Small Cap Value Report (Tue 5 Jan 2021) - lockdown 3, SAGA, BOO, NXT

Good morning, it’s Paul here with the SCVR for Tuesday.

Lockdown 3 is upon us, which shouldn’t come as a surprise to anyone – it was obvious that restrictions would have to be tightened further, so it really shouldn’t make much difference to share prices. If anything, it was slightly better than I expected, because the Prime Minister said that the most vulnerable groups should be vaccinated by mid-Feb, add 3 weeks for the vaccines to take effect, which implies an easing of restrictions somewhat possibly in early March? Previously we had been told it would be end March, early April (Easter time). He also talked about schools re-opening in mid-February.

Despite widespread criticism of the Government, the authorities here in the UK have at least so far been highly effective at approving, ordering, and administering, vaccines. Compare that with lamentable progress in France amp; Germany, where there is uproar at the sluggish, indecisive, and clearly incompetent approach of combining their efforts via the EU Commission (at the insistence of Merkel apparently, who seems to have lost the plot completely, once again putting political dogma before the interests of the people she’s supposed to be representing). Leading to Germany, the country which was pivotal in creating the first vaccine, not ordering enough for its own people. Things are going at a snail’s (!!!) pace in France too. All rather ironic, given that we were falsely warned that it was supposed to be the UK experiencing shortages of medicine after Brexit! Layers of unnecessary bureaucracy don’t tend to make things more streamlined, in my experience. So this seems a good example of where we can do a better job on our own. So well done to the authorities in the UK for being more nimble amp; effective than the lumbering EU bureaucracy. Sorry if this upsets anyone, but it’s clearly true, and the truth hurts sometimes.

In terms of profitability, I calculate that many retailers amp; hospitality companies would be probably no worse off closed amp; claiming furlough grants, than open and seeing low footfall. This was confirmed to me by a bars group, which I spoke to last week. They saw little to no difference in profits between trading, and not trading, during the seasonally quietest time of year from Jan-Mar. Hence zero revenues from Jan-Mar inclusive were already planned for, and survivable. Although the same is probably not the case for many smaller, independent competitors. Hence in tough sectors, the companies that survive, should enjoy increased market share, in markets with great pent-up demand, at least for a while in mid to late 2021. A classic case of whether the glass is half full, or half empty.

Another point is that people amp; companies know the drill now. Companies have proven remarkably adaptable, and many can operate largely as normal, during lockdowns.

Travel companies – I’m intrigued to see that Ryanair is running TV ads promoting holidays, with the strap line: “Just jab and go” (re vaccines). Also it’s saying that anything booked now can be re-booked if necessary. I reckon bookings are likely to be strong, as people are itching to go on holiday, I know I am. Air travel doesn’t seem to be high risk anyway, possibly because overhead air vents mean that air travels in curtains downwards, and out via floor level, and through filters before being recirculated. I imagine the hanging around in airports is more likely to be risky, than actually being on a plane.

Positive feedback – I received a wonderful email yesterday, from the boss of a city PR firm. He said he really liked my suggested list in yesterday’s report, for what needs to be included in current trading updates, and had emailed it round to his whole team. They totally agreed that it was a good checklist, and was already pretty much what they were aiming for. Isn’t that great! It’s really encouraging that comments here are listened to, at least by some advisers in the city.

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(I hold)

Directorate Change

The CEO of Saga’s core insurance business has stepped down with immediate effect. That’s obviously a worry, as Directors don’t tend to step down when things are going well. Although there are reassuring comments in today’s statement, e.g.

Euan Sutherland, Group Chief Executive Officer of Saga plc, said:

“Our Insurance business has performed resiliently under Cheryl’s leadership despite challenging market conditions and she departs with the business well placed to deliver on the opportunities we have identified as part of our new strategy. I’d like to thank Cheryl for her contribution to Saga and wish her well for the future.”

Sir Roger De Haan, Chairman of Saga plc, said:

”I would like to thank Cheryl for her work and commitment and wish her well for the future. We are focused on finding the right individual to replace Cheryl and to continue to drive our Insurance business forward for our customers. Until this appointment is made, Euan and the management team continue to implement our transformation strategy.”

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It’s guesswork with these things, but based on the words above that I’ve highlighted, it sounds to me as if there might have been a disagreement, or performance issues with the individual, rather than the business.

My opinion – I remain of the view that, with a say 2 year view, Saga shares could significantly re-rate. The recent refinancing provides enough leeway for now, and lockdown 3 makes no difference to the travel division, which was scheduled to start operating again in April/May 2021. Covenants on the cruise ship loans have already been waived until June 2021, so I don’t see any issues with debt, which is mostly asset backed anyway, or the £250m medium maturity dated, unsecured, cheap interest rate bond. Hence probably no issues with debt, after the bank debt was sorted with the £150m placing, two thirds funded by the returning former CEO/founder’s son, Sir Roger de Haan.

Cruise ship bookings are high, according to a recent Telegraph interview with Saga’s travel division head, so once those 2 brand new cruise ships can sail again, then the profits should roll in (£80m p.a. EBITDA forecast by the company, for its 2 owned, brand new, cruise ships, currently holed up in Tilbury docks).

The short term share price is extremely volatile, I’ve no idea why. We just have to wait for the sellers to finish in due course, then the upside potential could be unleashed. It sounds like the insurance side of the business is going OK, although obviously sales of travel insurance will have been meagre during lockdown. Although motor amp; household insurance should have benefited from fewer accident amp; burglary claims, possibly?

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(I hold)

I’m thinking of sending an invoice for my wasted time, to Morgan Stanley. Why are they issuing an RNS literally every morning, notifying of apparently trivial changes to their holding in BOO. It seems to be some swap arrangement, or hedging.

I’m not sure when the next trading update is from BOO, but we can’t be far away from it. Further lockdowns can only help online-only fashion retailers like BOO and Asos. Although note that BOO performed very strongly over the summer also, when its competition was able to re-open physical stores.

The trading update today from Next (LON:NXT) (see below), demonstrates again that online is absolutely key for everyone in the sector, apart from Primark.

I do think the last year has changed, probably permanently, shopping habits. I tend to order my bits amp; bobs from Amazon now, and get a delivery from them almost every day. Books, stationery, household items, etc. Probably the only things I don’t buy from Amazon these days, are food, electrical items (where I prefer a trusted brand like Currys, or Argos), clothing (2 or 3 trips p.a. to Primark for 5-10 identical black T-shirts, multi-packs of underwear, etc), and that’s about it. The idea of going into town to do general shopping seems irrelevant now.

What are town centres for? Increasingly, just as a meeting place to see family/friends, grab a meal/drinks, possibly browse for new clothes, and that’s about it. Most of the shops seem irrelevant now. Going to an out of town shopping centre is more pleasant, as you’re not surrounded by beggars and noisy/rowdy youths on skateboards so much as in town centres. Nothing against any of them, but I just don’t want to rub shoulders with them, thank you. Many small to medium town centres look dangerously close to a tipping point where there’s no future at all, and it might as well be mostly converted to residential, and/or serviced offices.

All of which is great for BooHoo. It’s rapidly expanding internationally, doesn’t have any legacy stores estate to worry about closing down, and is recovering from ESG problems. A pivotal moment for me, was when the Guardian’s latest broadside about supplier factories in Pakistan in late 2020, had only a glancing impact, taking a few pence off the share price, before it rapidly recovered and continued rising. This suggests to me that the supply chain story has finally run its course, and investors remaining in BOO shares seem satisfied with the company’s response amp; its comprehensive remedial measures. Or (like most of the customers) don’t really care. Hence the only way is up, in my view, providing strong trading continues, as seems likely. This share is my no.1 long-term share pick. It’s probably got the most ambitious, and hardest working management that I’ve come across, and that permeates throughout the business, with staff also being shareholders.

EDIT: thanks to moolahcoast for commenting below that apparently BOO is scheduled to issue a trading update on 14 Jan 2021. I’ve not checked that, so assume it’s correct. End of edit.

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7488p (up 8.4%) - mkt cap £10.bn

Trading Statement

Always the first retailer to report after Xmas, and with the most comprehensive detail amp; guidance, this company is such a class act. Its shares recovered well in the tumultuous year of 2020.

Here it is in a nutshell -

In the nine weeks to 26 December, the sales gained in our Online business compensated for almost all
those lost in Retail stores, with total product full price sales down just -0.5%.

Plenty of retailers are showing good online growth, but it’s more important to know what proportion of total sales are online – figures that are often hidden, if they’re not very good! Next does at least half of its business online now. So you could view it as an online business with a legacy estate of stores, the unprofitable ones are being gradually closed, and rent reductions generally secured on ones which remain open. So the stores are a manageable legacy thing, which just shows how well-managed Next is. None of us know what level physical retailing is likely to settle at in future.

Compare that with how Arcadia went from hero to zero, after being slow to realise the crucial importance of online sales, and ultimately being pulled down by the weight of its physical stores. That, and numerous other problems, such as under-investment, and Green’s bullying personal style, which encouraged the best people to leave.

I’m still amazed at how fast retailing has changed, with previous trends greatly accelerated in 2020 due to covid/lockdowns. We should find out very soon where the TopShop brand ends up – BooHoo and Mike Ashley being the front-runners, according to press reports. My worry with Ashley is that he could end up over-paying due to his ego wanting a final victory over his former rival, Philip Green.

Going back to Next, I love this table, which demonstrates how strong online sales have been, making lockdowns little more than a nuisance. Note also there was some catching up of sales in physical stores briefly, after the Nov lockdown ended. Overall, this is a remarkable performance in my view- a tremendously resilient business in awful circumstances.

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These comments below are all useful, and likely to have read-across for the sector generally.

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Impressive growth in customer numbers online, up 24.1% to 8.2m

Receivables book (customer credit) shrank about 18% in the first half, but has since risen again in Nov amp; Dec. Defaults remain low, which is clearly encouraging. It’s important to remember that Next has a receivables book which offsets its net debt. That’s important to take into account, if you’re calculating enterprise value.

The customer receivables book was £1,055m at end Dec 2020, and net debt is forecast at £625m a month later. So that’s a very healthy position, where we can safely disregard net debt altogether in my view, because it’s not far off twice covered by customer receivables.

Boxing Day sale (peak trading) impacted by lockdowns. Half the surplus stock will be cleared online instead, but incurring £5m additional costs. So it could be worth us all checking out Next’s website, to see if we can pick up some bargains! I do quite like their stuff. Although what is this awful menswear trend to dress up smartly, but not wear any socks?! Put some socks on man, nobody wants to see your bony, hairy ankles!

Property provisions – an additional £40m provided for, since assumptions about stores performance were too optimistic.

Logistics problems – there are currently logistics issues globally, with container and air traffic. I’ve heard from numerous sources that rates have shot up, containers are in the wrong places, etc. This might have been worsened by pre-Brexit stockpiling, but I’m told it’s a much wider problem than that, which could take months to be resolved. This is what Next says, which ties in with that. I wonder how many other companies will blame this factor in their forthcoming profit warnings? -

In addition to the closure of shops, the pandemic has adversely affected the flow of container traffic
from the Far East. At present many of our deliveries are running two to three weeks late and we
expect this level of disruption to continue into the new year. Our stock levels are currently down
-10% versus two years ago (January 2019). We expect stock levels to steadily improve and return to
more normal levels by the end of March.

Guidance – the all-important bit. There’s a lovely table below, called a profit walk forward. It’s a bit like a profit bridge, but laid out vertically instead of horizontally –

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The way I read the above, it seems to be saying that guidance for FY 01/2021 profit has only gone up slightly from £365m to £370m. Which raises the question, why is the share price up 8% today? Maybe the market was expecting worse?

Guidance for next year - more important, given that the current financial year has nearly ended (remember that Next uses a 31 January year end – sensible, as it’s a quiet time of year to do stock-taking, etc).

If only all companies reported with this level of clarity, it’s a joy to read this -

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Many companies do this internally – i.e. have a base case (most likely outcome) forecast, then an upside and a downside scenario. This is what I did in my CFO days (1993-2002) for a much smaller fashion retailer. I would plug the upside amp; downside scenarios into my giant spreadsheet model of the business, and see how the monthly balance sheet amp; cashflows were impacted. This is a vital way of forecasting amp; avoiding or planning for cashflow crises (which I often had to deal with!).

Next takes the bold step of publishing these forecasts, above. This is such a great way of managing investor expectations. As a result, even if the macro picture deteriorates for whatever reason, Next shareholders can consult the previous guidance, and know what to expect in terms of lower profits. That avoids people over-reacting, and panic selling, so it’s good for the share price.

A great friend of mine, who is a PR guru, always tells me that good PR is not about constantly talking things up. It’s actually about managing investor expectations well. Next are the masters at this, and I’d really like to see all companies adopt this approach of giving the market guidance with 3 possible outcomes. Surely that’s far more logical amp; intelligent, than trying to give one specific number for profit guidance, when there are so many uncertainties?

Giving a range of forecasts is also very much better for investors, than just saying it’s too uncertain, and not telling us anything! That’s atrocious actually, and companies deserve to be given a hard time when they completely withdraw guidance.

Every time companies update the market, they can then adjust the range of forecasts up or down as appropriate, and the range should logically narrow as the year progresses.

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Brexit – here’s another area where all the dire warnings we’ve been bombarded with since 2016 have turned out to be complete baloney! (as I had been saying all along, before I got banned from Twitter) -

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Valuation – my view is that Next usually under-promises and over-delivers. So looking at the FY 01/2022 guidance above, I’m thinking in terms of somewhere between base case amp; upside case, let’s say £700m PBT. Take off 19% corporation tax, gives us £567m PAT. Divide that by 133m shares in issue = 426p forecast EPS by my calculations.

The share price is whipping around a bit, but currently at 7344p. That gives a PER of 17.2

That seems priced about right to me. You could argue that a business which is mostly an online portal, for its own and others’ fashion brands, should be on a higher PER. However, some of the profits still come from the declining physical stores, which is inevitably likely to act as a drag on group profits. Hence overall profitability is held back, and EPS growth has basically been nothing in the last 5 years. Does that justify a rating about 17.2? Arguably not.

On the other hand, we’re in a raging bull market, where investors easily get over-excited about growth businesses buried within a bigger group – e.g. look at the excitement that has emerged about Reach (LON:RCH) – one minute it’s a moribund newspaper business, the next minute investors are talking about it being a growth digital advertising platform, comparable with Google! OK I’m exaggerating for effect there, but it’s to show that sentiment can change. That’s probably the upside with Next – strip out the stores altogether, and you can show a decently growing online business, that maybe should be valued on a crazy growth multiple?

My opinion – I’ve been keen on Next for years now, because it proved so effective at moving physical sales online, and effectively managing down its store network in a disciplined way. It’s a superbly run business. Although I do wish Lord Wolfson would stop appearing on Question Time, and being so careful not to offend anyone, that he says nothing of any significance.

The only reason I won’t be buying any Next shares, is because I think the valuation is probably about right now. It’s a terrific share to buy on market meltdowns though, as it always recovers.

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(work-in-progress)

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