Ann: 2021 AGM Presentation, page-66

Every AGM I like to trawl through some of the detritus, hoping to pick up a gem which has been indiscriminately discarded for some or other reason.

So I spent some time this morning analysing some of the salient drivers of KGN's financial fortunes.
I was especially interested in looking at KGN given, prima facie, the impressive growth in Revenue and Gross Profit since IPO, which was in strong contrast to the very poor share price performance over the past 14 to 16 months. (Also, the stock is heavily shorted, which is always of interest to me because short-sellers, just like all of us, put their pants on one leg at a time, and are just as prone to getting things wrong as the rest of us).

So I wanted to understand the reason for the the wide chasm between headline financial performance of the company and the sharp decline in its market value.

Thought I'd take the liberty of sharing my findings:

As always, headline numbers tell only the superficial story and the devil is invariably in the detail.
KGN has increased Revenue and Gross Profit by, respectively, 3.7 times and 6.2 times over the five years since it IPO'd. At first pass, objectively impressive.

But when one scratches below the headline veneer, there are some diametrically opposing trends in determinants of KGN's profitability which are concerning.

For starters, the assets base is not being made to sweat: Asset Turnover (effectively, Stock Turnover given Inventories represent more than Half of total Assets) is declining sharply. For a low-margin, high-volume business, this is a bad sign.




Combined with that adverse trend are the deteriorating Cost of Doing Business elements.
Warehouse Expenses-to-Revenue has been on a rise since IPO, Selling & Distribution Expense metrics have snapped sharply higher in recent years (obviously explainable to a large degree by supply chain congestion costs), and Admin Expenses chewed up 11% of Revenue in FY2021 (almost double the level of three years ago):




Total CoDB-to-Revenue (read off the right-hand axis of the graph) is now at almost 25%.

And when your business operates at 26% Gross Profit Margins, which is where KGN was for FY2021, then that leaves precious little wiggle room to cover the 25% of your Revenue which gets gobbled up by CoDB.
And those margin squeeze chickens came home to roost in a serious way in FY2021, when the until-then rising GP Margin (on which the company had relied to offset the surging CoDB-to-Revenue) stalled.

The result was not pretty; a massive crunch in EBIT margin and EBIT:




Of course, that is all looking in the rear view mirror, but its a toxic-looking cocktail and to reverse the impact of closing Revenue-Cost jaws in a business of this nature is not easy.
It would require significant effort in terms of either:

1.  Cutting back quite hard on the CoDB spend (which then runs the risk of falling behind in mission-critical investment in systems, logistics infrastructure, branding and marketing, etc.),

or

2. Increasing the GP Margin (which is arguably even harder to do because it depends, in large part, on extraneous factors such as supply chain conditions, consumer confidence, the competitive landscape, etc.). And as we know, retailers are currently cycling a period in FY2021 of supremely positive tailwinds in the form of citizenry who were effectively paid by the government to stay at home for extended parts of that period, with limited outlet to satisfy consumption habits, apart from buying stuff online.

[The 400bp compression, YTD, in the Gross Margin of the core Kogan business - to 15.2%, from 19.3% FY2021 YTD (for context, it was 16%, FY2020 YTD) - bears witness to the consumer buoyancy in the FY2021 year, and how difficult it is going to be to get the GP Margin back up again.   (NB.  The Gross Margin figures in this paragraph refer to Gross Profit on Gross Sales, not Gross Profit on Revenue, and the the reason Gross Profit on Gross Sales is being referenced is to provide a contextual proxy for what Gross Profit on Revenue will be experiencing)].   

Frankly, I think if the GP Margin (we're talking Gross Profit on Revenue now) for this year comes in anywhere north of 23% (it was 26% in FY2021), it will be a miracle.


CONCLUSION:

Establishing a base for KGN's current level of underlying earnings is difficult (heck, indications are that even the company's directors are uncertain about things, given the final divided for FY2021 was passed).
So what I do in these cases where the earning forecast risk is high is I reverse engineer the exercise by back-solving for the current of level of profitability being implied by the market valuation, and then forming a view of what needs to happen for that level of earnings to eventuate.

In KGN's case, the maximum valuation multiples I'd afford the stock are for EV/EBIT of around 20x (which could correspond to EV/EBITDA of 16x and P/E of ~30x). So, objectively, I'm not being at all conservative here.

At the current ~$800m EV, that suggests the company needs to be generating EBIT of $40m this year.

A likely pro forma, abridged P&L that will deliver that sort of outcome follows below, and is based on the following top-line assumptions:

- Revenue growth of 20% (YTD Gross Sales running at +19% on pcp)
- GP Margin of 23% (per preceding discussion)




As can be seen, with those Revenue, Gross Profit and EBIT inputs, the variable is the CoDB which would have to reduce by a substantial 15% on FY2021's level.

Frankly, I struggle to see how that can be achieved (that's even had Mighty Ape not been acquired;  remember, Mighty Ape was acquired roughly only half way through FY2021, so around half of its $30m CoDB still needs to annualise this financial year).

So, even after applying several layers of generous investment thesis assumptions (Imputed valuation multiples, GP Margins, required CoDB reductions), I still can't get to concluding the stock is sufficiently undervalued for me to purchase.

In fact, it being one of the most-shorted stocks on the ASX, I believe I can understand the thinking of those who have short-sold the stock so aggressively.
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