Prosus: Exceptionally Valued With High Return Prospects (PROSY)

Pgiam/iStock via Getty Images Investment Summary We are nearing the midway point of 2024. At this point, my estimation is the consumer discretionary sector has some of the least attractive market characteristics when comparing projected growth versus current sector weighting of the S&P 500 Index (Figure 1, see 4th from right). The composite below compares the current weighting of each S&P 500 index sector versus its projected growth rates over the coming 12 months. There are two lines of thinking based on this research: 1) search for names in sectors towards the left of the chart [materials, utilities, etc.] or 2) look for attractive plays towards the right of the chart [e.g. consumer discretionary], that are set apart from peers by their economic characteristics. Figure 1. Author, using data from Seeking Alpha and Bloomberg The broadline retail industry is dominated by large players like Walmart and Amazon, but globally, it is (i) not as concentrated and (ii) remains highly competitive at the margin. Based on my research of the domain, the future growth of the industry will be driven by three key factors. One, e-commerce and omnichannel retailing remain a key consumer advantage that many retailers possess in their basic economic structure. Consumers increasingly favour the convenience of online shopping [this is true when consolidating many ‘cross-industry items’], and retailers prefer the capital-light operating model. Two, the emerging trend is in advanced data analytics. Data is being used to 1) understand and adapt to consumer preferences, 2) optimize inventory management, and 3) personalize marketing efforts. Deloitte’s global retail outlook for 2024 suggests CEOs it surveyed are expecting their companies to (i) increase their data sharing to collaborate [we are already seeing this in the tech domain, for instance – look at Apple and OpenAI], (ii) increase the number of satellite locations for locations to work from, and (iii) increase the amount of process automation. Three, global retail sales are tipped to grow to $32.8 trillion by FY 2026, a cumulative increase of 29% (~$7 trillion), netting around 30% of the current global GDP of $101.3 trillion. Figure 2. Deloitte Global Retail Outlook 2024 This process of top-down security selection then led us to Prosus (OTCPK:PROSF), (OTCPK:PROSY), which, after extensive review, possesses the bottom-up characteristics we like in stock picking. I am buy on PROSY for 1) the strong global retail market outlook, 2) management is deploying capital at an advantage [abnormally high ROICs], 3) its ex-US revenue exposure, 4) it is priced at a ~27% discount to tangible book value per share as I write, 5) valuation growth is supported by fundamentals and multiples repricing, and 6) shifting sentiment [momentum is “A” on Seeking Alpha Quant grades with 16.2% 9-month performance vs. sector -4.2%]. These factors indicate the market is looking to PROSY’s fundamentals, and potentially its global footprint in my view, and could see it trade to a range of $12-$15 per share. Here I’ll outline a few of the levers driving this valuation. Background fundamentals Within the broadline retail segment, differentiation is key. PROSY achieves this in two ways: (i) bolt-on acquisitions of high-quality businesses to complement or grow its existing portfolio, and (ii) breadth of exposure across markets with deep consumer penetration. The company’s payments + fintech, and food safety divisions are the two key examples that spring to mind in my best estimation. PROSY’s competitive advantages are threefold in my view: 1) its sheer size that sees it cemented across numerous markets outside the US – giving it international sales exposure in the event of a US downturn and/or outsized global growth [the company estimates ~20% of the world’s populous uses its products in some way shape or form], 2) abnormally high returns on capital employed thanks to selective investments and highly productive business assets, and 3) its ~25% stake in Chinese conglomerate Tencent, which has many secondary competitive advantages. Valuation multiples remain tremendously conservative for this name, which was spun off from South African multinational Naspers in 2019. Specifically, PROSY was spun off to house Naspers’ international assets. It completed a secondary listing on the Johannesburg Stock Exchange in 2019. As a result of the carve-out, Naspers remains the majority owner of PROSY, and this is the nature of the pair’s relationship as it stands today. Investors have pessimistic expectations baked into the company’s stock price at current levels, with PROSY priced at a 27% discount to its net tangible assets of $10.14 per share as I write. I challenge anyone to find me a company 1) this size, 2) this level of operations, 3) operating history [although carved out in 2019, has been operational since 1994], and 4) with the intellectual property and business assets of PROSY, for below the accounting value of the net tangible assets employed in the company. Management has been “closing the gap” by buying back shares [as discussed a little later]. My opinion is these opportunities simply do not exist outside of the stock market. For starters, interests in great businesses – partial and whole – never sell at a discount. That’s if they even sell. To find an operation of PROSY’s calibre trading below the replacement value of its assets on the private market is, therefore, borderline impossible. Tencent stake A cornerstone of PROSY’s medium-term competitive advantage is its significant stake in Tencent, one of China’s leading tech conglomerates. Naspers first acquired the stake when PROSY was still folded into its operations for just $34 million. At today’s Tencent market value, the position has compounded to ~$118.4 billion (~25% of Tencent market value in USD, as management have reduced its holding over time). In my view, the company derives a substantial portion of its intrinsic value from this position. Why? 1. Tencent’s economics include enormous size and consumer penetration For the company’s H1 FY 2024, Tencent clipped revenues of RMB299.2 billion (USD $41.23 billion), up 11% year over year. Earnings jumped 31% from RMB53.7 billion ($7.4 billion) to RMB70.1 billion ($9.66 billion). Some of the notable games contributing to the top-line growth include “Goddess of Victory: Nikke,” “Triple Match 3D,” and “Valorant.” Combined monthly active users of Weixin and WeChat grew to 1.33 billion. Just process that for a second – more than 1.3 billion users on a company’s platform. That kind of exposure is unparalleled penetration of any consumer populous and captures consumers at all points along the value and price chains. 2. PROSY has unlocked substantial value from the investment in two ways beyond just the capital gains of the investment For one, Tencent remains a significant contributor to Prosus’ free cash flow and ability to 1) throw off dividends, and 2) reinvest surplus cash into future high-return business [just like Tencent]. It provided the company with a dividend of $758 million for the financial year – that’s hard to argue with. Two, PROSY has been actively buying back its own shares. These repurchases are being funded by the daily sale of a small number of Tencent shares. The trade-off off of course is reducing the position of Tencent. But the reward is skewed to the upside [~$760 million dividend + funding buybacks]. The correlation in the pair’s equity is evident in Figures 3 and 4 below, which show the stock price performance of PROSY and Tencent over 3 years and this YTD, respectively. Figure 3. Seeking Alpha Figure 4. Seeking Alpha Whilst it’s tempting to simply buy PROSY purely based on its Tencent holding, intelligent investing involves far more thoughtful judgement of the future. We need a thorough understanding of the business economics. Fundamental forensics Analyzing the company’s profitability characteristics against comparable peers, PROSY’s competitive advantages begin to shine through. It has in-line gross margins of ~32%; however, net margins are superb given all the income contributions below the operating line from its non-operating interests. As a result, net income per employee is substantially higher than all peers. This is interesting, as management has increased ‘productivity’ through its capital allocation decisions. A major plus for me. Figure 5. Seeking Alpha Given this is a highly asset-dense business, it’s tremendously important to see evidence of bottom-line differentiation here. Consequently, my judgement is that we can group all the corporation’s earnings below the operating line as “post-tax earnings”. Support for this is found in the fact that 1) management is recycling Tencent’s cash flows into capital allocation [and others held as non-operating investments], and 2) its reported operations do not reflect the true nature of the company’s full earnings. This point of differentiation drives up the “post-tax” margin [i.e. – all that income below the operating line] and sees the corporation book statistically high returns on all capital employed into the business structure (19.2% in the last 12 months). Here is where it gets rather attractive in my view: By Q1 CY 2024, $7.41 per share was tied up in PROSY’s invested capital Management produced trailing $1.42 per share in post-tax earnings on this, 19% return on capital and 19.4% trailing post-tax yield on market value as I write. From 2021 to 2024 (trailing 12-month values) management invested an additional $1.80 per share into the business to grow, earning an incremental $0.80 per share, a 44% return on incremental investment. It invested 10.8% of the cumulative earnings generated over this time. As such, it compounded the business value at a 4.75% rate of return. Not surprising, as it doesn’t have an extensive investment runway to deploy into new opportunities rapidly. On what investments it does have, these are highly productive. Compared to a 12% hurdle rate (one that reflects the long-term market averages) the long-term economic value is apparent. Here, I look to economic earnings, versus accounting earnings, to see the economic value created from management’s investment activity. Any returns produced on invested capital above 12% are economic earnings, and vice versa. Since 2021, management has created $6.60 in new economic earnings per share under this convention – yet, the stock trades flat to this period. So we have a situation where the company is throwing off piles of cash to its shareholders and growing incremental earnings with each passing reinvestment at attractive rates of return. Moreover, it is creating economic value for its shareholders, in my view. Figure 6. Company filings Estimates of valuation 1. Projections of earnings, business returns and free cash flow The first piece of data I wanted to obtain was what business would look like if PROSY continued along a similar trajectory as the last 3 years (Figure 7). I have included all sources of earnings/cash flow (operating, non-operating) in the calculus here as a cleaner view of the company’s earnings potential in the coming years. The assumptions encompass 1) ~2.8% compounding sales growth, 2) ~3% post-tax earnings growth, 3) ~$13 billion in rolling free cash flow, and 4) each new $1 of revenues requiring $2.77 of investment to produce, but this to be majorly funded from PROSY’s listed and unlisted investments. In my view, the company could compound its intrinsic valuation at around 2-3% per period under these assumptions, as seen below. Figure 7. Author’s estimates 2. Changes in earnings power The purpose of buying prorated portions of businesses in the stock market with a long-time horizon is to buy earnings. Earnings are usually received on your income statement (increasing wealth) in the business that is wholly owned. But in equity markets, earnings are capitalized, and they are received in market value on our balance sheet. The wealth is instead received via the changes in carrying value on our balance sheets. In that vein, the goal is 1) to buy earnings, 2) buy as many as possible. Warren Buffett is famous for quoting the same. Here I’ll run a scenario where I buy 1,000 PROSY shares at market today. The results are shown in Figure 8: Cost = $7,310 Earnings power = $1,422 ($1.42 NOPAT/share x 1,000 shares) Market return on capital (yield) = 19.5% Current P/NOPAT multiple = 5.1x The numbers outlined in my estimates above arrive at the following figures: $2.17 in NOPAT per share Earnings power of $2,169, a 52.5% increase in earnings power At the same 5.1x multiple, the position is now worth $11,146. To me, this illustrates there is a strong case for this stock to trade higher on fundamentals, even if there is no change in the current multiples pay to buy PROSY’s earnings. If the multiple were to expand to 6x, then the stock would be worth ~$14 under these same assumptions, and our position would be valued at $13,933 for an IRR of 90%. In fact, I estimate the stock could trade as low as 3.4x by this time under the same inputs and still be priced fairly (Figure 9). Figure 8. Author Figure 9. Author 3. Returns on capital injected The market has contracted the multiple paid on PROSY’s invested capital since 2021 from 3x to 1.6x as I write (Figure 10). The EV/NOPAT multiple has also compressed from 26x in ’21 to 8.5x. This is despite, in that time 1) NOPAT grew from $5.8 billion to $10.5 billion [all sources of post-tax earnings included], 2) but invested capital grew just $4 billion [although, this is reduced from a high of $65 billion in 2022], and 3) returns of capital averaged >15% [and >18% since 2023]. We can make a useful comparative analysis here: For the investor – cost of capital (“C”) = PROSY’s invested capital ; return (“R”) = market value For the corporation – C = 12%*; R = business returns Investor – R:C = $89,170/54,897 = 1.6x Company – R:C = 19.2%/12% = 1.6x * 12% is the long-term market averages and the opportunity cost So we are paying $7.41/share in market value as I write to receive roughly that amount per share of capital invested in PROSY (receiving a return on capital of 1.6x). Comparatively, the business is producing a 1.6x return over the capital charge I’ve applied here. This is fair value in my eyes. Figure 10. Author’s estimates I carry this multiple forward on the implied estimates from earlier, whilst also carrying an EV/NOPAT of 6.9x forward to be conservative. This EV/NOPAT multiple is LESS than the current multiple of 8.5x as evidence of the asymmetry in upside to risk in this scenario (it is also different from the price/NOPAT outlined earlier). On estimates out to FY 2026, this derives a price range of $12-$15.70 per share, 61%-102% upside potential as I write. This valuation range has two things going for it: 1) These are compressed multiples vs. the 3-year history, 2) They are built on conservative forward estimates [4.3% reinvestment of earnings to capital, c.8% earnings growth rate, 1.6x and 6.9x multiples respectively]. Figure 11. Author 4. Sum of the parts Lastly, disaggregating the company’s operating segments, I arrive at a similar valuation range starting at $11.50 per share. Note – this is the operating segments only – not including investments in any of PROSY’s listed investments. Here I apply a 2.7x multiple to the company’s high-growth segments [reflecting its FY 2021 range] with a 1.1x multiple on all other asset lines. The key downside risk is that if we are pessimistic and value all the company’s assets at around “book value” – that is, 1.1x my estimate, this gets you to an implied value of $6.00 per share, ~$1.42/share downside where it trades today. But again, this excludes any asset value impact from the company’s listed investments. Nonetheless, the value skew is biased to the upside in the SOTP vie in my estimation. The Tencent holding alone is worth ~$118 billion, more than the entirety of its invested operating capital. Figure 12. Author estimates, company filings Figure 13. Author estimates, company filings Figure 14. Author estimates, company filings Key risks Key downside risks include 1) the company’s assets not pulling their economic weight and dropping ROIC, 2) market turbulence in the company’s international exposure resulting in FX headwinds and interest rate differentials, 3) Tencent becoming an outsized slice of performance, and, then, 4) Tencent’s performance becoming substantially weaker in a short period. Investors must know these risks in full before proceeding any further. In short Based on the culmination of data presented here, my judgement is that PROSY is a buy on fundamentals and valuation. The stock trades cheaply at 1.6x EV/invested capital in my view, and carrying this multiple through to my FY 2026 forward estimates gets me to a valuation range of $12-$15 per share. Net-net, rate buy. Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

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