This article first appeared in The Edge Malaysia Weekly on October 19, 2020 - October 25, 2020

THE initial public offering (IPO) of home improvement retailer Mr DIY has understandably generated some excitement in the domestic market. After all, it will be the largest IPO in three years, seeking to raise RM1.5 billion. The listed company will have a market capitalisation of RM10 billion at the offer price of RM1.60.

At this price, its shares are valued at 31.6 times trailing earnings. This is a rich price-to-earnings (PE) valuation by almost all yardsticks — sold on the premise of its considerable growth potential. The company is looking to expand its footprint in Malaysia by opening more new stores. How realistic are these expectations, though?

Since opening its 100th store in October 2014, Mr DIY has been on a tear in terms of new store openings. In a span of six short years, the number of stores has grown from 100 to 674 currently, equivalent to a compound annual growth rate of 37.4%. The company intends to add 226 outlets, or 33.5% growth, to hit a total store count of 900 by end-2021.

We think this pace may not be sustainable. Why?

With 674 stores, Mr DIY already operates the largest chain compared with peers in the region. Ace Hardware in Indonesia has 205 stores while Thailand-based Home Product Center PCL operates 115 stores. Wilcon Depot Inc in the Philippines manages 60 stores (see Table 1).

More critically, Malaysia’s number of home improvement stores per million population is well ahead of that in Indonesia and the Philippines and just slightly below that in Thailand. In fact, we are on a par with some of the developed economies like the UK (see Chart 1). Bear in mind that Malaysia also has a much smaller population, which is its total addressable market.

As the number of stores continues to rise, it is inevitable that the quality of this source of growth will deteriorate. Retailers will always pick the best locations for the first few stores, with the largest catchment areas. Subsequent outlets will push further into less lucrative locations and/or new outlets will start to cannibalise earlier, nearby stores. Is this already happening to Mr DIY?

The company’s same-store sales growth (SSSG) has been falling rapidly over the past three years — slowing from 6.5% in 2017 to 4.5% in 2018 and further to just 1.8% in 2019. In effect, the strong sales growth in the past two years came primarily from new store openings (see Table 2).

Similarly, its inventory turnover has been falling, from 3.3 times in 2017 to 2.4 times in 1H2020. This basically means the company is holding its inventory for longer before sale.

So, while Mr DIY’s PE valuation is similar to those of its listed peers in the region, we think its future growth prospects are far more ­limited — given Malaysia’s relatively high ratio of stores per million population as well as small total population size. Looking ahead, market valuations will surely de-rate to reflect this new reality of slower future growth.

A slowdown in new store openings will have an additional impact on profits. It is common for mall owners to offer generous fit-out contributions to entice retailers that take up large lease spaces, especially those with low footfall. The fit-out gains inflate profits over the initial period of the lease, typically three years.

Mr DIY has been very aggressive in store expansion over the last two years. Thus, such fit-out benefits would have boosted its profits, which would otherwise have been lower. Management can offer more transparency in this respect — as this layer of profits will fall off when store openings slow, as they will inevitably have to.

Even with the boost from fit-out gains, net margin contracted quite sharply in 2019, from above 17% in 2017-2018 to only 14% in 2019. This is despite gross profit margin holding relatively steady at 42% to 44% in 2017-2019.

The narrower margin is due, primarily, to higher interest expense. This is the other big issue that is troubling us — not just the sharp rise in borrowings but also the reasons behind it.

Mr DIY had net cash of RM58.4 million at end-2017, which turned into net debt of RM482.7 million in 2019. Part of the cash was used to fund new store expansion. But the lion’s share — RM133 million in 2018 and RM501.7 million in 2019, or more than double the amount used in investing activities — was distributed as dividends to shareholders, pre-IPO (see Table 3).

Included in the investments in 2019 was the acquisition of the franchise in Brunei for RM104.8 million from its directors, essentially a related party transaction. The acquisition was priced at a PE of over 20 times. Given that Brunei has a population of just 459,500, colour us doubtful on its future growth prospects and the valuations paid.

As a result of the spike in borrowings, interest expense more than doubled to RM64.6 million in 2019 from RM30.1 million in the previous year — and ate into profitability.

This does not inspire confidence, to say the least — that its controlling shareholders would take out such huge amounts of cash on the eve of the company’s big expansion plan that is to be its key driver for future growth.

In fact, RM1.2 billion of the RM1.5 billion raised in the IPO will go to existing shareholders, whose stake would drop to 27.2% post-IPO. The balance that accrues to Mr DIY will go towards paring down debts, taken mainly to pay out hefty dividends pre-IPO.

Post-IPO, dividend payouts would likely be limited to its operating cash flow after funding store expansions. We estimate dividend yields to be low, at no more than 2%, assuming a 40% payout.

Our conclusion: The business is fundamentally sound in that Mr DIY has very successfully targeted and captured a market segment.

Over the past few years, Mr DIY’s growth has been driven by aggressive new store openings. But we think this pace is not sustainable. Competition is intensifying with the emergence of numerous big-box retailers based on a similar concept and, of course, e-commerce. In fact, the increasingly saturated market may be a big reason that SSSG is declining rapidly.

The combination of slowing store openings, owing to saturation, and flattish or even negative SSSG, would not bode well for overall growth prospects going into the future.

This would make it difficult to justify its high 30 times PE valuation — especially when profits are inflated by landlord contributions for fit-out, which is based on the number of new store openings, while overall profit margin is on the downtrend.

And, yes, what do the major shareholders think of this valuation? They have cashed out in a big way!

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