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SFH specialty fashion group limited

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$1.22

Taking a bite at SFH, page-5

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Transversal

1,502 Posts.

1362

26/10/17

16:34

Post #: 28226469
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Originally posted by Jimmy_C ↑

Some good comments, thanks @Transversal and @natnicnak.

I took a 2-to-3 hour look at SFH last week and came to many of the same conclusions - it's cheap, and its CODB has crept up over time. Some general comments on the overall thesis:

- I think a stay-in-business capex assumption should be based on sales, not EBITDA, because sales more accurately reflects footprint and thus capex needs - your capex for a retailer kind of is what it is regardless of profitability/margin. A $5m capex assumption for this business sizes to ~0.6% of ~$800m sales, and is very low based both on my understanding of retail (typically more like 1-2% sales) and what they've done historically - they spent $75m in capex from 2011-2017 excluding new store openings, on cumulative sales of $4,824m, i.e. 1.5% sales. Further, this assumes they'll never spend capex on opening new stores again, which is aggressive as they continue to open new units - they opened 30 new units in FY17 despite SSS being -2%.

- I'm not sure management can directly control employee costs per se for the whole business, as most of SFH's costs are in-store/customer interface employees - it's a dangerous game in retail to go around sacking in-store staff as service levels then drop and revenue tends to follow - the department stores are in that pincer and it doesn't work. The way to shrink this over time is to close unprofitable units (see below).

- As stores are closed, there may be exit/restructuring costs - this reared its head in FY17 ($4.9m exit costs) as they closed 79 stores. That's valuable cash out the door as the group attempts to downsize its way to greatness.

- A 2-year turnaround would be quick, i think. The task facing them is that there's presumably a big chunk of their ~1,000 stores that are losing money, most of which are on 5-year or possibly longer leases. You can only economically exit units at the end of the lease, which means there's only so much culling you can do each year as leases roll off, not to mention the exit costs (like lease make-goods etc.) referred above being a drain on cash flow. And retailers being a generally optimistic bunch, i suspect they're not shrinking as fast as they should be because they're hoping to 'trade their way out of it' or pretending that some stores which are borderline might be viable in future - this is a recurring theme with struggling retailers.

I agree with the comment that this could potentially be a total loss scenario, or a 3+ bagger. The mechanics of gross margin being sensitive to a weak AUD made me particularly nervous - if you get a weak AUD and heavy discounting piling pressure on gross margins in a recessionary retail environment, you start looking at a total loss scenario quite quickly given the business is barely breaking even today on a cash operating basis net of capex. Given the possibility of total loss, i have left SFH on my watchlist for the time being.

Good luck with the holding and thanks for sharing your thoughts.

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@Jimmy_C

Thank you for your comments.

You make a very good point saying that sustaining capex should be expressed as a percentage of sales, rather than EBITDA margin. In fact, I started with a 5m$ figure in mind (relative to a revenue base of 560m$, i.e. 0.9% ca) and then included it into the formula as a percentage, so that it would scale up depending on the revenue assumption.

0.9% may be a bit on the low side relative to the historical 1.5% average, but I would also factor in the fact that, going forward, online sales (which are less capital-intensive per unit of good sold) are going to represent a fast-growing slice of the pie; and yes, they’re still opening new shops, but I would focus on sustaining capex only for valuation purposes (as non-sustaining capex is revenue-additive).

When it comes to the degree of control Management have over their variable expenses (such as Employee Costs): I hear you, but it does not seem unreasonable to me to bring those costs (as a percentage of revenue) back in line with historical average; I do agree that this is likely to occur mostly by closing down unprofitable units.

Regarding exit/restructuring costs; yes, that is why I am assuming a deterioration in Net Debt to 16m$ by FY2019, even though I expect the Company to be FCF-positive on an underlying basis. I do not know the specifics of their rental leases, but I would expect them to be able to get out of some of the contracts by paying early termination penalties, rather than have to wait for the full residual term to roll off in each instance; if the latter were the case (i.e. no early termination), then I agree it would take longer than two years to resize the business. I have no conclusive evidence on this point, but the speed in the reduction in lease commitments over the past two years makes me think that they do have room for early terminations.

Finally, you are right in that there is wrong-way correlation (in the event of a recession in Australia) between the effect of the FX rate on margins and the impact on revenues of a recessionary retail environment.

It is a high-risk proposition at this stage, for sure, but I do like the asymmetry of the potential payout.

Thanks again for your input

SFH Price at posting: 21.0¢ Sentiment: Buy Disclosure: Held
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