the consumer will be just fine

I recently undertook an exercise in the retail sector, by revisiting my modelling assumptions for retail stocks, having observed the underperformance of the sector - especially discretionary retailers - during the past 9 months as the Reserve Bank raised interest rates. Two stocks that stood out to me are SFH and MCP. I ahve since acquired SFH, but not MCP. Let me at the outset say that while I believe MCP is indeed an investment grade company, I don't see it presenting deep enough value for me at the current price levels.

Here's why:

According to my modelling, MCP will earn EBITDA of $47m and NPAT of $25m (EPS = 35.5cps) this financial year, and NPAT of $27m (36.9cps) next year. Valuation-wise, that places the stock on a FY2011 P/E of 7.1x and, assuming a dividend payout ratio of 50% (pre-GFC is averaged 55%), the dividend yield appeals, at 7.2%. And assuming Working Cap-to-Sales of 22% (last 4 halves it was 21.7%, 24.8%, 22.9% and 21.5%), then Operating Cash Flow will be around $30m to $32m pa. Take off around $2mpa in Stay-in-Business capex, and it leaves FCF of ~$28m, which represents a FCF yield of 10% on an Enterprise Value basis. I admit that this is reasonably attractive compared to cash investment alternatives.

However, whenever I look at MCP, it reminds me of Specialty Fashion House [code SFH] (the ex- Millers Retail) in some of its financial characteristics. Both businesses are substantially exposed to discretionary consumption in Australia, both are perceived to be relatively mature businesses, both are suitably cash-generative in nature, and they today have similar market capitalisations (MCP = $195m, SFH = $210m). But SFH generates far greater Operating Cash Flow than MCP. Taking the past 5 years as a full business cycle, between 2004 and 2009 SFH house generated a cumulative $230m in OCF, compared with MCP?s $125m. A huge difference. However, SFH's store refurbishment and store roll-out demands make it a far more capital-intensive business than MCP, which is essentially a catch-and-pass distribution business (and a smallish printing business of dubious quality, as you probably know). SFH consumed $115m in capex over the review period, compared with MCP at a mere $23m in total. The net effect is that FCF for these two companies is somewhat similar, $112m for SFH and $102m for MCP over the 5-year review period.

As to the difference between the two companies, SFH has demonstrated better growth attributes due to its store rollout opportunities, with top-line organic growth of 5%pa over the past 5 years, while MCP has grown its revenues 2%pa, less than GDP. Accordingly, SFH in FY2009 generated $36m in EBIT, 40% higher than FY2005. MCP's $39m in EBIT today has remained largely constant over the past five years. Additionally, SFH's financial performance has been more stable than MCPs. EBITDA margins for MCP are quite volatile (too volatile for my thinking, given the nature of its business). They have varied between 15.7% (DH04) to 13.1% in DH05, back up to 16.6% by DH07 and then down to 14.1% in DH09. The seasonally quieter June half has been even more variable for MCP margins, for example 14.6% in JH08 down to 10.5% in JH09. By comparison, SFH demonstrates greater margin resilience, consistently between 11% and 12% for December halves, and 7%-8%, in June halves. The most important difference in the two stocks, to my mind, are their capital structures. SFH is essentially debt free while MCP has around $80m in net interest bearing debt. Not that I think that presents solvency risk for MCP (on the contrary, its debt servicing ability is beyond question with EBITDA/Net Interest over 5 times last year and rising above 7x in the current year), it's just that SFH has far more flexibility for growth funding and/or capital management opportunities (SFH has 15cps in franking credits, and even though the company is sitting on $98m of retained losses, new accounting rules will allow companies to pay dividends even if they aren't profit-backed, as long as the company remains solvent). I also think SFH's pristine balance sheet provides scope of private equity participation or management buyouts, which have already been mooted in the media.

So, while these stocks trade on similar forecast P/E multiples around 7x, on my preferred valuation methodology - namely EV/EBITDA - SFH trades on 3.6x, and MCP 5.6x.
That's a very substantial difference and highlights a fundamental flaw in the use of P/E multiples in their omission to account adequately for balance sheet indebtedness.

Finally, like you I look for management alignment with shareholders, and in SFH's case there is plenty of this, with CEO Perlstein owning 9.4% of the company?s outstanding stock, chairman Levy 1.3%, and non-executive director Miller 7.5%. One of the niggles that I have with SFH is that I don't see it demonstrated that the board is independent enough to my liking.

In closing, SFH is not without risk. Indeed, I would not be surprised if the June half result is a bit soggy. However, I think this has been largely factored into the share price, and that the consumer will prove - absent a major financial market turbulence - to be quite resilient in the coming 12 to 18 months, especially if employment levels continue to be robust (which I believe they will) and interest rates will not rise much further (which I don?t believe they will given inflationary pressures are diminished globally by excess capacity). So, I am not standing on the roof-tops shouting to BUY SFH. I am just of the view that it - along with MYR- turned up as one of the best investment opportunities I was able to unearth in the retail space.

I also need to stress that I am not advising anyone to buy SFH, I am just providing some grist to the mill for thinking around the discretionary retail sector. For the record, my batting line up of investment opportunities (ranked in order of preference) is: SGN, SLM, WHK, APN, MYR, DTL, ORI, BOQ, QBE, SFH, COF, SKE, COU, EMB, SDI, BSA, CPI. I declare that I have an interest in each of these stocks. Feel free to comment should you have any strong insights into any of these companies.

Happy and prudent investing!
Cameron