Matahari Department Store The Bright Morning Star

We reinitiate coverage of PT Matahari Department Store Tbk (MDS) with a BUY rating and a DCF-derived TP of IDR22,000 (implying a 32.6x FY15F P/E). We like MDS due to its: i) solid strategy positioning; ii) widening market share lead; iii) excellent supply chain network; and iv) strong free cash flow generation and healthy balance sheet. MDS targets the fast growing Indonesian middle-income segment. As of Dec 2014, it had 131 stores covering 62 cities throughout Indonesia.

Solid strategy positioning
MDS is strategically placed in the ideal quadrant of high margin and high asset turnover business. Its pricing power is achieved from its strong brand Matahari, which won the Marketing Magazine’s Top 2014 Brand in the Department Store category and its successful push for its very-well accepted private label brands, such as Nevada. MDS also operates on an asset-light strategy in that it leases all its stores, resulting in high asset turnover ratios.

Market share lead continues to widen
MDS has managed to increase its market share every year since 2008. Based on a Euromonitor survey, its market share was 34.4% in 2013 as MDS kept profitably expanding into 2nd and 3rd tier cities which, unlike Jakarta, are still underserved and have little competition. Given that Ramayana Lestari, its closest competitor, targets the lower income segment, we believe MDS has limited direct competition for its middle income target segment.

Excellent supply chain network
With a network of more than 1,200 local suppliers (representing 90% of its total merchandize), MDS is able to customize its offerings to meet the needs of its local target market and limit its exposure to the risks associated with importing goods (such as delays, import taxes and currency fluctuations).

Reinitiating coverage with a BUY and a TP of IDR22,000 (a 15% upside). Our DCF-based TP is derived using a WACC of 12.4% and TG of 5%, which will imply a 32.6x FY15 P/E.

Risks
Increased competition from foreign competitors, related party transactions, changing regulation on retailers in Indonesia.

Investment Thesis
Solid strategy positioning
MDS is strategically placed in the ideal Quadrant 3 of high margin and high asset turnover business (Figures 1 and 2). Its pricing power is achieved from its strong Matahari brand, which won the Marketing Magazine’s Top 2014 Brand in the Department Store category and its successful push for its very-well accepted private label brands, such as Nevada.

Well-managed private label brands
Nielsen Global Private Label Survey 2014 reveals that more than 60% Indonesian consumers surveyed, more than the global average and its South-East Asian peers, think that private labels can be considered a good alternative to name brands and that private label brands’ quality is as good as that of name brands.

MDS’ private label brands contribute c.80% of Direct Purchase (DP) Sales (or c.27% of MDS’ Gross Sales) with the top 5 private brands generating 55% of DP Sales (or c.19% of MDS’ Gross Sales).

Asset-light strategy results in a high asset turnover
MDS also operates on an asset light strategy in that it leases all its stores, resulting in high asset turnover ratios. Strong relationships with large real estate developers, such as Lippo Group, allow MDS to identify, negotiate and secure premium locations for new stores, especially in underserved regions outside of Jabodetabek region. In FY14, MDS leased 65% of the properties from non-affiliated parties (compared to 64% in FY12) and 35% from Lippo Group’s owned properties (compared to 34% in FY12).

MDS typically enters into long-term lease agreements, mostly for a primary period of 10 years with options to renew the lease twice for a period of 5 more years each. Of the total 131 store leases, 91 stores (or 69% of total stores) provide for a fixed, step-up rent and 40 stores (or 31% of total stores) provide for a variable rent. Fixed rents are quoted per square meter and mainly in rupiah with escalations during the contract periods. Variable rents are calculated as % of the store’s gross sales subject to minimum rents. Going forward, MDS aims to have more fixed, step-up leases.

Market share lead continues to widen
MDS has managed to increase its market share every year since 2008. Based on a Euromonitor survey, its market share was 34.4% in 2013 as MDS keeps profitably expanding into 2nd and 3rd tier cities which, unlike Jakarta, are still underserved and have little competition. Given that Ramayana Lestari (RALS IJ, NEUTRAL, TP: IDR780), its closest competitor, targets the lower income segment, we believe MDS has limited direct competition for its middle income target segment.

Excellent supply chain network
With a network of more than 1,200 local suppliers, representing 90% of its overall merchandise, MDS can limit its exposure to the risks associated with importing goods (such as delays, import taxes and currency fluctuations) and respond quickly to changing inventory needs and the highly dynamic trends in fashion. The merchandise mix (including the mix between DP Goods and CV Goods) is adjusted on a store-by-store basis, customized to the store’s local target market.

MDS’ supply chain is run on a ‘just in time’ basis
Goods are not stored at the distribution centre. Instead, it serves as a ‘flow through’ facility, with suppliers making regular deliveries to the center, from where the goods are distributed immediately to the stores. This reduces costs and inventory risk while maximizing efficiency and flexibility. MDS achieved low levels of inventory shrinkage, not exceeding 1.2%, from FY11 to FY13.

MDS has been generating increasingly robust free cash flows since FY09 due to its asset light strategy and sector leading operating margins. As such, MDS will distribute 60% dividend payout ratio going forward. MDS will further reduce its acquisition loan and plans to be debt-free by end of this year in FY15. The interest expense from the acquisition loan is not deductible and that is the reason MDS has been paying off its debt and it wants to get rid of it completely.

MDS had a negative cash conversion cycle of negative 22 days in FY14, with the following breakdown: its receivable days at 2, payable days at 57 and inventory days at 33 (versus 27 days in FY13). The six day inventory increase was due to the back-ended store opening in FY14 and MDS deciding to keep some inventory in its Papua store to avoid stock-outs.

Focus on outside Java expansion
We forecast that MDS will open 12 stores every year going forward. Outside of Java is the main focus as it is underserved and has less competition. For a typical new MDS department store, the fit-out time is approximately four months. A new store typically generates operating profit in its first year and earns back its capital investment within three to four years. After four to five years, a new store’s productivity, net revenues, and EBITDA margin converges on the average revenue for a similarly sized store. MDS expects to fund its expansion with existing cash and cash flow from operations.

Business Overview
Matahari Department Store (MDS) introduced its first modern store concept to Indonesia in 1972 and is now Indonesia’s largest department store operator by sales with 131 stores, targeting the fast growing Indonesian middle-income segment. As seen in Figure 15, MDS’ consistent gross margins indicate its pricing power gained from its excellent management of private label brands.

Double-digit Same Store Sales Growth (SSSG)
As MDS has been constantly gaining market share since 2008, its annual SSSG has also been constantly above 10%, with an SSSG of 10.7% in 2014 (comprising 6.8% increase in average rental unit and 3.9% in volume). Likewise, its Gross Sales per Square Meter has also been growing and reached c.IDR17.6m per square meter in FY14.

MDS’ sales are also quite distributed in terms of product category breakdown. Non-Java generates c.38% of the total gross revenues. Due to its consistent strong performance of MDS’ exclusive brands, the DP sales have been increasing compared to the Consignment Vendors (CV) sales since 2011.

Strong merchandising on young customers and shoes products
MDS has benefited from its strong Youth Boy, Youth Girl, and Children product categories, which combined have contributed more than 40% of its total Gross Sales since 2010. Likewise, the shoes business has contributed c.20% its total Gross Sales in 2014, compared to 18% in 2010.

Going forward, MDS plans to expand its Cosmetics product category as it generates the highest sales per square meter. Another room for growth is the Female category. Currently, around 70% of MDS’ customers are women, yet as a category, it only represents 9% of MDS’ consolidated sales. One reason for this is, in the middle income class, as most of the breadwinners are working male, the wives are the ones doing the shopping for their families.

Low risk CV business
CV sales represents 66% of MDS’ total Gross Sales and it costs less because the consignment vendors maintain their own inventory and bear all purchasing, payroll, working capital, distribution, and warehousing costs. The consignment vendors are regularly evaluated and may be replaced if they do not perform. Their consignment margins on CV goods can be adjusted when an agreement is entered or renewed, which tends to occur on a bi-annual basis.

Targeted marketing program via Matahari Club Card (MCC)
The MCC loyalty program has been a tremendous success for MDS. It has active membership of over 2.9 million as at Dec 2014, making it the largest department store loyalty program in Indonesia and it is still growing. MCC members contributed c.40% of the total Gross Sales in 2014.

MCC allows the company access to valuable insights into the purchasing habits of over 2.9 million of its most loyal customers. Using data collected through the use of MCC loyalty cards, it can track merchandise preferences and purchasing habits on a time-specific and store-by-store basis.

This enables MDS to target marketing programs more accurately and communicate directly with customers via SMS. The MCC cardholders enjoy a broad array of benefits such as reward points, exclusive shopping opportunities and third party tie-ins, including special discounts with over 120 hotel, F&B, and entertainment merchants.

Key Risks

Malaysia’s Parkson Holdings has brought Centro department stores, which cater to the middle income segment. Moreover, Lotte Department Store in the Ciputra World Jakarta has a similar business portfolio to that of MDS. We believe that these two players would need longer time to build their logistics and distribution networks first in Jakarta before expanding to outside Java. By the time they are ready to expand to outside Java, MDS will have already significant bigger scale to thwart the competition.

MDS leases c.35% of its stores from Lippo Group related parties, such as Matahari Putra Prima (MPPA IJ, BUY, TP: IDR4,650), Lippo Karawaci (LPKR IJ, NEUTRAL, IDR1,460), and Lippo Mall Indonesia Retail (LMIR) REIT in Singapore. As one of the largest mall owners in Indonesia, Lippo Group helps MDS secure prime mall locations. To ensure that the transactions are at arm’s length, rentals from affiliated parties are based on MDS’ rental as a percentage of gross sales paid to third parties’ properties.

The Indonesian government has been quite vigilant in issuing /modifying regulations to protect traditional retailers from being crushed by the larger and more efficient modern retailers. Since MDS works with the local suppliers and 90% of its supplies are provided locally, MDS is, in effect, exempted from the numerous regulations on modern stores.