Fellow (and prospective) SFH shareholders,There are some salient...

Fellow (and prospective) SFH shareholders,

There are some salient features of the most result financial result that warrant some highlighting, notably the evidence of some really strong pricing discipline in the June half of FH'10, against the backdrop of a highly competitive retail environment. Accordingly, I think there are some relevant aspects that can be interpreted from this latest result that helps reinforce my definition of SFH, as a specialty retailer.

One of the things that I was expecting going into the SFH result was the inevitability of some pressure on SFH's Gross Profit Margins, a consequence of a continuation into the new year of discounting that started to become manifest in the period leading up to Christmas last year. And anecdotal evidence pointed to an intensification of discounting practices among women's apparel retailers leading up to the close of financial year end.

The composition of SFH's result was somewhat different to my expectations. It is very clear that SFH management resisted the industry-wide practice in the half of engaging the customer aggressively on price, with the consequence that the GP margin not only "held up" well, but at 57.5%, it actually was a near-record for SFH, as historical analysis shows:
JH10: 57.5%
DH09: 56.5%
JH09: 56.6%
DH08: 58.4%
JH08: 55.5%
DH07: 54.3%
JH07: 54.8%
DH06: 51.7%
JH06: 51.1%
DH05: 54.7%

Of course, this pricing discipline comes at a cost during times of weak retailing conditions, and that cost is that sales tend to dry up, as the discerning and spoilt customer simply spends elsewhere. In SFH's case, the June half 2010 sales slump of 20% on the previous corresponding period is unprecedented (although it needs to be remembered that the pcp represented the peak of the stimulus package from the Federal government, so SFH in the past 2 financial halves has been cycling strong comparative periods).

For any retailer where stock turnover is a cash flow KPI, stock management is critical during periods of sluggish sales. In SFH's case, pleasingly, while inventory levels have indeed risen (by $1.8m to $45.8m from $44m in June '09), but have not blown out excessively. Inventory-to-Sales is still at a respectable 18.1%, although it is up from 16.0% in JH'09. So, while the adverse trend of recent years needs monitoring, I expect a reversal of this measure in the curent year, as sales growth recovers due to a levelling off in interest rates and higher personal income levels underpinned by a robustly strong employment market. SFH's Inventory-to-Sales trends are as follows (note seasonality):
JH10: 18.1%
DH09: 13.2%
JH09: 16.0%
DH08: 13.9%
JH08: 16.7%
DH07: 14.1%
JH07: 13.8%
DH06: 14.7%
JH06: 15.2%
DH05: 14.4%

So, in summary, the SFH strategy apears to be clearly one of competing not on price, but on differentiated merchanising offering. The outworking of this is that sometimes during the retail cycle this will not yield an optimal profit outcome, such as the past 6 months where EBITDA was $14.1m, compared to $21.8m in JH'09 (although it should be noted that JH'09 was a record June half result by a wide margin given historically, the June half EBITDA averages $15m.) So, in this particular financial result, the adverse effects of top line contraction more than offset the gains from improved GP margins.

However, as a shareholder, for longer-term value creation, (as opposed to short-term kneejerk responses that ultimately fail to address underlying business flaws), I far prefer this sort of pricing and branding discipline to the unsophisiticated retail model of "Source-Rack-Discount-Dump", which can play havoc with inventory managment systems and most importantly, induce a lack of brand loyalty among customers (essentially an attitude among customers of: "even-if-I-see-something-at-Millers-or-Katies-that-I-like,-why-pay-full-price-when-I-know-they're-soon-going-to-be-having-another-one-of-their-cut-price-sales,-and-I-can-buy-it-there-for-30%-off?"). And brand loyalty, when lost, is extremely hard to win back.

So, in summary I am encouraged to see SFH management has stuck to their knitting in the face of a very tough retail environment. In fact, the past 6 months encompassed a perfect storm for retailers - recycling strong comparative periods, rising interest rates, economic uncertainty, and actute discounting - and I think SFH performed reasonably well (8 out of 10, in my book) under the circumstances. With the worst of the retail slump behind us, and with some strong retail leading indicators (rising job ads, employment levels, wages growth and stable interest rates (I think?)), I think the sector is both on the brink of improved business conditions over the next 12 months. SFH, in particular, is undervalued in that contaxt, and the current company valuation seems to me to be pricing in an indefinite continuation of the retailing slump.

I do, however, want to issue a note of caution on investors who think that SFH will automaticaly record increased earnings in the current financial year. Readers should note that DH10 is cycling a very strong DH09, when the givernment's stimulus package was at its point of maximum effect. SFH generated over $46m in EBITDA during JH'09, by far beating the previous DH record by far (namely DH07, where EBITDA was $36m.) While I forecast JH11 EBITDA to be greater than 35% up on JH10 - $19.4m vs $14.3m, it is important to remember that December half EBITDA is seasonably around double June half EBITDA for SFH, and it will be impossible to get close to DH09's EBITDA in the current half. For the record, I am forecasting EBITDA of $38.7m for DH10).

So, my FY11 growth (per half, on pcp) in Sales, EBITDA and NPAT are modelled as follows:
Sales growth:
DH010/DH09: -4.1%
JH11/JH10: +5.6%
EBITDA Growth:
DH010/DH09: -17%%
JH11/JH10: +36%
NPAT Growth:
DH010/DH09: -23%%
JH11/JH10: +95%

Overall, then, for the full-year, I forecast FY11 NPAT to be $28.1m (14.7cps), down 7.5% on FY10. [Clearly this is predicated on assumptions that are not at all heroic in terms of a recovery in the top line....any evidence of a sustained improvement in the consumer spending cycle, will lead me to upgrade, i.e., these forecasts factor in a flat retail outlook, despite my intuition that things will emerge to be somewhat better.

But even under a "downside scenario" the stock remains unequivocally undevalued, in my opinion, at:
EV/EBITDA = 4.1x
P/E = 8.6x
DY = 6.3%
FCF Yield (on market cap) = 10.5%
FCF Yield (on EV) = 11.6%

If I was to incorporate into my modelling a more upbeat view of the retail landscape for FY11, then the valuation metrics would become:
EV/EBITDA = 3.4x
P/E = 6.9x
DY = 7.9%
FCF Yield (on market cap) = 13.3%
FCF Yield (on EV) = 14.7%

Either way, I see limited downside to the stock price. The only major risk is some unilateral raising of interest rates by the major commercial banks in Australia, independent of RBA moves. But that will be a quality problem to have because it might hopefully adversely impact the share price, so that I can buy more.

In the imterim, because I recognise my limitations when it comes to predicting the movements in interest rates, I have been acquiring more SFH since its result.

Prudent Investing

Cameron