UK Retail Redux

Quarter in, quarter out for some time now, the results emanating from UK quoted retailers make for dire reading. I have looked at the sector in some detail due to what is an extraordinary low level of valuation. I have not been willing to part with any hard cash and actually invest in the sector due to what are structural weaknesses, significant lease committments, questionable strategy and a poor outlook for UK consumer spending. I am of the opinion that the UK has way too much retail real estate. An aggressive management team or an activist approach by shareholders could well unlock some value in the sector.

Home Retail

I cannot understand the strategy being followed by the Home Retail management team. I have written previously that I believe it is reckless and puts the balance sheet at risk for no obvious reward. This mornings h1 results from the company, encapsulates for me the futility of management action. If this strategy were to change, then depending on the cost, I believe that there would be significant upside potential in Home Retail.

For the Argos retail format, sales fell 7.6% with like for like sales declined by 9% whilst operating profit fell 94% as the margin sharank to 20bps from 3% (ouch).

In terms of the Argos brand;

Total internet orders, including Check & Reserve grew to comprise 33% of Argos’ total sales, with the remaining 13% of multi-channel sales being products ordered in-store for home delivery or by telephone.

Despite 46% of sales being derived from online or telephone sources, the company opened 6 new locations compared with the same time last year. No while many customers order online or via the phone, they collect the requested item from the nearest store. I do not believe that this is justification for opening new stores. I would wonder what was the proximity of these stores to other Argos locations. Given the growth of the internet and phone channel, I would have thought this would have presented management with a rationale to close down many stores (particularly) in cities and towns with overlap, and move to a hub and spoke strategy or an expanded delivery startegy. Obviously the issue here is that many operating leases are costly to exit. In addition to expanding store count, the company has refurbished a further 50 stores. Now unless these stores were in abysmal condition I fail to understand the rationale here. The Argos format is one of catalogue ordering in a warehouse – it is not a place where consumers go to be pampered. If I were management I would be incentivising customers to order online and stay away from the physical stores.

Worryingly, the results from Homebase format (DIY stores) were also poor. While sales declined 1.8%, operating profit fell by 35%. I wonder is there a read across here for Grafton plc? 

Using trailing 12 month results, I calculate the following fixed charge cover;

EBITDA: £251.9m

Rent: £366m

Net Interest: £0.2m

EBITDAR/Fixed Charge Cover: 1.69x  (from 2x at the 12 month stage).

Net Debt (incl Leases)/EBITDAR: 4.7x (from 3.6x at the 12 month stage).

Given the state of the UK retail economy, it would be unsurprising to see 2nd half sales and earning to continue to slide – if this were to be the case, then fixed charge coverage would continue to slide. A glimmer of hope would be that between 2012 and 2016, there are 150 lease renewals and 35 lease breaks. This should give the management some leeway to resize the retail estate. (Pg 41. Interim Results presentation slides). On the conference call, management spoke of 10% on average rent reduction on present lease renewals.

In regards to operating leases, I noticed an interesting story in relation to builders merchanting group, Wolseley, on Bloomberg the other day. Wolseley has hired a lease breaking company to help extricate itself from several of its leased property estate.

Valuation

Price/Sales is now 0.145 on a trailing 12 month basis. P/B is flattered by the presence of a significant amount of goodwill on the balance sheet. In its absence the P/tangible book value is 0.77.  The valuation is becoming more attractive.

If I take the present level of sales as being normalised, and then use an operating margin of 4% (as opposed to the historic median of 5.2%), then it is possible that the stock at 1000p trade on a P/E of 5x. There is an opportunity, but the balance sheet is in poor condition with Net Debt/EBITDAR now in excess of 4.2x.

As of now it is watch and wait. Management must accelerate lease restructuring in my opinion. Unless minimum fixed charge cover agreements are very generous, then the balance sheet is unlikley to survive until 2012-2016 in the absence of a recovery in the UK consumer. 

Mothercare

The recent collapse in the share price of Mothercare prompted me to pay a quick visit to the stock. Fascinating company, in that a large UK sales base is dwarfed in terms of profitability by a much smaller but faster growing international business. It is crying out for the dreaded sum of the parts approach to valuation. The CEO has recently stepped down having lead the company for much of the past 9 years.

Successful international expansion during 2009 and 2010 lead to the share price breaking out of the long term range between 300p-400p and trading up to almost 700p in late 2009/early 2010. Since then a succession of profit warnings has been met with hard selling and the stock now trades at sub 200p.

Key Metrics

P/S:  0.2

P/B:  0.95

G&D PE: 15

Fixed Charge Cover: 1.5

Net Debt(+leases)/EBITDAR: 5.9

Interestingly, in the past decade the company has been in a similar situation. During 2003, a spike in cost of good sold saw profitability and cashflow collapse. As a result Fixed charge cover fell below 1. The company survived that time.

UK Division

Revenue in the UK business has expanded from £414m in 2006 to £587m in the last annual report. Organic growth is significantly lower, in that Mothercare acquired the Early Learning Centre during the latter half of 2007, and that conributed to 37% top line growth in the follow year. UK margins have hovered between 3.8% and 6.7% betweeen 2006 and 2010. In the last fiscal year (ending March 2011) the UK margin has fallen to 1.9%. THe UK business is operated out of a predominantly leased store estate. The overall rent roll is £68m, which has fallen from £71m four years ago. Most of the rent roll relates to the UK business unit.

International Division

Presently, the international business is the jewel in the crown of Mothercare. Fast growth and high margins from far flung locations. The international business is asset light in that much of the renenue is redived from franchise operations. Sales have grown from £68m in 2006 to £206m in the last fiscal year. Margins have expanded annually from 7.8% in 2006 to 13.3% presently. The sceptic in me wonders how much further that margins can expand, however it would be curmudgeonly not to be impressed with the growth rates. The company has almost 900 stores in over 50 countries throughout the globe. Much of the expansion  recently has been in Asia and China. There are 11 stores in China and 62 in India. Some stores are operated on a JV basis and others on a franchise basis, where the franchisee pays a royalty to Mothercare. It is not clear at this stage of my analysis whether all of the revenue stems from franchise payments or is there a portio that is generated by underlying slaes and profitability of the franchisee. This would worry me, and requires more investigation.

Store Strategy

The company is attempting to ‘rightsize’ its store portfolio over the next 3 years. The company is in a fortunate position in that there are 90 operating lease expiries during the current fiscal year, followed by 30 next year. That equates to 1/3rd of the UK store portfolio.

It seems likely that these leases will not be renewed as the company has articulated a strategy for reducing its UK store portfolio by 107 stores over the next two years. Mothercare claims that,

In total, 150 stores will be affected with approximately 110 stores closed and rents renegotiated to a substantially lower level on a further 40 stores. We are in the fortunate position of having 120 lease expiries in the next two years, which is one-third of the entire estate, 90 in 2011/12 and 30 in 2012/13. The vast majority of these lease expiries fall within the lower profit in-town store estate. There are also 30 more stores which do not have a lease expiry and which we plan to exit with a cash cost. Total cash costs are expected to be less than £5 million, although this will depend on negotiations. The results of this activity will be to transform the UK estate by March 2013 reducing total store numbers from 373 to an estimated 266, 102 of which will be out-of-town Parenting Centres and 164 in-town.

On the company’s own estimates this will result in savings of £12m per annum in terms of rent payable, with total savings of £18m including rates and service costs. Not sure how realistic those savings are in light of the ongoing margin compression on the UK high street, but it gives me some comfort that unlike Home Retail group that there is an exit startegy.

Is there an opportunity?

On the basis that successful retailers (think Next plc or Inditex) trade on sales multiples of between 1.2 and 2.2 (as opposed to 0.2 at Mothercare), then optically there does indeed seem to be an opportunity.

I run the following simple sum of the parts calculation.

Sum of the Parts Intl UK  
Sales 239.4 557.8  
       
Margin 12% 0%  
Operating Result 29.9 5.6  
Central Costs -4 -3.5  
Savings store closures   3  
Cash EBIT 25.9 5.1  
Interest Costs -2.00 1.00  
JV Costs -2.4 0  
Pre Tax Profit 21.5 6.1  
Tax @ 28% -6.0 -1.7  
Net profit 15.50 4.38  
       
NAV (including central liabillities) 84 88  
RoNAV 18.5% 5.0%  
       
Sum of Parts      
Revenue Multiple 1 0.15  
Implied Valuation 239.4 83.7 323.1
Current Market Cap     167.316
Theoretical Upside     93%

 

 I chose a 1x revenue multiple for the International division as it seemed appropriate when comparing the unit to other high margin European retailers (many on multiples of 1-2.8x). The 0.15 multiple for the UK unit is reflective of the situation that many UK retail chains find themselves in at present.

I have no idea as to how realistic a valuation this is, it is a first stab in the dark. However it is sufficient that I am now interested in investing in Mothercare. Before I do that I will look for reasons where I maybe wrong on the valuation of the international business. It is afterall a franchise business, and this does involve some loss of control. I need to get behind as to how revenue is actually earned in this unit, and how stable it is.

 

PS

I note that I was fellow blogger Expecting Value, beat me to the punch in terms of publication yesterday. You can read his post on Mothercare here.

 

 

8 Responses to “UK Retail Redux”


  1. 1 Lewis October 20, 2011 at 1:13 pm

    Only just!

    I note we reach fairly similar conclusions on most points. It’s really a very interesting case at the moment, particularly because of the lease situation and the potential to rejig the troublespots – those badly performing UK stores.

    Do you have an opinion on their plans to open large, out-of town stores to replace high street ones? I’m really unsure as to whether I like it or think it’s merely throwing more good international cash after bad, and they should just begin to cut down to barebones.

  2. 2 jmcelligott October 20, 2011 at 1:31 pm

    Hi. I have a pretty strong opinion on the OOT store openings programme. I can see no reason why it should go ahead whatsoever. I am struggling to find it now, but I had some reasearch on the relative density of UK retail a few years back. It puts the UK high up the Developed world chain of retail densities. I am of the opinion that the UK consumer is overshopped. A poor economic outlook combined with austreity, poor credit availability and does not strike me as the type of environment that one should be expanding and upscaling stores on a wholescale basis (maybe on a trial basis in some locations). The opportunity to close dead weight stores is too great to be squandered by empire building ina different location.
    Now each store needs to be looked at in terms of its own P&L and its prospects, so my view is a general one. For example, we do not know whether the 120 leases that expire over the next 18 months represeent the most or least profitable stores?

    Reading between the lines of the recent departure of the CEO – I would not be surprised if there was a change of UK strategy.

    The big impediment to me buying the shares here and now, is trying to get an understanding as to the dynamics of a franchise business. How long are the licenses. What happens if the franchisee is unsuccessful? Is it a pyramid type scheme – that is when one runs out of franchise opportunities across the globe, will sales and margins implode? I need to look at similar operations (eg NEXT, Inditex (Zara) etc).

  3. 3 jmcelligott October 21, 2011 at 12:51 pm

    Hi Richard. I dont disagree with much of your post on iii. My point on retail estate stems precisiely from the growth of alternative modes of shopping. To my mind, many UK retailers are suffering from similar problems, some of which are cyclical, and others (such as internet retailing) which are more secular. Given the amount of increasing amount of Home Retails sales going through the web/phone, I am wondering whether an accelerated store closure programme would be in order, and instead focusing on more on the direct route. In towns and locations in the UK and Ireland that I am fmailiar with, it seems to me that there are areas where Argis stores are in reasonably close proximity to each other.
    Some companies (maybe like Game Group, I think) are likely to be hurt via the net. Home Retail seem to have embraced it and the strategy seems to be working – but is diluted due to a harsh economic cycle and a high retail cost base. It has many characteristics that I am seeking, but the balance sheet and cashflow IMO are carrying too many lease obligations that are more than likely not delivering in terms of value. Finally, I am not a fan of share buybacks in general. I think (but hindsight is wonderful), that it was a poorly judged move in the present economic climate. I stand over my comment on the dividend – it is not resently well covered by cashflow, and I imagine that it would have deteriorated further during the year. I notice that management were not keen to defend the dividend on the conference call a few days back. That maybe no bad thing.
    Thanks
    J


  1. 1 The long view of retailing | Interactive Investor Blog Trackback on October 21, 2011 at 12:25 pm
  2. 2 Friday Reading | Expecting Value - UK Value Investing Blog Trackback on October 21, 2011 at 6:54 pm
  3. 3 Market Musings 22/10/11 « Philip O'Sullivan's Market Musings Trackback on October 22, 2011 at 10:49 am
  4. 4 Lesenswertes – Wochenrückblick | valueandopportunity Trackback on October 23, 2011 at 6:30 am
  5. 5 On catalysts and competitive advantage | Interactive Investor Blog Trackback on November 7, 2011 at 10:58 am

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