GXL investment thesis

I am now a holder of this stock. Thesis in a nutshell:

- Management guidance provided at 2016 AGM (which i think is eminently achievable, and arguably even slightly conservative, given the underlying trends in LFL sales growth, gross margin performance, and strong acceptance of vet co-location strategy) calls for ~10% growth in "underlying" EBITDA, which implies (1.1*$97.5m) = ~$107m.
- "Underlying" EBITDA should more closely match statutory EBITDA this year. The $10.4m gap between "underlying" and statutory EBITDA in FY2016 was comprised of $3.4m defence costs (shouldn't repeat this year given no corporate activity/PE bids), $3.5m integration costs (mostly incurred in 1HFY16 in relation to City Farmers, so shouldn't repeat), $2.4m redundancy costs (management team has been stable this year, so shouldn't repeat) and $1.2m share based payments. I'll just say for argument's sake there's $3m of expenses this year that management chooses to classify as "not underlying", so FY17 statutory (i.e. real) EBITDA of $104m.
- $15m interest costs (vs. $14m FY16) - i assume a slightly higher debt balance will outweigh the 30bps cost in debt reduction, so interest costs slightly higher.
- $20m cash maintenance/stay-in-business capex (was $21.7m in FY16, but that $21.7m included $7.1m in supply chain and online business development, both of which i assume will come down this year as the supply chain upgrade was mostly completed by end of FY16 and web platform was rolled out during FY16), which coincides with roughly what i think accounting D&A will be (was $17.8m in FY16 and i would expect slight increase in FY17 given increased store fleet)
- No increase in net working capital. Arguably slightly aggressive for a growing retail business, but this takes into account the fact the business (quite incredibly) released $6.6m working capital in FY16 as a result of its improved supply chain and better debtor/creditor management; and, additionally, that $6.6m working capital release would have been ~$11m had GXL not increased inventory by $4.5 as a result of transition to direct supply. So, to me, it looks as though they'll be able to keep working capital growth rather limited even as they grow the fleet (a nice thing for a retailer to have, as other category killers such as WOW and Bunnings have discovered in the past)
- Gives pre-tax equity cash flow of (104-15-20-0) = 69
- Tax of 30% * 69 = 21
- Approximate FY17 equity cash flow of (69-21) = 48
- Gives forward equity free cash flow yield of (48/790 on current MC) = 6.1%.

I really like the idea of buying at a >6% equity cash yield a retail business which has the following attributes:

- Excellent underlying momentum in all facets of its business, minus a sluggish WA (which all retailers face)
- Clear opportunity to expand gross margin further via increased market power leading to better purchasing terms, and continued roll-out of private label strategy
- Clear opportunity to grow SSS faster than operating costs in existing fleet, given: 1) co-location strategy to lever occupancy costs, 2) gradual taking of market share from incumbents who can either compete on price but not on range or service (i.e. supermarkets), or can compete on service but not on range or price (i.e. smaller pet chains), 3) cross-selling and gradual capture of customer wallet via loyalty schemes and one stop shop concept.
- 5+ year organic growth platform using proven and largely de-risked model (i.e. roll out co-location stores into existing fleet, and roll out greenfield sites using strict economic criteria and backed by analysis of existing customer data obtained from loyalty scheme card swipes). The opportunity to organically invest ~$40m annually into high ROIC (GXL budget their co-location strategy as a 20% ROIC opportunity, and they are exceeding budget to date) and relatively low risk expansion opportunities is pretty enviable and not something most retailers have at their disposal.
- Focused management team and board who have: 1) put their collective corporate reputations on the line by forcefully knocking back a PE offer at $6.75, 2) shown a healthy propensity to think long-term rather than short-term (i.e. investing in supply chain for future benefit, investing heavily in staff training to make the retail experience a good one, investing in online platform with a view to move to click-and-collect model, showing discipline in not overpaying for existing vets and instead focusing on co-location strategy which is less profitable in short term but more profitable in long term)
- Genuinely differentiated offering, with competitors who appear to have limited ability to respond. The supermarkets will, no doubt, attempt to compete on price if they deem GXL's retail offering is taking too much market share, but the supermarkets can't compete on service, range or convenience, and the smaller pet shops, i think, have very limited ability to respond on any facet of price, range or service (they can't do click-and-collect, for example).
- Relatively sensible capital management, with debt having recently being termed out, and balance now having peaked at ~2.2x EBITDA, and self-sustaining cash flow forecast to occur by FY18 (which is saying something in the context of a business spending ~$40m p.a. on expansionary, organic capex)
- $6.75 PE bid was backed by Jeff David who, as the guy who built GXL's retail platform via Mammoth, should have a very good idea of what this business is capable of in the next 3-5 years. I had been following GXL for a while and Jeff David's sudden resignation from GXL in mid-2015 was a big red flag for me initially, but then he turned up 6 months later heading a PE bid to take the company private again. I can only imagine he saw the dollar signs in teaming up with PE again (which is what he did with Mammoth, which is the nucleus of GXL's retail platform), and he would've been obligated to coinvest alongside his PE backers at $6.75. So, in effect, you had both GXL current board & management, GXL's former CEO, and some clever PE shops all saying in January 2016 that this business is fundamentally undervalued at $6.75, and the business has only improved further since then.

Happy to hear thoughts of others.