The announcement that both Poundland and Pets at Home were to float on the stock market earlier this year garnered widespread attention from investors and market analysts alike, with both parties speculating about the future trajectory and performance of the businesses.
However, thus far the only one has delivered on its early promise, with Pets at Home languishing far behind its debuting counterpart, and a somewhat compelling question has now arisen; why exactly are two companies of similar roots and past situations now performing so contrastingly in the stock market?
Indeed, there is a multitude of similarities shared by the two companies; they were both purchased in the midst of the recession by buyout factions in 2010, they were both in a deep struggle to survive, and they have both experienced a meteoric rise in their business levels ever since.
So why exactly are Poundland outperforming Pets at Home so emphatically? The key factor behind their different performances comes down to their use of debt, the expansion strategies that they have utilised since and the manner in which their equity deals were negotiated right back in 2010.
Poundland investors ahead from the start
For all who are not aware of Poundland’s rags-to-riches story, the company was purchased by investment group Warburg Pincus back in 2010 and has since opened up over 250 branches across the UK.
The result of this has been a monumental 73% rise in revenue over the course of the past 4 years, whilst operating profit has soared by an equally impressive 88% during the same period.
The same meteoric rise has been illustrated by Pets at Home, who have opened 119 new branches since it was acquired by investment group KKR back in 2010. The company’s performance since 2010 has mirrored that of Poundland’s, with sales rising by 61%, and its operating profit creeping up past 80% as well.
The key factor that has played a decisive role in their contrasting trajectory’s on the stock market is their equity holders utilisation of debt to increase their returns since 2010. Warburg Pincus intentionally opted to utilise minimal leverage and has since chosen to lower this as time has gone on in a decision that has proven to be a masterstroke for when it released its IPO earlier this month.
The cost of the purchase meant they had to utilise loans in order to fund 25% of the costs, but significantly, they did not opt to take out any further liabilities after this, despite reportedly having relatively easy access to low-cost credit. This has meant that as of December last year, the Poundland franchise only has £9 million worth of debt attached to it, which is far lower than Pets at Home.
In fairness to KKR, they had to undergo a far more financially strenuous procedure in order to acquire Pets at Home, and were forced to overcome a host of other interested parties in the auction for its ownership by paying a substantial £955 million, which represented 12 times the businesses earnings before tax, depreciation, interest and amortisation. The high price they had to pay for winning the auction meant that KKR had to utilise loans in order to pay for half the costs, which already put them into more debt than Poundland right from the point of purchase.
Warburg Pincus, however, were ahead from 2010, as they bought Poundland uncontested, and for a substantially lower £200 million, which is 8 times the businesses earnings before tax, depreciation, interest and amortisation. Whilst they did take dividends, they intelligently chose to not take on further liabilities, and this has made them a far more attractive investment from a stock market perspective.
Financial engineering failed
KKR, however, opted to utilise a financial engineering strategy that has most certainly resulted in it being regarded as a far less attractive and riskier investment by institutional investment groups.
The strategy consisted of them taking out a further £135 million worth of loans to pump into Pets at Home as part of a larger tactic called dividend recapitalisation. Whilst this has been used to finance a dividend fund for the group, it has meant that they have been forced to utilise some of the money from its IPO to lower their levels of debt, and thus they have only garnered 2,5 times the businesses earnings before tax, depreciation, interest and amortisation. Essentially, Pets at Home has given the impression to investors that they are high in debt and high-risk, whilst the presence of private equity group KKR in their ranks has further deterred prospective pundits from purchasing shares in the company.
This is because it has created a leverage problem with their offering, which can be hugely damaging considering pre-existing apprehension that exists with institutional investors when dealing with stock market shares that are run by private equity groups. Whilst Warburg Pincus decided right from the start that they were going to utilise a tactic that would not make leverage a problem when their IPO was released, it seems that KKR did not display the same foresight.
The superiority of Warburg Pincus’s approach has clearly been represented by the return on investment it got when it went public with Poundland. The company has already made 4.5 times the amount it paid for the company in the first place and has used this position in order to make their offerings to investors more attractive. Poundland’s IPO has now been oversubscribed by over tenfold, and their shares rose by 2.3% to 238p.
Conversely, KKR only acquired a return on investment of 1.8 times when it floated Pets at Home, and it already appears as if the company has peaked on the stock market, with shares falling by almost 3% to 238p during this week.
Tony Shiret, an analyst at Espirito Santo, identified that their approaches towards leverage have been the key factor in their varying performances, arguing that KKR’s high debt and recapitalisation approach has deterred investors as it gives the company the image of being risky and insecure.
“Investors don’t think the growth prospects of Pets At home are commensurate with the risk that they are taking on board with the financing,” he said.
However, Nicolas Gheysens, director KKR London, argued that the group “maintains an important stake in the company, and we see a clear path for further continued development of the company.”
Whether Mr Gheysen’s remarks manifest in reality is yet to be seen, but what is for sure is that Warburg Pincus substantially outstripped Pets at Home in their initial performances on the stock market, and perhaps pose a lesson to future investment groups about how to use debt in equity deals and more importantly, how to present their product as being secure and investor friendly.
Written by: Mike Smith