That was the week that was (TW3)

A few things which caught my eye…

Tech – Snap was down over 30% on the week, which is another illustration of the punishment meted out to “growth” companies which disappoint. Of course, when Gorillas halves its HQ staff, it’s hardly surprising that there will be some fallout in ad spend.

VC fund Sequoia gave a presentation to its investees about how to cope in the new environment. This quote is relevant:

… the cost of capital has fundamentally increased. Over the past two years, monetary policy loosened to avert an economic disaster in the midst of the pandemic. Negative real interest rates led to effortless fundraising for growth
companies and record valuation levels. Given the circumstances, that was perfectly rational. But now rates are rising, money is no longer free, and that has massive implications for valuations and fundraising.

Venture capitalists have flooded the start-up world with cash which has been burned in acquiring growth. This party is over. Even Klarna cut staff last week - this tech layoff tracker may be useful.

Meanwhile Alibaba bounced on decent results, as did Baidu on less sparkling figures.

Venture capital – I attended a VC fundraising event with 15 decent startups at various life stages raising money. The audience was bigger than ever and some of the asking valuations continue to be ambitious. But some impressive disruptive businesses. One family office investor asked me if I thought private valuations might retreat. Seriously……

UK Private Investors – I spoke at two London conferences for private investors. Attendance at both was well down, as was spending, according to a number of service providers. Any business servicing the investment community is likely to be suffering. My presentation on Netflix was well received and I shall be writing it up for a future newsletter.

Time lags – if you are researching a company, inflation can be a huge risk to margins, as I discuss later. We always under-estimate the time lags in the system – it can take several quarters to pass on price increases. Note also how there is a gap between the hard economic data being reported (generally still strong) and the soft data, mainly surveys, which are trending down.

New book – I am reading Dan McCrum’s book, Money Men, about the Wirecard fraud. I got it yesterday and I am already half way through. It’s astonishing how these companies can carry on for years before getting caught.

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Introduction

This year the London Value Conference featured presentations from Hong Kong, Geneva and several from the US. Two of the British presenters recommended UK retailers which have been caned on fears of

- Online taking market share: a natural fear but omni-channel retail is the current vogue and this is hardly anything new

- UK inflationary pressures: this is clearly a risk with many retailers, notably restaurants, seeing labour both as a major pressure on costs and a risk to sales as disposable income declines

- UK recession fears: if inflation continues, a recession looks quite likely.

The managers both recommended deep-value, bombed-out retailers. Nick Kirrage, Co-Head of Value at Schroders, recommended Currys, while Edward Blain of Orbis recommended discount retailer B&M Value. Here are the charts:

Source: Behind the Balance Sheet from Sentieo Data

B&M is 35% down from its high, while Currys is down 84% from its peak and 49% from its 2021 high. The chart dates from B&M’s float and shows that B&M has been a growth story while Currys has not. Currys has changed its name several times – it used to be Dixons – and the name change is designed to disguise a torrid past. The stock peaked at £5 in 2015, after what proved to be a terrible merger with Carphone Warehouse. Watch out for successful founders selling out!

The Businesses

My UK readers will be very familiar with both companies, I imagine, but this newsletter has a much wider reach. Actually, I don’t know how many countries we reach, but my podcast has been downloaded in more than 100 countries, and last year (entirely coincidentally) I had website visitors from exactly the same number. Better than the painter below . . .

Currys is an electrical retailer, also trading under PC World, offering a wide range of products from washing machines and similar white goods through to PCs and phones, via all manner of products from the likes of Dyson and Apple. Checking their website, I came across this:

Source: Company website

It’s where I go when I need a new laptop (value investors can find the old model discounted in store) and for almost everything else I go to John Lewis, but I am probably not a typical customer.

I have never actually visited a B&M store (spoiler: wealthy, London-based analysts tend to visit discount retailers to do research rather than to shop), but it’s a typical dollar-value type discounted store, often situated next to an Aldi or Lidl, offering a limited range of branded food products where they have bought surplus stock that Kellogg et al have needed to dispose of, for whatever reason, and a changing range of products geared to the season – garden products in the spring, toys at Christmas. All cheap and cheerful.

Source: B&M Company website

As you can see, this is a classic low-cost format store, with effective private label sourcing. The smaller town centre stores place greater emphasis on groceries and FMCG, while there is a wider range in out-of-town outlets. I can testify to the cost discipline. The founders, the Arora brothers, decided to take an expensive holiday in the Caribbean post float, when they were worth several hundred million. This was our regular Christmas destination when our kids were younger. There were free drinks and canapes at the beach bar on Christmas Eve and the entire Arora clan was instructed to take full benefit of the free canapes – I so admire cost-conscious management.

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Valuation

This is the key attraction of the stocks. Obviously, B&M should benefit from trading down in more difficult times, even if their traditional customers are suffering. Currys will sell less big-ticket discretionary items and will have to be cheaper than peers. Given the uncertainty of earnings forecasts in the UK’s current economic circumstances, as well as the volatility of retail profitability, given high fixed costs, it’s much more sensible to use my favourite parameter of EV:sales to value these businesses.

Source: Behind the Balance Sheet from Sentieo Data

On Sentieo data, Currys is trading at 19% of sales, which is lower than it was at the start of the pandemic, although the data suggests that it has traded even lower – I have not investigated. B&M is only 17% above its pandemic low. These clearly are low valuations.

IFRS 16 Distortion

The EVs are distorted in my view by the new-ish standard IFRS 16 which adds a notional debt to the balance sheet for the leased stores. I don’t believe that the standard is fit for purpose and the initial calculations companies made on introduction were subject to a significant degree of judgment. It’s therefore worth looking at the EVs in “old money”, again using the Sentieo data.

Source: Behind the Balance Sheet from Sentieo Data

B&M has £1.3bn of notional debt on its balance sheet, which relates to the lease liabilities. Obviously these liabilities are real, but relative to pre-IFRS 16, our EV:sales calculation is not like for like. I prefer to think of my EVs ex this notional number – call me old-fashioned. These are 27% of trailing revenues so the EV on this basis would be 1.09x sales. Margins have averaged 9% and revenue growth has been strong – as shown in the charts above and below. The question on the valuation is less likely to be on revenue growth as the company should benefit from trading down and more one of the margin outlook.

Inflationary environments can pressure margins through the supply chain as it can take time for your input costs to feed through into sales prices. The 1970s was a very different environment so it’s hard to draw analogies but I am assuming many companies will see waves of margin pressure then expansion. There is no reason to expect B&M to be immune, but its ability to change product ranges should give it more flexibility and some element of protection.

Source: Behind the Balance Sheet from Sentieo Data

For Currys, the numbers are even more dramatic. The 19% of sales includes more than £1bn of notional lease liabilities which are around 12% of trailing Revenues. So the EV:Sales on a comparable basis is just 7%. And this excludes £35m of cash reserved for the insurance business (presumably extended warranties). That valuation really is a low number – it’s highly unusual to see a company with net cash trading below 10% of sales and it’s usually a buy. Spoiler: sometimes, though, they do go bust.

There is a clear investment case for B&M. It’s conceivable that it could continue growing even through a UK downturn. Although it is heavily represented in the north of England and less so in the more affluent south, it has less than 700 stores of the main format in the UK; there is an additional convenience store chain (Heron Foods, 300 stores) and a French business with just over 100. But there should be reasonable opportunity for further growth in store numbers. One risk is that the main driving force will be retiring but with a founder-led, family-owned business, succession risk will hopefully prove less of an issue.

The case for Currys is pure and simple: valuation. There are clear risks for the revenue growth and for margins, and in this area, Amazon is a formidable competitor. But at this valuation, you are being paid to take the risk.

JP Morgan’s Investor Day highlighted “storm clouds on the horizon”, which is a great metaphor for current economic conditions. I chatted to a UK equity fund manager last week and he has no retailers. He says that there are indeed storm clouds, and the market has probably over-egged the valuation derating, but we probably need to feel a few raindrops before people will buy these stocks – he suggested that a catalyst might be when the profit downgrades start to come through in reported numbers, then people can look at the upside.

I have always thought that it's impossible to second-guess when the market will start to focus on a particular issue. That’s why it’s helpful to take a long-term view and to resign yourself to being patient. It’s almost certainly early to look to buy the UK retailers, but Currys has such a low valuation that I can understand Nick Kirrage’s selection. B&M could well fall further, especially if it sees margin pressure, but the ultimate risk-reward looks interesting.

Paying subscribers can read on to access the company models, including an explanation of the IFRS 16 adjustments and another UK retailer which looks interesting.

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Behind the Balance Sheet

A tale of two retailers

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