Investment summary
The investment landscape has changed drastically in the past 6 months from one of (i) projected rate cuts, (ii) upward revisions to GDP, and (iii) potential P/E contractions, to one where the market now expects [a] basically zero changes to rates this year, and [2] several downward revisions to US GDP. At the same time, the forward P/E multiple on the S&P 500 Index hovers ~21x as I write, vs. ~16x for the equal-weighted S&P 500 index. The risk for broad equities, as Goldman Sachs says (Figure 1) is the underperformance of the mega caps in earnings and multiple contraction.
Figure 1.
As seen below, tech and consumer discretionary lead the index’s valuation bands, with the consumer staples sector still priced at 20x forward earnings. What I find interesting is that the sector also offers a trailing 4.2% FCF yield at this multiple and could suggest investors have outsized expectations for corporations in the domain.
Figure 2.
The consumer staples and merchandise retail industry is highly competitive but does have its competitive advantages over other sectors. Pricing advantages are one, alongside capital efficiency and asset turnover for the industry leaders.
Costco (COST) is the industry leader, as seen in Figure 3, with:
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Highest profit per employee [return on talent],
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Highest ROIC [return on business assets],
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Highest capital turnover [asset efficiency], and
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Lowest gross margins [lowest sales prices].
Part of the attractive economics are based on its membership model (providing a source of float), and the breadth of its offerings. The flywheel is such: it invests in lower prices to drive memberships which then drive sales volume and turnover on invested capital. This is repeatable and scalable.
Figure 3.
A company with a similar set of economics is PriceSmart, Inc. (NASDAQ:PSMT), a warehouse club operator across Central America and The Caribbean.
PSMT was founded in 1996 by Sol and Robert Price. They were the duo behind Price Club, the original warehouse club concept in 1976. Headquartered in California, PriceSmart operates 55 warehouse clubs across 12 countries. The company is modelled off warehouse club operations similar to those found in the US (e.g., Costco, Walmart). In fiscal year 2023, the company generated ~$4.4 billion in revenue, driven by 1) ~2 million membership accounts and 2) <$3 million cardholders.
Figure 4.
PSMT operates through multiple business segments, categorized by region: (i) Central America, (i) the Caribbean, and (iii) Colombia. It books revenues across several business lines:
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Warehouse club sales: The bulk of the company’s revenue comes from merchandise sales at its warehouse clubs. Around 50% of its merchandise is sourced regionally, with the remainder imported from global suppliers.
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Membership fees: Consumers have the choice of either Diamond and Platinum memberships. Fees range from $35 to $80 annually, providing members with benefits such as cash-back rebates and lower product prices.
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Private label products: A point of price differentiation is the “Member’s Selection” private label. This offers a range of basic consumables and unique products and is a differentiator to provide additional consumer advantages (which typically translates to higher profit margins).
Recent developments have been positive for the company’s expansion efforts and profitability. However, the market looks to have fully discounted the incremental growth PSMT can produce at current multiples. As such, I am constructive on PSMT’s fundamentals, but neutral on the company due to valuation. Rate hold. Figure 5.
Key factors in investment debate
(1). Q1 FY 2024 Earnings
PSMT put up Q1 revenues of ~$1.3 billion, up 13% year over year, while comparable net merchandise sales rose by 8.8%. Growth was underlined by higher merchandise sale revenues in all its markets [Central America +12.4%, Caribbean +7.2% and Colombia +34.5%].
Membership income grew by 14.6% to $18.5 million, driven by a 5% increase in membership accounts and an average 12-month renewal rate of 88.3%.
Figure 6.
Despite this, gross margins contracted ~30 basis points to 15.7% due to 1) the removal of COVID-premiums on its merchandise pricing, and 2) reduced liquidity premiums on its Trinidad sales. So it wasn’t necessarily a business factor – more a regulatory tailwind gone.
The business saw 250 basis points growth in average ticket price, driven by a 9.1% increase in transaction volumes. It also helps that the average price per item increased 3.9%. My question is, was this is a function of price inflation or, due to demand/supply mechanics? Most likely both at the end of the day.
It realized ~400 basis, points of leverage at the SG&A line with these expenditures reducing to 12.2% of total sales. It pulled this to operating income of $64 million, 18.2% year over year growth.
(2) Interpretation of results
The growth percentages PSMT hit in Q1 were largely in line with expectations and don’t stand out to me for a couple of reasons. Firstly, the entire consumer retail segment benefits from top-line growth tied to general inflation. This does not change during periods of excess inflation.
Secondly, the growth was engendered on substantial sums of capital reinvestment. In the 12 months to Q1 2024, capital expenditures were $193 million, whereas revenues grew by $150 million in the same time. As such, to produce a $1 of revenues required an investment of $1.29 into warehousing, product, marketing, and so forth. The problem is, in a high-inflation world, all new asset growth is priced in today’s dollars- that is, today’s overinflated dollars (making the same investments incrementally more expensive to make for the same unit of value).
However, as we will see a little later, that $1.28 investment is expected to return $3.84 at the current rate of invested capital turnover.
Catalysts – upside and downside
(1) Growth drivers
Management set out its growth drivers for the coming few years on the call:
- The first is its real estate strategy in which it is expanding to countries throughout South America including El Salvador and Costa Rica. It is planning to open its ninth warehouse in Costa Rica this year. It is also remodelling its high-volume clubs, which may carry some execution risk.
- I touched earlier on the fact that its private label memberships are a point of differentiation offering a higher margin segment. Management is focused on growing this division, which contributed ~27% of merchandise sales in Q1 – an increase of 120 basis points over the year.
- I would also point out the integration of the various health services among most of its centres (especially pharmacy services) which increases consumer penetration and potentially could drive a higher margin revenue stream.
- Omnichannel shopping is a growing trend amongst consumer preferences and management is focusing on implementing this for its members. It saw a 31% year over year increase in sales from its digital channels (website and app). Not only that, the average sales price increased by 180 basis points on the specific unit sales, so it is my opinion management will be focusing on this area moving forward. I believe Wall Street and the general investing public will also focus on this domain.
(2) incremental returns are justifying higher growth – but not higher market values
- Given this is such a cutthroat industry at the margin, capital efficiency is paramount. The company rotates its invested capital over around 3.6x every 12 months, meaning a one-dollar investment into the business returns around $3.60 in revenues.
- Pre-tax returns on business capital have expanded at a decent rate, adding 220 basis points since 2021 and producing 17.4% in the last 12 months. Should this continue at the current rate to FY 2026, my estimations suggest it will have added a cumulative 350 basis points in total pre-tax margin since 2021.
- Management has committed an additional $4.76 per share of capital since 2021 to maintain PSMT’s competitive position and grow the business. On this, it has grown post-tax earnings per share by $1.04, a 22% return on incremental capital.
- It reinvested ~8.5% of the earnings generated over this time, meaning it compounded its intrinsic valuation at 4% over the last three years (22%x8.5% = ~4.03%).
Figure 7.
Figure 8.
Alas, while the marginal returns on business assets are high, the opportunity for management to aggressively redeploy funds at these high rates of return is limited. This is why metrics such as profit per employee are important in these industries, indicating profitability per unit of human and business capital.
Secondly, the market looks to have captured this incremental growth value well at the current market values. Whilst the business has justified a 4% growth in value as seen below, the market has increased the share price by 6.4% over the testing period, suggesting it has expanded the P/E multiple by 2.4%, which is fairly standard. PSMT has rotated one dollar of incremental retained earnings to a dollar of incremental market value – it has just not done this at a high enough rate.
Figure 9.
(3) Valuation scenarios implied little flesh to put on the investment skeleton
Consensus looks for 10.5% growth in sales in FY 2024 which looks to rotate into around 12% pre-tax earnings growth on these estimates. This calls for $4.8 billion at the top line and $230 million pre-tax, which could pull to $153 million in post-tax earnings at a 30% tax rate. My forward projections are shown in Appendix 1 at the end of this report. Here I have baked in a 2.7% quarterly compounding sales growth rate to FY 2026, on 4.5% post-tax margins, and capital intensity in the following manner: $0.02 of net working capital for every new $1 of revenues; $0.15 investment to fixed assets for each $1 revenue growth.
Figure 10.
Despite the growing pre-tax returns on all capital injected into the business, investors have reduced the multiple paid on these business assets from 2.5x in 2021, down to 2x at the time of writing. The price paid per $1 post-tax earnings has also narrowed in from 24x to 17.4x as I write.
Any change in valuation appears highly dependent on multiples expansion in my opinion. If I peel back the current multiples to 1.9x EV/IC and 15x EV/NOPAT, The stock appears fairly valued where it trades today ($80 per share at the time of writing).
This is despite the fairly aggressive growth numbers outlined before. It needs to trade at high multiples to justify a higher market value, regardless of growth.
Figure 11.
If we bought 1,000 shares of PSMT stock at market today the cost would be $79,400 to receive:
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$4.58 of post tax earnings for earnings power of $4,577.
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The return on market capital (analogous earning yield) is 5.8% and the multiple paid is 17.3x.
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By year three we would hope to achieve $5,430 in earning power under my growth assumptions 18% cumulative growth, 7% CAGR.
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I’m looking for companies that can demonstrate at least a 12% CAGR in earnings power over this period in time, so PSMT does not fit the bill here.
Figure 12.
Finally, the projected earnings I have modelled don’t appear to be economically valuable in the first place (Figure 13). Here I create a capital charge against the projected earnings by indexing them against an 8% hurdle rate. This is made up of the 6% starting yields most investors can presently achieve on investment-grade corporates, plus a 200 basis point inflation premium. Earnings produced above this 8% hurdle rate are considered economically valuable to me (and vice versa).
As observed, summing the value of these economic profits and discounting them at a 12% hurdle rate – one that reflects the long-term market averages – arrives at a valuation of just $63 per share.
Even without adding the capital charge to the projected earnings and extending the forecast period (but discounting at the same 12% rate), I get to $77 per share in equity value (Figure 14). In my opinion, this is about fair value range for this company, give or take a few dollars for dividends and buybacks.
Figure 13.
Figure 14.
In short
Companies that operate in industries with commodity-like economics must produce highly efficient revenues on their business assets. The problem for individual corporations is, that most competitors are just as diligently doing the same thing. Therefore metrics such as profit per employee and incremental return on capital are telling.
Even though PSMT has been producing reasonable profit growth on its incremental investments, it has not had the magnitude of investment opportunities to deploy these funds to create substantial economic value. As such, the percentage returns are high, but the magnitude of dollar returns when benchmarked against reinvestment rates is low. Consequently, a justified valuation range of $75-$80 per share at the time of writing is fair in my view. Rate hold.
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