Deal-It-Yourself: Cashbuild takes a risky punt

In challenging times, companies often decide to stick to their knitting. They dispose of non-core businesses, especially when those businesses are underperforming and are dragging on shareholder returns. The cash is often used to pay down debt, de-risk the group and allow for complete focus on what the group is actually good at.

This exact playbook has been used by Pepkor as it elected to sell its building materials subsidiary, The Building Company (TBC), to Cashbuild for nearly R1.1bn.

The Building Company spans across 13 brands including Buco, Timber City, Tiletoria and others, with 160 outlets and 21 franchise stores. The group employs 7,000 staff.

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Don’t let the door hit you on the way out

It may not have been a hard decision for Pepkor to let TBC go. TBC isn’t a particularly great business to be honest, generating R8.2bn revenue in the last full financial year but just R153m operating profit. That’s 11.6% of Pepkor’s group revenue but just 2.2% of group operating profits. An operating margin below 2% is poor in this sector.

In the 6 months to March 2020, TBC’s operating margin improved significantly to 2.9%, but that’s still low considering the business lives and dies based on discretionary spend by consumers. Those are the sorts of margins one expects to see in a defensive sector like grocery retail.

For comparative purposes, Italtile generated R10bn revenue in its last full financial year and R1.8bn trading profit, an operating margin around 6x higher than that of TBC. Italtile has grown revenue and operating profit every single year for the past decade, reminding me of Famous Brands in its glory days before the business was ruined with a foolish foray into the UK.

The TBC deal has been inked at a valuation of 5x EBITDA, which is at the lower end of valuations for companies of this size. Despite investment bankers trying to use complicated financial models to justify their advisory fees, most deals I’ve seen in South Africa are concluded at between 5x and 7x EBITDA.

This looks risky

Cashbuild is taking a serious punt here. Cashbuild will nearly double its revenue through this transaction, so this is not far off a “betting the farm” type of deal.

Cashbuild’s management must be feeling confident of their abilities to do some DIY on TBC to get the profitability to where it needs to be. They are so confident that they are funding this entire R1.1bn acquisition with debt, which is no joke when Cashbuild’s market cap is only R4bn.

With margins thinner than a ceiling board, there is very little margin for error.

Why is Cashbuild buying this fixer-upper?

Cashbuild runs at an operating margin of around 5%. If Cashbuild can successfully apply its own operating strategies to TBC, it could nearly double the profitability of TBC without having to rely on sales growth.

Not relying on sales growth is important, because there isn’t much of it. With selling price inflation in this space of barely 2%, it becomes extremely difficult to maintain your margin when most of your input costs are growing at 5% – 6%. Brutal management of gross profit margin and a bloody fight for volume growth is a feature of most retail sectors in South Africa at the moment.

From a geographical perspective, the deal looks quite sensible. It extends Cashbuild’s reach in the coastal areas of South Africa and especially among higher LSM retail customers, as well as in a few African territories.

Management will be betting on an increase in DIY in this upper LSM sector as wealthier South Africans choose to improve their existing properties rather than upgrade to better houses. If I listen to the general sentiment of such people towards sinking their wealth into the ground in South Africa, it’s probably not a bad punt.

Shareholders aren’t getting a say in this

The JSE recognises different types of transactions and applies different rules to them. A deal that is more than 30% in value of a listed company requires a full shareholder approval process and is known as a Category 1 transaction.

This deal is around 25% of Cashbuild’s value, so it does not require shareholder approval as a Category 2 transaction. All Cashbuild needed to do was publish a detailed terms announcement, which it has done.

Shareholders will need to vote with their feet instead. The share price was up 2% today, so they seem to be in favour. I’m just not sure why, because this feels like an incredibly risky deal in this environment to acquire a business that looks marginal to me.

I’m happy to sit this one out. Good luck to Cashbuild!

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