Dis-Chem’s regulatory headaches may hurt its M&A strategy

• South Africa
• Baby City, Clicks, Competition Commission, Dis-Chem, Pharmacy
• November 7, 2020

Dis-Chem had a rough few months in the court of public opinion. The company wanted special concessions from landlords, even though it was one of the few retailers allowed to remain open. That paled in comparison to the reputational damage from the allegations of hiking the prices of masks.

Thankfully for Dis-Chem, Clicks had a real “hold my beer” moment when it comes to reputational damage. Nobody will ever forget the Tresemmé advert that gave the EFF a new lease on life.

Before we get into Dis-Chem’s results and their strategy of pursuing further acquisitions, it’s important to touch on the current relationship that Dis-Chem has with the Competition Commission.

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Competition issues

The mask pricing case is still being heard by the Competition Commission. There are fascinating arguments being made, particularly as the Commission faces a significant burden of proof in a case such as this.

The Competition Commission needs to prove that Dis-Chem is a “dominant firm” which means a 35% market share or, in the absence of this, “market power” – a grey area of note. The law protects consumers from being practically forced into paying the higher price. If it’s easy to shop elsewhere, then there’s no competition problem here. If consumers feel like wasting money at one retailer vs. another, that’s hardly an issue for regulators.

Even if the “dominant firm” argument is successfully made, the Commission must then demonstrate that there was “excessive pricing” – another grey area!

Minister Ebrahim Patel signed into law on March 19^th that there would be limits for price increases on essential goods, but Dis-Chem’s morally reprehensible behaviour (where surgical mask prices were allegedly hiked by as much as 250%) took place before the rule was made by Minister Patel, so that’s another tricky situation for the Commission.

Why are the Competition Commission issues so important?

At an extreme, a company can be fined 10% of its annual turnover. The Commission is trying to achieve that with Dis-Chem but it feels like an impossible outcome. This would be a fine of potentially R2.5bn which is ridiculous in the context of opportunistic sales of masks.

The fine is intended to be a deterrent though, so if the Commission can prove its case, it will almost certainly be a big number relative to the actual sales of masks.

There’s another reason why this issue matters: Dis-Chem will need Competition Commission approval for most acquisitions going forward.

Expanding through acquisitions

Dis-Chem announced back in May that it would buy Baby City for R430m, which will benefit from added clinic services and inclusion in the Dis-Chem loyalty programme. I think it’s a very smart deal, but it’s still with the Competition Commission for approval. I’m concerned about how long this approval is taking and what that might mean for Dis-Chem.

Against a backdrop of interim results with market share gains as the highlight (8.2% revenue growth vs. estimated 4.4% market growth using Stats SA), Dis-Chem announced that it is currently pursuing two more acquisitions.

One of these is a community-based pharmacy group with potentially 50 pharmacies across the country. These are mainly in convenience centres, a departure from Dis-Chem’s big mall strategy and more in line with Clicks’ footprint strategy. Dis-Chem is really stepping on Clicks’ toes with this acquisition and may find it challenging to adapt from a “big box” format in the Pharma and Health & Beauty space to these smaller stores.

The other opportunity is a primacy care insurance asset. This is an alternative to medical aid which promises to be more affordable. This is an interesting move by Dis-Chem, which ties in with a focus on nurse-led care, telemedicine and lower price primary healthcare in general.

In chasing these acquisitions, Dis-Chem has elected not to pay an interim dividend. The company is preserving cash to enable it to chase these deals.

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What did the market think?

The share price didn’t love the interim results. It was down 5.3% despite the JSE All-Share climbing at the end of last week. Deciding to withhold a dividend is a big step and investors usually get nervous.

It doesn’t help that Dis-Chem’s share price has performed poorly since listing, down over 41%. Many questioned the valuation at the time of the listing and history has proven those people correct.

Even now, Dis-Chem trades on a Price / Earnings ratio above 25x. That’s a big number to pay for a business operating in a country with struggling consumers and inflationary cost pressures.

Dis-Chem’s sales may have been up 8.1% but costs were up 10.8%. We need to look closer at these numbers to see if any adjustments are appropriate.

The Group incurred R45.4m in Covid-19 costs ranging from protective equipment to staff vouchers. If we strip these costs out, expenses grew 9.1%. To be fair, we must also add in R250m in lost sales (management’s guidance of the impact of lockdown), which implies underlying sales growth of 10.2%.

With those adjustments, sales growth (10.2%) looks a lot stronger vs. expenses growth (9.1%). That may make shareholders feel better, but it’s not quite that easy.

For example, Dis-Chem would’ve experienced a staff cost benefit of reduced trading hours. The R250m in lost sales is a thumbsuck at best and we don’t know what the blended gross margin on these sales might have been. Growth in Headline Earnings Per Share of 16.2% was assisted greatly by a R35m drop in finance costs attributed to lower interest rates. The interest rate benefit of lockdown nearly offset the Covid costs.

It’s difficult to draw too many conclusions from these results. At this valuation and with such uncertainty over whether the Competition Commission will be supportive of Dis-Chem’s growth strategy, I’m not currently invested in Dis-Chem.

Other interesting tidbits

As has been common across the world, Dis-Chem’s online business surged over lockdown. Online sales were up 344% in the 24 weeks to August 15^th but this is still off a small base in the greater scheme of things.

Interestingly, despite South Africa not having a traditional flu season (a message consistent from Clicks and Dis-Chem), strong chronic drug adherence offset some of this impact. This tells us that many people don’t stick to their chronic medication normally but elected to do so out of fear of Covid-19.

And you wonder why people had to be reminded to wash their hands?

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