Seeing value in Brait through the noise

New Look written down to zero

Simon Anderssen

As recently as July 2016, shareholders in Brait valued the company at more than R80 billion. A short 18 months later and its market value has been slashed by over 70% to slightly more than R20 billion (see graph below). We believe this is a reflection of both extreme optimism then, and extreme pessimism now.

It is true that a large holding in Brait’s portfolio, UK ladies apparel retailer New Look, is experiencing extremely challenging trading conditions and that the investment may have little or no value for Brait shareholders. However, the remaining investments have good operating histories and sound prospects. We believe that at the current market price, the value of the remaining assets is being unfairly tarnished by New Look’s poor performance.

Founded in the early 1990s, Brait grew into a successful South African private equity manager. In 2011, it restructured into an investment holding company that introduced management

and well-respected external business people as direct

shareholders in the company, thereby creating substantial direct alignment between the interests of management and shareholders.

The new structure allowed Brait to raise a pool of ‘permanent’ capital to invest with a long-term horizon. It acquired interests in SA’s leading value clothing retailer, Pepkor, and in Premier Foods. Shortly after, it acquired a share in Iceland Foods in the UK. After realising significant value by selling Pepkor to Steinhoff in 2015, Brait acquired controlling interests in Virgin Active and New Look.

Upbeat about Virgin Active

Virgin Active is Brait’s largest investment to date and is familiar to South Africans as a leading health club operator. What is perhaps underappreciated is the group’s international operations, which span developed and emerging markets across four continents, with operations tailored to meet differing market preferences.

In SA, the multiple format model caters to more than 700 000 members and generates very attractive returns on investment. The group’s 45 UK clubs contribute a similar share of revenue, despite having a much smaller membership base (180 000). These clubs cater to the premium market and offer a highly personalised customer experience.

Virgin Active is Brait’s largest investment to date

Source: Bloomberg

In SA, the multiple format model caters to more than 700 000 members and generates very attractive returns on investment. The group’s 45 UK clubs contribute a similar share of revenue, despite having a much smaller membership base (180 000). These clubs cater to the premium market and offer a highly personalised customer experience.

The group also operates 34 premium clubs in Italy where, unlike SA’s early bird approach to exercise, peak times start much later in the day. Another difference - playing to the country’s appreciation for design and personal-grooming - is the lavish changing rooms. Larger than in any other market, they offer an extensive spa complete with hydro massage pools, relaxation areas and ‘emotional showers’ where soothing lighting and audio immerse you in the sounds of the rain forest.

The group anticipates most of its future growth will come from its Asian operations, where strong demographic trends and under-penetrated markets offer attractive growth opportunities. It currently operates nine clubs across Bangkok (Thailand) and Singapore. These are positioned as premium health clubs and the Virgin brand is a recognised differentiator. Members in these markets participate in group exercise classes (such as spinning or aerobics) more regularly than in any other region, and often visit clubs as much for socialising as for exercise.

Virgin Active has delivered robust earnings growth in recent years. We believe it is well positioned to capitalise on enduring demand for healthier lifestyles and that it will continue to optimise its club portfolio in larger markets and grow its estate in the East.

Virgin Active has delivered robust earnings growth in recent years

Source: Bloomberg

Active shareholders

Brait’s investment model is designed for active involvement in strategy at investee companies. This enables Brait to act decisively when challenges arise - as demonstrated in recent years with the turnarounds achieved at both Premier Foods and Iceland Foods.

Premier Foods is a leading SA food producer with iconic brands including Iwisa No. 1 maize meal, Snowflake flour and Blue Ribbon bread. After taking an initial interest in Premier in 2011, Brait strengthened the management team and supported a

R3 billion capital investment programme.

This enabled Premier to upgrade and expand its mills and bakeries to achieve better quality, invest in new products that extended its brands into adjacent categories, and acquire complementary businesses that provide diversification or scale advantages.

These changes have led to significant growth in market share (see chart below) and a six-fold increase in trading profits over the last seven years. We believe Premier will continue to benefit from its investment programme and is well positioned to navigate the challenging consumer environment over the coming years.

Iceland Foods is a value-orientated UK food retailer specialising in frozen foods, which contribute a third of its sales. Traditional branded groceries contribute the remainder.

After Brait initially acquired an opportunistic minority interest in 2012, Iceland Foods experienced a very challenging trading period. Low-cost discount food retailers gained market share and food deflation swept the market. Its earnings declined 35% between 2013 and 2015.

Brait increased its shareholding to 60%, strengthened management and invested in the business. Specifically, it invested in innovative new products, a promotional campaign, a significant store refurbishment plan and a new operating format that trades in parallel to the original model. These interventions have again shown excellent results in what continues to be a very challenging market, with Iceland growing revenue ahead of the market (see graph) and a recovery in earnings.

Why all the fuss about New Look?

In 2015, Brait acquired a controlling interest in New Look at a valuation of £1.9 billion. The majority of New Look’s sales come from the UK where it is the second-largest ladies apparel retailer, with a specific focus on value fashion.

Buoyed by strong operating performance and high valuation multiples for similar companies, Brait revised its own valuation of the business up to a peak of £3 billion in March 2016. This optimism changed rapidly, however, as the operating environment in the UK toughened.

It remains to be seen whether New Look’s earnings can recover sufficiently

Source: Bloomberg

New Look’s trading performance began to falter around the time that the UK voted to leave the European Union in 2016. Already under pressure from growing competition by online retailers, New Look was caught off-guard by the Brexit vote and the slow-down in consumer spending that followed. The sharp depreciation of the pound compounded the slowdown

in sales, and profitability has declined precipitously.

However, New Look’s true Achilles heel is its gearing. By September 2017, the group owed more than £1.2 billion to debt holders, compared to annual cash earnings before interest and tax of only £90 million. This is an unsustainable position and, without a substantial and rapid improvement in profitability, it is unlikely that Brait will realise any value for its shareholding in New Look.

In Brait’s most recent assessment of value for its investments, the carrying value for New Look was slashed to zero. This represents a substantial loss and has been an important factor in the decline in Brait’s share price.

In response, Brait has acted as it has in the past to address underperforming investments - by strengthening management and supporting an investment programme.

A new management team is in place and the business has secured liquidity that provides the flexibility for it to attempt a turnaround. Any recovery will only be evident toward the end of 2018 due to the design and procurement lead times common in apparel retail. Until then, it is likely that New Look will have to invest in marketing and reduce product prices, and that results will deteriorate further.

UK ladies apparel retailer New Look is experiencing challenging trading conditions

Source: Bloomberg

Not paying for the risk

We don’t know whether New Look’s earnings can recover sufficiently for it to represent any value for shareholders. However, at current market values, we don’t believe investors are paying for this asset. This means investors avoid the risk that the business fails, but retain the potential benefit if it succeeds. ■

Simon Anderssen is associate portfolio manager at Kagiso Asset Management