of New Look, but may also be implying that some of Brait’s other investments are worth more than they reported in the company’s NAV. Given that Steinhoff is listed – and we can assume that its price is a fair reflection of the market’s views – then it only remains that Virgin Active or Premier Foods are possibly worth more than stated. While Brait’s management has historically placed a very conservative value on its unlisted investments, mainly PEP and Premier, they have recently increased their valuation multiple used for Premier to a level that is now in line with listed peers. This leaves Virgin Active. Brait recently purchased an 80% stake in Virgin Active for a price of GBP690 million. The sellers were The Virgin Group and the private equity company CVC Capital Partners. In fact, Virgin was planning a listing on both the JSE and LSE, before Brait purchased their stake so it is difficult to imagine that Brait bought Virgin at a significant discount to fair value. Nevertheless, if we assume that both New Look and Virgin are worth more than Brait bought them for, the current share price implies that collectively these two investments are worth about R68 billion, or about 2.4 times the R28 billion that Brait paid for them. Or looking at it another way, either the Brait share price is overvalued or the management of Brait created R40 billion of value in the past month.
Passive fund buying
Another reason for the strong BAT share price could be a technical one rather than a statement about the fundamental value of the company. Over the last 12 months BAT has been added to a number of equity indices, including the MSCI SA index and the FTSE/JSE Top 40 Index. An investigation of holdings data shows that a number of large international index funds and smart beta funds have been buying Brait aggressively over the past few months. Data provided by Bloomberg shows that passive funds run by Blackrock as well as other large passive investors bought more than three million shares of Brait over the months of June and July. As new companies are added to indices, passive investors are forced to add these stocks to their ETFs and passive funds irrespective of the price or valuation, a situation that could have played out with the BAT share price over the past few months.
We have missed many an investment opportunity when we thought that an investment was expensive only to be proved wrong as the company delivered exceptional earnings growth over the next few years, so it is important for us to try and falsify our beliefs and test where we could be wrong. What is the outlook for New Look and Virgin Active, and could their future growth potential justify a large valuation?
- New Look
New Look aims to be a value fast fashion retailer. It offers fashionable clothing at a discount to higher fashion stores such as ZARA and a more fashionable offering than peers at the same price point such as H&M. For South African consumers, one way to think of it is a more fashionable Mr Price.
Why do we think that it is not reasonable to place a very high value on New Look?
New Look is very highly geared with about GBP 700 million in outstanding debt, of which more than half is floating rate debt and exposed to potential UK interest rate increases. This is about 4.5x 2016 EBITDA and stands out versus its peers. While Brait has already restructured this debt and brought down New Look’s funding costs materially, the absolute level of debt is still high and may reduce New Look’s strategic flexibility compared to competitors with far more balance sheet freedom. On top of this Brait is using debt to purchase New Look.
- International margins
While New Look has been particularly successful in its primary market (UK female consumers), its international expansion has been less successful with its international-owned stores suffering a margin decline over the last five years, with margins significantly lower than in UK stores.
- Chinese expansion
One of the potentially exciting sources of growth for New Look is its planned expansion into China. The company appointed a new CEO in 2013, who has extensive experience in retail within China. The company plans to roll out 500 Chinese stores over the next five years. Furthermore this store roll out will require capex, further delaying New Look’s ability to degear its balance sheet.
While the South African business of Virgin Active is an extremely attractive business, with a very high market share, exceptional margins and great cash generation, this is a global anomaly and outside of South Africa the health club market is generally a fragmented one with low barriers to entry and consequently much lower margins.
The South African health club market has benefitted from two unique situations that have led to this market structure. Firstly the predecessor to Virgin Active, Health and Racquet clubs, managed to gain a large market share quickly. Secondly the relationship that Virgin Active has with Discovery Vitality has also had a unique impact on the SA market. Given that Discovery subsidises health club membership in SA, membership fees have arguably been higher than they would have been otherwise. In addition the number of members per club in SA also seems to be higher than global norms. One possible reason for this is the large number of Discovery Vitality clients who merely maintain the minimum number of gym visits per month to maintain their Vitality discount. All of these impacts lead to SA margins for Virgin Active being much higher than in other regions.
While Virgin Active does have a potential opportunity to grow internationally, our concern is that this could come at the expense of group margins and that a health club business is inherently a business with quite a low competitive advantage.
In November 2014, post Brait’s sale of PEP to Steinhoff, the share price fell to about R70 and offered an attractive entry to purchase a position in Brait shares for our client’s funds. At the time our thinking was that at R70 the stock was trading at our assessment of NAV and a large part of that NAV was either in cash or in Steinhoff shares protected by a one year put option. This resulted in an investment opportunity with limited downside and potential upside if management could deploy the proceeds of the PEP sale in an attractive investment. Given Brait management’s strong history of capital allocation this seemed like a very attractive risk return profile. We didn’t expect that capital to be deployed so quickly or so effectively, but we will take a lucky outcome wherever we can get it. We took profit on our client’s investment at around R110 a share. In hindsight we made a common error of selling a winner too early, but at the current price we are very happy not to own Brait shares and to rather look for more attractive opportunities elsewhere.
*Brad Preston is portfolio manager at Mergence Investment Managers