SA Equities: Peak pessimism or structural reset?


Over the past 12 months, the impact of loadshedding on corporate profitability has been severe. Although the FTSE/JSE All Share index returned 8.5% over this period, South African sensitive stocks have been extremely weak and now trade at deep discounts to their long term valuation multiples. In this article we explore the impact of loadshedding on corporate costs and revenue, assess if these are permanent or temporal in nature and finally consider their valuation impact.

The impact of loadshedding is well documented and is having a profound effect on corporate South Africa.

Although Eskom has implemented various loadshedding programmes over the past decade, there has been a significant ramp-up over the past 12 months as increasing electricity demand following Covid lockdowns has met weak supply. Deteriorating power plant availability, neglected maintenance, poor planning, and the effects of two decades of public sector corruption are the main reasons behind this.

Yet, the JSE All Share Index has returned 8.5% in Rands (31 May 2023) over the past year. A closer analysis of this performance reveals that it is explained by strong contributions from index heavy-weights Naspers/Prosus, BHP, Richemont and local listed gold stocks. All of which have benefitted from a healthy global backdrop together with a weaker Rand, this has masked the impact of extremely weak performances from SA sensitive stocks (Chart 4).

Chart 4: Median sector returns – 12 months (in Rands)

Source: S&P CapitalIQ, Northstar AM, 31 May 2023

Of the inward focused JSE stocks, retailers and telecoms have been the hardest hit but the sell-off has been broad-based, with most financials, local industrials and manufacturers faring poorly over the past year. These hardest hit areas of the markets, as highlighted in chart 4, are also the cheapest on a forward PE basis with discounts of 20% to 40% relative to their respective average 5-year histories and even larger discounts when compared to longer periods of time.

Impact on profitability

From a cost perspective, the impact from loadshedding has been more pronounced for food retailers at about 5.9% of operating profit (EBIT), given their higher energy requirements for refrigeration and their cold supply chain needs. The impact on SA telecoms has also been severe, as MTN and Vodacom, to ensure network operability, absorbed incremental operating expenditure due to diesel consumption. This has been approximately 4% of EBIT.

Costs for clothing and drug retailers, based on our estimates, are lower at 3.8% and 1.9% respectively but are also not homogenous. In general, retailers operating battery infrastructure, such as Clicks and Truworths, have fared significantly better from an operating cost perspective, having already sunk capital, against other businesses operating diesel generators.

While the effects of loadshedding from a cost perspective have been severe, this has not been the main determinant of stock performance. A more significant component of margin and earnings reduction has been caused by product markdowns and sales losses caused by reduced trading hours and a highly strained consumer. Estimating the impact on sales caused by loadshedding alone is difficult but we estimate losses of between 2% to 5%, with clothing retailers and telecoms experiencing higher losses compared to food and drug retailers.

Chart 5: Degree of operating leverage (DOP)

Degree of operating leverage (DOG): Expected change in EBIT / Change In sales
Source: S&P CapitalIQ, Company reports, Northstar AM (31 May 2023)

To fully appreciate the disproportional impact on earnings across these four groups of companies, it is also important to consider their degree of operating leverage (DOP: impact of 1% change in sales on EBIT), which based on our estimates, ranges between 2.6 and 4.2 times.

Although food retailers have the highest DOP (chart 5), they equally have been far more successful in passing a larger proportion of costs onto their consumers. Clothing retailers and telecoms, on the other hand, have not only had to contend with increased costs and revenue loss, but also, given their discretionary nature, struggle to pass costs on. Consequently, they have been the clear losers in this group.

Is the impact temporal or structural?

The market has over-penalised this group of stocks as its collective view is that loadshedding-related pressures will persist in perpetuity. Our valuation work corroborates this; based on a more optimistic medium-term view, which we share, significant valuation uplift for food and clothing retailers, should be in offing.

We are not making a case for a V-shape recovery of these businesses, but we believe these sectors are likely to experience better profitability over the medium-term, this should be accompanied by market valuation support as volume growth and costs normalise.