I give a sell rating for Dino Polska SA (OTCPK:DNOPY), as I am very worried about the price war that is ongoing in Poland today. With inflation being sticky and the central bank reiterating their view to keep rates steady, I don’t see how the macro environment will turn for the better in the near term. As such, I expect DNOPY to cut prices in order to stay competitive, and this will hurt both growth and margins. Hence, I believe the market may continue to downgrade DNOPY’s valuation closer to where peers are trading.

Business description

DNOPY is a proximity supermarket chain that operates in Poland. The difference between DNOPY and large incumbents like Biedronka (under Jeronimo Martins) is that it operates smaller-sized stores (DNOPY average store size is around 394 sq m vs. Biedronka at around 720 sq m), but is bigger than traditional store operators like Eurocash (mid-100 sq m per store). This strategy has enabled DNOPY to capture a portion of the market that incumbents were not able to properly address. As such, DNOPY was able to increase its number of stores from 410 in 2014 to 2406 in 2023.

Competition is a pricing headwind

While DNOPY has been able to grow at a rapid pace over the years through its differentiated strategy, capturing a huge amount of share in the industry, I believe growth is going to see a massive slowdown in the near term as competition gets intensified given the poor macro conditions in Poland. Poland's inflation situation is similar to that in the US, where it has come down a lot (from as high as 18.4% in early 2023 to 2.5%) but has remained sticky at mid-2% levels. Hopes of this going further downwards have been dashed when the past 2 months of data showed acceleration (Mar’24: 2%; Apr’24: 2.4%; May’24: 2.5%). As such, the Polish central bank has decided to hold rates steady (at 5.75%). Consequently, this continues to hurt consumer spending power, forcing them to cut back on spending (as can be seen from the consumer confidence index).

In order to capture more volume, retailers have stepped up on competition by going on a price war, which I believe is going to hurt DNOPY's ability to continue reporting strong growth levels. The impact of the price war is apparent from DNOPY's recent results, as like-for-like sales growth fell sharply from 27.2% in 1Q23 to 11.9% in 1Q24. Comments from both incumbents also suggest that this price war situation will continue for the foreseeable future.

I have to say that it's a mix of both. As we want to keep price leadership in Poland, as we want to keep our competitiveness in all markets, this means that we will continue to invest in price, is our expectation. Biedronka 1Q24 earnings

So now the price gap that we see, which is around 5% plus minus 1% 2%, which points to Biedronka is one that we believe is competitive because that means for the consumer that we are -- we have a part of our assortment on discount prices.

We are more aggressive on prices due to the inflation, but we have also revised kind of the role that each channel plays for us. So we have repositioned Cash & Carry stronger to being the discount channel in our mix. Eurocash FY23 earnings (source: Bloomberg)

As such, I expect DNOPY to be forced to continue cutting prices. In fact, DNOPY is already cutting prices (as they want to match other players pricing). Even with this, growth has slowed, which means DNOPY has to cut prices by a lot more in order to rejuvenate growth. This weak pricing and consumer spending environment also put a lid on how fast DNOPY can open new stores (another headwind). For reference, DNOPY store opening outlook (1Q24 only opened 32 stores vs. past few years average of 74 stores/quarter). Put together, the growth outlook is extremely challenged.

So, our primary concern is to ensure that the prices are attractive to consumers. And that's why the prices are benchmarked to other networks, what other networks are doing. Company 1Q24 earnings (source: Bloomberg)

Margins expected to compress further

The pricing environment has also hurt DNOPY’s margin profile greatly. Gross margin fell from 25.4% in 1Q22 to 23.1% this quarter, a drop of 200bps. The rate of gross margin compression even accelerated in 1Q24, falling by 100 bps vs. 1Q23. In the past, DNOPY was able to sustain a higher gross margin vs. Biedronka (low-20% vs. DNOPY at mid-20%) because consumers were willing to pay for the convenience. In the current environment, I believe consumers are willing to go a little farther to get their groceries if it is cheaper. As DNOPY has pretty much no choice but to reduce prices to stay competitive, I am expecting the gross margin to decelerate further. As of 1Q24, the delta in gross margin is still around 260 bps (DNOPY at 23.1% vs. Biedronka at 20.5%), so there is still room for DNOPY gross margin to compress.

Although the impact of gross margin compression has not been fully felt at the net margin levels (gross margin fell from 24.9% in FY21 to 23.1% in 1Q24, but the net margin only fell from 6% to 4.4% in 1Q24), I am expecting a higher flow moving forward as fixed costs represent a bigger portion of gross profit and as wages continue to increase (the Polish government plans to raise the minimum wage by 7.6% in 2025). For comparison, Biedronka net margin is in the low single-digits (1 to 2%), so there is certainly room for DNOPY net margins to compress further.

Valuation

The entire situation so far makes both revenue and earnings growth outlooks very uncertain and hard to estimate with precision. However, what I am expecting is DNOPY growth to slow down to similar levels as peers (mid-single digits). This mid-single-digits growth is already starting to show up in the slowdown in reported like-for-like sales and stores opening. As for stores opening, as I discussed above, I am expecting it to slow down as well, which will drag down consolidated sales growth.

When these happen, I believe the market will further downgrade DNOPY’s valuation nearer to where peers are trading. Currently, DNOPY trades at a premium forward P/E multiple of 20.7x vs. Biedronka (Jeronimo Martins) at 14.7x and Eurocash at 16x. If DNOPY were to trade down to a smaller premium against peers’ average, at 17x (assuming 1x above Eurocash), this implies an 18% downside in the near term.

Risk

Consumers may value the convenience aspect that DNOPY offers more than I expect, and they are willing to pay a premium for it. This would mean that DNOPY doesn’t need to cut prices as aggressively as I expect them to (this also protects margins). Of course, the turnaround in the macro environment is a big positive for DNOPY, as not only have consumers become more willing to spend, but the pricing competition will also ease accordingly.

Conclusion

I give a sell rating for DNOPY. The sticky inflation and high interest rate environment have forced retailers to compete on price, and this is a massive headwind to DNOPY’s growth and margins. Recent results are already showing a slowdown in like-for-like sales growth, and I expect DNOPY to cut prices further to stay competitive. The cut in price will also lead to margin compression. Altogether, my view is that when growth slows and margins get compressed, DNOPY’s current premium valuation compared to peers will likely get compressed as well.

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