Value Investors Club / Card Factory PLC (CARD:LN)

Description

What I like most about this investment is how easy it is to dismiss in ten seconds. I admit that was my

first reaction.

So do I hear you right? You’re telling me you’ve got a retailer in an economy threatened by Brexit whose

stock gapped down 30%. And they retail greeting cards? They run printing presses? Have you been

asleep for the last 20 years? Yeah, I got a bunch of newspaper stocks for you too – they’re cheap. Get

out of my office.

Everybody knows Amazon must be killing them, and everybody knows greeting cards are bought by

those same old people who buy newspapers. And print…don’t get me started.

If you take the next step (why would you?) you could look at the biggest competitor and see that they are

losing share and closing stores. That confirms it - the business is dying. We’re done, right?

The greeting card business in the UK is indeed being disrupted but not by whom you’d think. Who’s the

disruptor here? Do you buy greeting cards on Amazon? I don’t even though I buy nearly everything else

from them. No, it’s your mother’s birthday in three days so you stop at the store and buy a card. Hmm.

And what about e-cards? Internet “cards” I occasionally get by email on my birthday but it’s still rare

even 15 years after these things started to appear.

What do I know about greeting cards from my admittedly USA experience? They are stupid expensive.

$4, $5 for a printed card and an envelope. Why? Because American Greetings and Hallmark control

distribution and they’re greedy. This is true in the UK as well. Certainly looks like a business asking to

be disrupted.

So once again, who’s the disruptor? In the UK, you’re looking at it – Card Factory. This simple business

with a boring name in a no growth category is running one of the most old fashioned and reliable

disruption schemes I know of. Take market share little by little from high priced competitors in a no

growth industry. It’s working.

Card Factory was founded 20 years ago as one little card store by a husband and wife. They have grown

organically and through a handful of very timely acquisitions (they acquired 80 stores from a bankrupt

competitor in late 2008 and acquired their printer in 2009) to get where they are today. The founders

exited to private equity, and the company came public in 2014. A new CEO started last year who is the

third to run this company. She does not appear to be changing the core strategy of vertically integrate,

gain share slowly, keep prices low.

Card Factory is the UK's leading specialist retailer of single cards (i.e. birthdays, anniversaries, Thank

You, Mother’s day, sympathy…), boxed (Christmas mainly) cards, wrapping paper and gifts. Single cards

is all that matters – that is about 55% of revenues and likely over 75% of profits. They are vertically

integrated and focus on the value and mid-market segments of the UK's single cards market with an

average card going for 99p, which is a fraction of the price charged by competitors. The customer

associates Card Factory with value and quality.

The last market share data we have is 2015 where they had 18% U.K. revenue market share in Single

Cards. This equates to 33% market share in units, demonstrating the price gap against competitors.

The market for single cards has been flat for 10 years. Card Factory’s like-for-like store sales have been

positive every year since the company’s founding. At the same time they have been adding stores year

after year. They currently have about 900 with a stated goal of 1200. 100 new ones seem easy – they just

opened their first few in Ireland which is a future 100 store market.

They are strategically taking about 50-100 bps of share a year without much of a reaction from

competitors. If they were 80% share this wouldn’t fly, but they’re only 18%. Put yourself in the position

of the competitor retailing Hallmark cards, or Hallmark itself. The incumbents selling $4 cards have a

bad set of choices. Strategically they would appear to be in the unfortunate position of somebody with a

fly on a sensitive body part and only a sledge hammer to deal with it. What are they going to do? Cut

prices? As long as Card Factory doesn’t get greedy and try to rush things I think they could grow at 5%

for a long time just taking 1% or so more share a year.

The financials are pretty simple. Through the last reported fiscal year (YE Jan. 2017) you will see over

70 million of free cash flow – while growing store count. There is 140 of debt on the balance sheet,

perfectly reasonable. 22% EBIT margin. ROA in the high teens. If you take intangibles off the balance

sheet there are virtually no net operating assets in the business. The company has historically paid out

virtually all of its earnings as dividends while growing. Beautiful numbers - and simple.

Opportunity: The stock is down over 30% since January and now trades at about 11x earnings.

We believe the sell-off was a response to the updated guidance provided by the company on January 11

which represented their second guide down of margins in six months. They stated that YTD sales are up

5.9% (2.7% comp sales) with sales growth coming largely from non-card categories which are lower

margin (and currency exposed). They guided to 2018 EBITDA of 93-95 mm because FX and wage

inflation will result in 7-8 mm of additional costs in FY19 (2018) which will make EBITDA growth for

the year limited. As a reference point, they generated 98.5 mm of EBITDA in FY17 (2016) and 95 mm in

FY16 (2015). We are not talking about a huge stepdown!

In spite of higher sales, margins have been coming down due to 1) currency, 2) higher wages, 3) general

retail slowdown after Brexit.

Foreign exchange- With approximately half of annual COGS expense relating to products sourced in US

Dollars (not single cards – think Chinese manufactured goods in the rest of the store), a depreciating

pound has hurt them. Though the pound has rebounded, they are hedged so will not see normalization this

year.

Higher Wages – There was a minimum wage increase in the UK. In 1H18 store wages increased from

30.5 to 33.7, a 10.5% increase with revenue only up 6%. While this is a real headwind and permanent

change in their cost structure, the national living wage impact should now be in the numbers.

In the context of Brexit and a minimum wage increase, it is not hard to see why business has slowed a bit

and why there has been some decrease in margins. But this doesn’t look like a company where the

wheels are falling off. If in a year we can see a path to resumption of predictable earnings growth and the

current earnings base of around 0.20/share holds, we see no reason why Card Factory should not trade at

15-16x earnings once again, which would be a more than 50% gain with dividends.

The views expressed are those of the author and do not necessarily represent the views of any other person.

The information herein is obtained from public sources believed to be accurate, reliable and current as of the

date of writing. The author will not undertake to supplement, update or revise such information at a later

date. The author may hold a position in the securities discussed.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.

Catalyst

Earnings growth resumes.

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			2018	2019
Price:	2.03	EPS	0	0
Shares Out. (in M):	341	P/E	11	0
Market Cap (in $M):	975	P/FCF	11	0
Net Debt (in $M):	200	EBIT	0	0
TEV (in $M):	1,175	TEV/EBIT	10	0