I have kept SFH on my radar screen for some time, as a potential...

I have kept SFH on my radar screen for some time, as a potential value investing target, initially attracted by its sub-10% Price/Sales ratio. During the past few weeks, after its further drop in market cap to a measly 5% of annual revenue, I have been looking more closely into its financials. Encouraged by the quality of the posts on the SFH threads, I thought I’d share some of my findings and estimates here, to hopefully generate some constructive investment debate.

Admittedly, I do not like the retail sector in general, and did not particularly like the Company’s recent results and announcements either, but I kind of belong to the camp according to which “there is a price for everything” (as far as financial securities go, at least); therefore, I have been trying to determine whether SFH has now got cheap enough to initiate a long position with decent odds of success.

Looking at the financials of the Company over the past decade, what I found most remarkable was that, in the years between FY2007 and FY2010 (not exactly golden years for the broader economy, as they included the GFC), SFH was able to generate EBITDA margins in the region of 10% (as opposed to the current ~3% margin). Furthermore, over the same period, the average Gross Margin was 55.7%, which is pretty much the same as in FY2017. It follows that the collapse of the EBITDA margin to the 3% area (and probably dropping further towards 2% in FY2018, looking at the most recent guidance), has been entirely due to the Cost of Doing Business getting out of control.

Looking at the individual items within the CODB, what appears to have driven the blowout is Employee Benefits (26.8% of Sales in FY2017, vs 23.0% average in FY2007-FY2010) and Other Expenses (9.7% of Sales in FY2017, vs 6.7% average in FY2007-FY2010), which together account for virtually the whole EBITDA margin drop from 10% to 3%.

Therefore, while a lot of attention seems to be paid to external factors such as the looming threat of Amazon, or the currency exchange rate exposure (things which should not be underestimated, of course), it would appear to me that a possible turnaround of the Company depends most critically on getting the CODB back under control.

Management claim to be doing this already, by closing down underperforming shops and implementing cost-cutting measures, and given their big stake in the business they are certainly highly incentivised to do so. But, as we speak, no improvement is showing in the actual results (even on an underlying basis, i.e. before one-off costs).

So, why contemplate an investment in SFH at this stage then, while its earnings are still deteriorating? In this kind of situation, when it comes to deciding whether it is worth buying the shares at today’s price, to me it boils down to the following points:

1) How long it is going to take before Sales and EBITDA margins stabilise
2) What the Balance Sheet is likely to look like at that point in time
3) What the “new normal” level of EBITDA could be

Regarding the first point, I don’t really know, but I would assume two years should be a sufficient time horizon for a turnaround to materialise. Obviously, there is also a non-negligible chance that the business will no longer be around (in its current form, at least) by then.

Regarding the second point, it is worth noting that the Company was Free Cash Flow positive in FY2017; but, looking at the 14m$-20m$ underlying EBITDA guidance for FY2018, and factoring in Capex and ongoing restructuring costs (such as redundancy payments and penalties for early termination of leases), there is a definite possibility that more debt will have to be drawn out of the existing credit line.

In this respect, I note (from page 80 of the 2017 Annual Report) that, while the total available finance facility currently amounts to 52.0m$ (with 24.7m$ unused as of 30 Jun 2017), that will amortise down to 35.0m$ by 30 Jun 2018, leaving only 7.7m$ undrawn. That might be enough, even though there is a possibility that the Company will need to raise some capital if a new credit line cannot be negotiated by then. In any event, it looks reasonably conservative to me to assume that Net Debt will increase from its current 8m$ to approximately 16m$ by June 2018, and remain around that level into FY2019.

Finally, when it comes to estimating at what sort of level EBITDA is going to stabilise, a way of looking at it is by setting a lower bound to the new level of Sales and by applying a reasonably conservative EBITDA margin estimate to it. Let’s assume, for instance, a drop in sales by 30% to approximately 560m$ per annum; that is essentially equivalent to going back to GFC levels, without even counting the revenue contribution from the acquisition of Rivers. Despite the increased competitive pressure and the impending arrival of Amazon, I struggle to believe that things could get much worse than that, from a pure revenue perspective.

Note that I am not talking about Same-Stores-Sales here, I am assuming revenues to plateau also as a consequence of underperforming shops being closed down. It goes without saying that a 30% drop in SSS would be a killer, given that the current Fixed Charges Cover Ratio (before D&A) is around 1.25x.

In terms of what an achievable EBITDA margin could be, once the cost cutting process has been completed, I don’t think it will be anywhere near the 10% level it used to be, given the ongoing structural changes and challenges to the retail business model. But, simply operating reasonable cuts on Employee Benefits and Other Expenses (and considering that the closing down of shops will eventually reduce Rental Costs as well), a 100-200bp improvement to a 4%-5% margin looks eminently achievable to me.

Thus, taking 4% as a more conservative margin estimate gives 560m$*4% = 22.4m$ EBITDA for FY2019.

Now, what EBITDA multiple is appropriate to value this business, if 22.4m$ is the sort of level around which EBITDA is going to stabilise? Given the uninspiring growth prospects, the intense competitive environment, the risk of business model disruption, the high operational leverage, and the fact that currency exchange rate movements can eat significantly into margins, I would personally want a FCF yield on EV of at least 10% per annum to own the business. Estimating sustaining Capex needs at roughly 20% of EBITDA (i.e. around 5m$ per annum), that equates to an EV/EBITDA multiple of roughly 5.5x [*].

That gives an EV of 5.5*22.4m$ = 123.2m$ and, because we are assuming Net Debt of 16m$, the corresponding Market Cap is 123.2m$-16.0m$ = 107.2m$, or 107.2m$/192.2 = 56c per share.

If, slightly more optimistically, we assume Sales to stabilise only 20% lower at 640m$, with an EBITDA margin of 5%, then EBITDA = 640m$*5% = 32m$, EV = 5.5*32m$ = 176m$, and Market Cap = 176m$-16m$ = 160m$, or 160m$/192m = 83c per share.

[*]: I am using the relationship [FCF Yield] = 0.7*EBIT/EV and the assumption EBIT = (1-20%)*EBITDA to work out the EV/EBITDA multiple implied by a 10% FCF Yield. Note that the 20% assumption for DA charges is not reflective of historical levels, but merely of my own estimates for sustaining Capex.

Because the shares are currently trading at 20c, it is evident that the market is pricing in a very high probability (70% or more, according to my own back-of-the-envelope calculations) that the Company is not going to be turned around successfully, resulting in either administration or very substantial dilution through capital raising.

There are several reasons why I see such an outcome as unlikely (albeit not impossible):

1) Employee Costs are something that Management have direct control on, and even a 100bp drop in those costs would have a very significant positive impact on EBITDA; the same argument applies to Other Expenses.
2) Management and Board are highly incentivised to turn the Company around, as they collectively own approximately 35% of it.
3) Even at a FY2018 EBITDA of 14m$ (bottom of the latest guidance range), and factoring in ongoing restructuring costs, the Company should still be roughly cash flow neutral in FY2018; the availability of an additional 7.7m$ of credit line also provides some buffer before any raising of capital is needed. That should give enough time for a turnaround to materialise.
4) Lastly, at today’s price, an opportunistic takeover does not look unlikely: whether it is Al Alfia Holdings coming back, or some private equity fund attracted by the prospect of a high FCF buyout yield, it sort of makes sense to me that, if Management cannot turn this business around, someone else will want to do it for them. An eventual takeover offer by Cotton On is also possible.

To conclude, from the perspective of a potential investor as of today, I see this as a situation with a non-insignificant probability of losing everything; but, having said that, I also see very reasonable chances of hitting a three- or four-bagger over a two-year horizon. And, by the time any meaningful improvements start showing up in the actual financial results of the Company, that share price upside will probably be already gone.

As such, while I have determined that this is not something I want to put more than 1% of my investable capital into, at this stage, I do feel comfortable enough with that sort of amount; I have therefore started buying the shares, and will reassess the size of my allocation as more news and results start flowing in.

Meanwhile, any constructive feedback (or comment on things I might have missed) is more than welcome.

IMHO & DYOR