Description

Description

AO World (AO) is a UK based electricals retailer.  They were founded in 2000 by John Roberts, who remains on the board and recently transitioned from CEO to a “Founder” role.  Like many internet retailers, AO is a better mousetrap vs. traditional retailers and has three key combined advantages: more selection (currently 4000 SKUs in the UK), they control the customer experience from order through delivery (purchased a 3PL business, Expert Logistics from Iceland Frozen Foods in 2009 and provide seven day/week delivery to nearly all UK postcodes), and they have a lower fixed-cost base vs. traditional retailers.  They are led by a Founder/CEO team with a track record of success and are beginning to scale the business through increased categories and new markets where they can duplicate their model.  It trades for .65x EV/sales today and is down 70% since their IPO in March of 2014 despite continuing to improve their overall customer proposition and consistently invest in their brand.  The key concern is clearly profitability which I’ll address below.

AO was founded as Appliances Online in 2000 and originally focused on the Major Domestic Appliances (MDA) market in the UK.  It was rebranded AO.com in 2012 and listed in March of 2014.  From there, they’ve steadily expanded their UK business to include Small Domestic Appliances (SDA) as well as AV, computing and gaming.  In 2014, they expanded to Germany, with the goal of duplicating the same UK model (one distribution center, large volumes, referrals primarily through word of mouth, and friendly customer service).  They then expanded into the Netherlands in March of 2016. 

Owner Operator- Despite transitioning from CEO to Founder/Board member in February ’17, Roberts continues to play a key role and owns ~24% of the company.  Steve Caunce, the relatively new CEO, was previously the CFO/COO and originally joined AO in 2005.  Caunce owns just over 11% of the company and given his previous background, I expect increased focus on both delivery execution as well as overall profitability.  Management collectively has a track record of success through the addition of new categories to the UK MDA business as well as the willingness to solve problems in creative ways.  Recently, they faced a problem of disposing of the appliances that they picked up when making deliveries and they ultimately decided to create a UK recycling business.  Not only does this solve the current problem but it also creates an opportunity for them to sell their excess capacity to others in the industry.  There’s no magic behind this one example but it does demonstrate consistent execution skill and the willingness to cheaply experiment.

How big is the prize if they win?  It’s hard to say with precision because of the revenue growth/operating losses in Europe but it’s easier to break it down by market.  For the UK, the broader electricals market is £7.7bn and the computing market is £13.1bn.  For Germany, the size of each of these categories is £7.9bn and £21.1bn.  For the Netherlands, these categories are £1.5bn and £4.0bn in revenues.  As a whole, the total revenues across their current markets and categories are £55.3bn vs. AO’s current revenues of £744.5m or just under 1.5% total share.  For all of Europe, the sum of all categories is £91.1bn.  One note, AO World originally operated third-party websites in addition to its own AO.com.  They have made the deliberate decision to deemphasize this business and as a result, expect this portion of overall revenue to continue to decline.  It is currently down to 9% of total revenue.

Globally, online as a percentage of retail continues to increase, although it’s off of a small base, and that’s no different for the UK or Europe more broadly.  For example, online UK sales are ~15% of overall retail, with online penetration in electricals at ~36% of category sales.  For Germany, ~21% of the categories that AO World sells are sold online.  This structural tailwind should continue to support increased growth and dominance for the market leader, as it has in other geographies such as Zooplus in European pet supplies. AO is the overall market leader in the online MDA market in the UK, commanding 19% market share from the AO.com website.  UK and Europe (Germany and Netherlands today) revenues and gross profit are below.

Why do I think they can achieve this?  It’s tough to say with precision, given the financial statements combine three businesses: a well-established UK MDA business, an expanding UK business where new categories are being introduced, and two nascent but high growth European businesses that are subscale but are growing over 50%/year solely from customer referrals.  That being said, I think the company provides some hints and other businesses do as well. 

First, UK gross margins have increased from 17.4% in 2011 to 21.2% in the most recent annual report (#s below).  This supports the company’s story that bulk purchases plus lower overall shipping costs (at least those added to COGs) come as a result of increased volumes.  The company provides UK and European revenue and COGs detail but consolidates SGA costs.  As a result, I looked at pre-IPO SGA, since they weren’t active in Europe then, to guesstimate longer-term SGA levels.  In the three years prior to the IPO, AO had 16% SGA expenses vs. overall SGA (including those from Europe) of 20.3% today.  Using the original 16% SGA expenses, I think a 5% long-term operating margin is a reasonable target, once the UK business is steady state and has both sufficient volumes and customer referrals to drive down both marketing and warehousing costs and return overall SGA costs to ~16%.  In addition, the company confirms, in the annual report, that customer acquisition costs are continuing to decline.      

Second, AO World discloses the percentage of repeat customers for their UK customers and that number has steadily increased from ~0% in 2008 to ~50% today.  Although not a guarantee, this provides credence to the idea that marketing and advertising as a % of sales should decrease over time for a steady state business.  As shown below, it’s gone from ~2.5% of total sales in 2011to 4.6% today.  It also makes the business more of a recurring one, given that customers buy an appliance when a previous one breaks.

Third, the business is being built for scale.  Two of the most recent pieces of evidence are their revenue vs. van growth chart and their chart showing warehousing costs as a % of total cost-to-deliver declining as they scale through 2021(p.28-29 of their Capital Markets Day presentation from Feb ’17).  Clearly, they need to prove themselves on the operating leverage across their now expanded business but their high inventory turns (14 vs. well respected retailer Costco at 11.9) at least support the notion that they’re capable of driving very high relative volumes through their business.

Valuation- Using the above, the current UK business at steady-state would generate £32m of operating profit vs. a current EV of £428m.  This is for a business (the UK one) that was been growing gross profits at north of 20%/year and has a small single digit percentage of its overall market.  In addition, it requires no-to-negative working capital and very little total invested capital (£800m most recently) so the business is able to largely finance its growth and the ultimate ROICs should be very high (50%+).  For comparison, Dixons Carphone, which owns major competitor Curry’s, has been generating ~4.5% EBIT, growing single digits, and generating ROICs of mid-single digits with goodwill or over 100% on NWC+PPE.  Its traded in the 8.5-mid teens EV/EBIT range over the last 10 years and between .4 and 1.2x EV/Sales.  Assuming AO World reaches scale, it’s cheap on both an absolute basis as well as relative to a disadvantaged competitor.

What do you have to believe? The UK business achieves a 5% operating margin.  If they do this, you’re paying 13.6x EV/operating income and assuming the European business is either closed or doesn’t consume cash.  This seems conservative, despite the negative gross profit that the European business is currently generating.  You’re also assuming they no longer take additional market share and they slow to GDP type growth.  Could all of the above happen, sure but I like the odds.  And based on management’s track records, I’m betting they’ll figure out both Germany and the Netherlands.  Time is also on your side as the company has net cash and therefore an ability to play the long game in order to win the European prize.

Currency- No strong view here for either GBP or EUR.  However, on a real effective exchange rate basis, both are moderately cheap (GBP=98 and EUR=95 using BIS data).  On an adjusted PPP basis, GBP is 14% cheap and EUR is 1.5% expensive vs USD.  On balance, I’ve decided to own this position unhedged.

Risks

·         LT Profitability- failing to scale.  This is the risk that I’m most concerned about.  On balance, I think it’s worth taking and the scenario where they fail to execute still results in some M&A value but the execution risk is very real.

·         It’s hard to think about retail without thinking of Amazon and that’s no different here.  Amazon is clearly a threat but there are examples of retailers dominating verticals where Amazon can’t/decides not to compete.  Zooplus, mentioned above, in pet supplies and ASOS in clothing become to mind.  Interestingly, one of AO World’s directors, Brian McBride, is the Chairman of ASOS and was previously the MD of Amazon UK so at least there’s board level insight/expertise there.     

Catalyst

·         Improvement in Calendar Year 2018 Adjusted EBITDA and revenue growth for the UK

·         Third-party sales declining to an insignificant level so they don’t affect UK revenue growth rates

·         Company coming off of £6m annual capex cycle and expects very little going forward