Pepco (PCO.WA) Stock Analysis

1. Executive Summary

Europe is under immense pressure from the consequences of the Ukraine war. Progressively cut off from Russian energy, the continent’s economy is not unlike a cruise ship heading for an iceberg. Massive damage is inevitable, and investors are heading for the lifeboats.

This crisis will place serious economic stress on European consumers. That’s a burden, but it will be a tremendous opportunity for shops able to provide quality products at affordable prices. As budgets tighten and discretionary income shrinks, brands owned by the Pepco Group, which has long emphasized affordability, will fill the gap left behind as more expensive brands and outlets see sales shrink.

The company has fine-tuned its business model in Eastern Europe for 2 decades, offering quality goods at very low price points while still generating a gross margin double that of traditional clothing retailers. In parallel, its successful UK-based brand has shown it how to create a more diverse discount offer successfully in more affluent countries and urban areas.

The two brands are now expanding into the Western European market, which has a large middle class fearful of downgrading its lifestyle in difficult times. Pepco allows struggling families to maintain their shopping habits, even on a budget.

The company is fairly valued for a retail stock and undervalued for an exponential growth stock.

The main limitation of Pepco is not the business fundamentals but its listing on the Polish Warsaw stock exchange, which gives it limited visibility. US investors will need to have a brokerage account with a broker giving access to this stock exchange to buy the shares.

3. Recession & Discounters

The Coming European Recession

If you follow financial news, you have seen a lot of discussion about energy prices, recession, and the impact of the Ukraine war. To sum it up, the whole world is short of energy, and the shortage is especially acute in Europe. The continent suffers from shortages for several reasons:

• Excessive dependence on Russian gas.
• Insufficient renewable production to replace closing fossil fuels plants.
• Aggressive closure of nuclear power plants (especially in Germany).
• Dramatic reduction in Russian gas inflows to punish European countries supporting Ukraine.
• A lack of LNG ports able to receive gas from other sources.
• A planned embargo on Russian oil by the end of the year.
• A strong drought has reduced hydropower generation in most of Europe, and also reduced nuclear output.

All of these factors have resulted in skyrocketing electricity and energy prices. For just one example among many, we can look at the price of electricity in France: it went from below 100 €/MWh (even in the “high energy era” of 2008) to 840 €/MWh. For reference, 600 €/MWh is the equivalent in energy of $1000/barrel of oil. Essentially, electricity is becoming too expensive for many Europeans to use.

The consequence of this brutal rise in energy costs will be felt by both companies and consumers. This comes on top of pre-existing inflation at higher levels than Europe has seen for decades.

Energy price increases could double UK inflation up to 18% and energy bills are expected to soar from £2,000 to £4,000 or more. Germany, the industrial center of Europe, is rapidly closing down metal smelters and fears factories leaving the country in droves. And if that was not enough, the drought has done extensive damage to agricultural yield, so food prices are up as well.

Energy use is largely inelastic: even the highest prices can only cut demand to a certain level. People can cut consumption to some extent, but when they’ve cut all they can, they will cut from other spending in order to afford the energy they need.

Closing factories, impoverished consumers, and a recession right ahead paint a grim picture for European equities, especially the ones focused on retail, right?

The Opportunity in the Crisis

Every crisis creates an opportunity. The current European energy crisis promises to be painful, but it will not be world-ending either. Instead of panicking, we should focus on the consequences and who will profit from them.

When pressured by rising prices and large energy bills, European consumers will not suddenly stop buying things altogether. We live in a consumer society and people will not stop shopping. However, they will look for better prices. The primary beneficiaries will be discount brands and outlets.

The problem is that most of the major discounter franchises (like Aldi and Lidl) are private companies and not publicly listed. Investors cannot buy their shares. This also means that the very few discounters that are publicly listed should at some point get attention from the investing community.

The ideal target will be a company small enough to have room to grow, but also big enough to have already reached an economy of scale. It should operate in multiple countries. Since we’re focused on Europe, the stock covered in this report, the Pepco Group, fits the bill.

Can such an investment be profitable? Judging by the American equivalent of the “dollar store” concept, it can be a good bet. For example, the Dollar Tree franchise stock has gone up almost x100 since its listing in 1995.

The Pepco Brand

Pepco is a Polish retailer focused on apparel, housewares, and toys. The focus of the brand is on “Mums on a budget“. This is a solid target in the current context. No matter how tight the budget gets, kids will need bigger clothes and need birthday presents. As a father of a 4-year-old boy who is growing like a weed, I can confidently say that this is not an expense you can avoid.

Pepco offers a selection of clothing with a store space roughly arranged with 50% kids’ apparel, 35% women’s clothing, and 15% men’s clothing. Apparel accounts for most of the shop space, with around 20% for toys, household items, and kitchenware.

The thought process is rather simple: “Mom goes to the shop to buy new clothes for her kids, enjoys browsing very affordable clothes for herself, and might even bring back something for Dad“. Some extra cheap toys, glasses, pillows, candles, or batteries are tempting as well and can increase the total visit value.

If some clothes don’t fit and need to be returned, you can return them to any shop in the franchise for 30 days.

As a side note, I must say I live near several Pepco shops and this shopping process is something of a ritual in our family several times a month. This is actually how Pepco first came to my attention. Both clothes and toys are cheaper than anything I could buy direct from China on AliExpress.com.

” Visiting stores and testing products is one of the critical elements of the analyst’s job.“

Peter Lynch

Peter Lynch is THE reference on investing out of the beaten path. So beyond my direct experience, I went around and grabbed some of their marketing material to show their price range. Frankly, these prices are unbeatable in my area.

Pepco’s marketing approach focuses on low prices for goods that don’t feel cheap. That’s important for apparel, which is so tied to self-image and social status. If you don’t mention it, no one will notice that you dressed yourself or your kids for a quarter of the price you’d have paid in a mainstream store.

You can judge by yourself (and forgive my poor photography skills):

Click on images to enlarge

Price can be one of the strongest moats possible. It is also a very durable sales point. This is something another extremely successful brand, Amazon, knows very well:

The obvious answer is that customers will always want low prices, fast shipping and a large selection. It’s impossible to imagine someone saying, “‘Jeff, I love Amazon, I just wish you delivered a little more slowly. When you identify those big ideas that are stable in time… they’re usually customer needs.

Jeff Bezos – “Think about what is not going to change”

I think Pepco is in a similar position. None of its customers will tell them, “I wish it was a bit more expensive, a little less good quality or that you did not have the cheapest possible children’s clothes and toys“.

The Pepco Business Model

Pepco products are not just remarkable for their prices. The quality is not much different from more expensive competitors like H&M or Primark. There are even plenty of popular branded kids items like Jurassic World, Harry Potter, Star Wars, etc, usually below 5 €. Non-branded apparel can be as low as 2-3€. Multiple socks or underwear might be 1€ or below.

So how does Pepco do it? Through a remarkable mastery of their supply chain and rigorous cost control.

The Pepco Supply Chain

Most apparel retailers buy their products through intermediaries. This allows them to pick from an absolutely gigantic pool of suppliers worldwide. This way they can frequently turn over their collections, bring in new designs, and keep their offers fresh and trendy.

This flexibility and constantly changing selection come at a cost. Intermediaries need to make a living as well. So the average gross margin with this third-party supplier model is usually around 25%.

By comparison, Pepco claims a 50% gross margin.

Pepco achieves this through direct relationships with the factories producing the clothes and goods. Most of the goods come from China, but new suppliers are entering the company’s supply chain, notably in Turkey, India, Bangladesh, and Pakistan.

PGS, Pepco’s sourcing department has also directly performed 2,000 factory audits since 2017 to keep a close eye on product quality.

Cost Control

The other side of the price story is cost control. Pepco shops are generally smaller than other apparel retailers, so the selection is smaller. But really, how many 5-year-old-size T-shirts with Star Wars or Harry Potter branding do you need to see before choosing one for your kid, especially at a 3-5€ price tag?

Smaller shops allow for fewer employees and lower rent payments.

A smaller selection also allows for faster inventory turnover, and the ability to replace a bigger segment of the inventory at limited costs. While larger brands like H&M or Primark need third-party suppliers to source enough products to stock a large store, Pepco can do it directly.

Lastly, Pepco management is razor-focused on cost optimization. It is significant to see large sections of corporate communication to investors focused on “small” things like switching all lights to LEDs or stopping all air freight to cut costs.

The company is also adopting self-checkout in the newer shops and implementing modern ERP (Enterprise Ressource Planning) software in its warehouses, so we can expect the overall efficiency to keep going up.