Delko investment thesis

Summary

Delko is a microcap operating in a defensive sector of fast-moving consumer goods (FMCG), both as a wholesaler and as a retailer, with vertical integration through the acquisition of supermarkets.

Strong management alignment

Delko trades at a FCF yield of 22%, providing a high margin of safety.

We expect a special dividend to be announced with the 6/30/2023 results offering  more than 7% yield.

Introduction

Established in 1995 by a group of entrepreneurs operating in the wholesale distribution segment specializing in household chemicals, and cosmetic products. As it has grown, it has expanded its product offerings to include food and building materials. The company is pursuing a growth strategy based on M&A by acquiring other distributors and vertically integrating into other segments such as retail.

Business

Delko is engaged in the sale of fast-moving consumer goods (FMCG) both as a wholesaler (74% of sales) and through its own stores (26% of sales). The company has implemented a vertical integration strategy by acquiring other distributors and expanding into the retail sector by acquiring supermarket chains. As a wholesaler, the company enters into agreements with producers to distribute its products to both traditional retail stores and chains, in addition to supplying its own stores, which enables it to generate additional margin.

Delko works with more than 200 suppliers, none of which represents more than 10% of the company's total sales, so it is not overly dependent on any specific supplier. In addition to the distribution of other brands' products, Delko also markets private label products, in which it is focused on increasing its share due to the better margins they produce.

Some of the most important third-party brands:

In the retail sector, the company has supermarket and drugstore chains where it operates its own stores and franchises them. In the case of drugstores, it operates 3 under the Lavende brand and 5 under Drogeria Rossa, but its main chain is Blue stop, with a total of 462 stores, all franchised.

Sedal: It has 21 stores of its own. It was the company's first supermarket acquisition made in 2017. These are supermarkets ranging in size from 100 to 800 m². At the time of the acquisition, they operated 24 stores.

Sloneczko: 24 company-owned stores and 264 franchised stores. It was acquired in 2019 and specializes in fresh produce such as fruit, bread, vegetables... Its supermarkets are slightly larger than 200 m² on average.

Avita: 21 company-owned and 64 franchised stores. It was acquired in 2019, originally had 24 company-owned stores and 57 franchised stores. The acquisition was made at a multiple of 0.3 times sales.

A&K: Owns 8 stores. Delko acquired a 50% stake in 2019.These stores are of the so-called "discounter" format and are the type of store that is gaining the most market share in the sector. They are more spacious supermarkets in the style of Lidld and focus on offering local products. In 2021, the company has also invested in the aesthetics and functionality of two stores to offer an improved customer experience.

Industry

The industry is defensive, as most of its products are basic necessities, which makes it robust to economic downturns. However, although it is a defensive industry, there are factors affecting demand that are currently having an impact.

Poland is among the countries with the highest inflation in Europe. This situation is affecting sales volumes, these have decreased by 2.5 % according to McKinsey in 2022.Consumer confidence has decreased by 8 % compared to 2022 and by 22 % compared to 2019 (McKinsey), which has led to a shift towards cheaper products and an increase in market share of private label brands.

Inflation affects wholesalers more negatively, since the flexibility to raise prices is less or is delayed depending on the contracts they have signed, in addition the bargaining power of the wholesaler is less against a supermarket chain than that of the supermarkets with the end customer, here is an example:

https://www.reuters.com/article/jeronimo-martins-antitrust-poland-idUKKBN28O11M

A possible negative effect in the short term is a reduction in food prices. According to the World Bank, food prices are expected to fall by 7% in 2023 and stabilize in 2024.

On the other hand, as a positive effect on demand, is the increase in population due to Ukrainian refugees, causing an increase in population compared to 2020 of 7 %. This increase has helped ease the labor shortage and although it is difficult to know how many it is clear that some of these refugees who have already found employment in Poland or have started a business may be able to stay and live here permanently.

Market growth is expected to be 9.3% in 2023, 5.3% in 2024 and 4.1% in 2025 (source: PMR).

The retail market is dominated by large chains. The top 10 companies in the sector are as follows:

In terms of market structure by type of store, it is expected that discounters such as Biedronka or Lidl will continue to gain market share over smaller stores, as in Poland the more traditional stores have a market share higher than in most European countries. It is normal for these smaller stores to survive in the cities where they are more efficient and more convenient for the consumer.

Now we will see 3 competitors that operate only in Poland, the objective is to get an idea of what kind of stores they have and to be able to compare them with Delko's, since companies like Carrefour or Lidl, most of us have already been in their stores.

Jerónimo Martins (Biedronka and Hebe):

Market leader with a 28 % share in Poland. Also has presence in Colombia and Portugal under other brands. In Poland it operates Biedronka supermarkets, at the end of 2022 it had 3395 stores generating revenues of 175

82 million. These stores are like Lidl supermarkets and have an average store size of 700 m per store. It aims to continue expanding in Poland, with the intention of opening between 130 and 150 new stores and remodeling its older stores. Their drugstore line is called Hebe with 315 stores and 358 M € in revenues, they have recently started their international expansion of the brand.

Eurocash:

The most similar company to Delko, operating both wholesale (73 % of sales) and retail (25 % of sales), plus a third segment that generates 2 % of sales. It combines company-owned stores with franchises and its main brand is ABC supermarkets, small and medium-sized local stores. During 2022 it reduced the total number of stores from 17,052 to 15,504.

Dino Polska:

It operates medium-sized supermarkets in small towns in Poland. In recent years, it has undergone a major expansion, from 234 stores in 2012 to 2156 in 2022. The business model has some similarities to that of Walmart in its early days. The company has experienced steady growth since 2016 of over 30% per year and expects to continue to open stores in the future.

Management and shareholding structure

the company do not pay in shares.

Dariusz Kawecki:

PhD in technical sciences in the field of automation and robotics. He graduated from the Faculty of Fundamental Technological Problems - Applied Physics at Wrocław University of Technology and completed doctoral studies at Warsaw University of Technology and Moscow Machine Tool Institute. CEO since 2019 with a 1-year break due to an internal dispute.

As a curious fact the CEO every year says how cheap the company is even saying once "It's worth buying. I'm buying! The reality is that he was not lying when he said he was buying as his stake went from 20.8% to the current 30.35%.

Mirosław Jan Dąbrowski: Current vice president, a graduate of Akademia Wychowania Fizycznego Jozefa Pilsudskiego but we have no details on what type of studies. Practicing in the position since 2012.

Dispute:

The company was founded by a group of entrepreneurs and in the early years of its IPO a sort of dispute for the power of the company must have occurred. In 2009 Dariusz was appointed CEO, but in 2010 the board of directors removed him from the position on behalf of Andrzej Worsztynowicz, the previous CEO before the IPO. There is not much information about the reasons, but Dariusz's departure from the position did not last long as the following year he collected enough support to regain the position. At the time of the dispute Dariusz was already the main shareholder with 20.8% of the company. When he regained power he implemented a restructuring, seeking efficiency and cost reduction. The restructuring was finalized in 2014 and since then the company's margins have improved year after year.

capital allocation

Most of the capital has been allocated to acquisitions of related companies, such as distributors and supermarkets. Another part is expected to be allocated to modernize and open new stores. In 2022 capex increased by 70% due to new store openings, but still did not reach even 1% of sales. Finally, the company pays a dividend since 2014 with a payout of 26 %.

This year there is a special situation with the dividend that is quite interesting for those of us entering the company now. Delko changed its fiscal year to start in June 2023, which means that the next annual report 18 months long. This caused the company to not pay the 2022 dividend yet and they rather wait to close the fiscal year. The management has already shown its intention to pay a dividend, probably by increasing the payout and instead of paying it for a period of 12 months, they will pay it for 18 months. Which makes me expect a dividend of at least PLN 0.84, a 7.7% yield at current prices.

Economics

Since the implementation of the restructuring in 2012 completed in 2014, a steady efficiency improvement has been observed in the company with an increase in margins practically every year. This is reflected in that while revenue has grown at a CAGR of 7.7%, profit has grown at a CAGR of 20.48%. We speak in terms of net profit because it is practically similar to FCF excluding some annual oscillation due to working capital, which is corrected the following year.

The Retail segment leaves better margins than the wholesale segment, so if it continues to grow at a higher rate than the wholesale segment, either organically or inorganically, we may continue to see slight improvements in margins.

The company's ROIC is at normal levels for the industry and ranges between 9 % and 12 %, supported by debt, ROE reaches 20 %.

Delko usually works with a net debt/EBITDA of between 2 and 4 times, which is typical for the sector, however, it is currently at a low leverage level of 1.5 times net debt/EBITDA.

The company's cost of financing had been quite cheap, as it is based on WIBOR plus the bank's margin. For example, in 2021 it was 2.4%. However, the rise in interest rates over the last year has caused WIBOR to rise significantly, from around 2 % to 7 %. Luckily Delko is in a low debt period so it should not have a significant effect.

Valuation

Before going into the valuation of the company, I would like to state what I expect from the company in the long term, and that is:

1. Organic growth of 5% combined with M&A.

2. Margin improvement as the Retail segment gains more weight.

3. If there are not many M&A opportunities, an increase in payout (currently 26%).

For the valuation, we will perform a 3-year discounted cash flow and compare it with other companies in the sector.

The multiples show that Delko trades at a considerably lower valuation compared to similar companies despite having margins, growth and ROIC in line with an average.

With the valuation by comparables we have a problem, Delko is a very illiquid small cap and has been trading at multiples of between 4.5 to 6 times for years. What we should ask ourselves is whether this illiquidity justifies trading at 1/3 of the industry average and at an FCF yield of 22%, which in my opinion it does not.

If it were to trade at Carrefour's multiples, a company with virtually no growth, half ROICS and twice as much leverage, the target price would be PLN 22.61.

In order not to rely on comparable companies with a much higher market capitalization, we will make a DFC. We will use conservative assumptions only with organic growth and leaving out margin improvements, with an EBIT margin lower than last year and in line with 1Q 2023 .We have included a 3.4% premium to the WACC due to the low liquidity of the company. Finally, we must make an adjustment by adding the impact of the A&K supermarkets of which the company owns 50% and which are accounted for by the equity method. Not doing so would mean leaving out 12 to 15% of the company's profit. With these assumptions we would obtain a target price of PLN 17.46.

Risks

Due to the industry and the company's history, I see little risk to the business. Although there are certain risks that may be related to the investment, the main ones are the following:

Exchange rate

100% dependence on Poland

Poor execution of M&A and supermarket expansion.

Squeeze out: The 3 main shareholders own more than 50% of the company and with the company trading at these multiples there may be a risk of a takeover bid at a low a price.

Lack of information: As with many Polish companies, communication with the market is lacking and reports are only in Polish.

Get trapped in the company waiting for a re-rating that never happens

Conclusion

Delko doesn't offer high growth, but a defensive business at a super attractive valuation. On the downside it has always traded at these multiples, and I don't see any catalyst in the short term for this to change, except for the Polish market in general when inflation eases. The potential is quite high for the type of business and above all the margin of safety is huge. Losing money on this company seems very complicated and in case that re-rating does not come, we can expect it to compound between 5% and 10% per annum and a normalized and growing dividend of around 5% yield which is not bad at all for the low risk of the business.

Disclaimer: This is not an investment recommendation but a personal opinion. The author is long on the company's shares.

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