Description

*All figures in Australian Dollars*

Overview

          dusk is a vertically-integrated home fragrance specialty retailer in Australia trading at a deep value price of only 3-4 times EV/EBIT with further runway for growth, a proven business model, strong management and culture, and very attractive unit economics. I believe the IPO timing, lack of financial data on financial platforms, and relative lack of investor attention have contributed to this mispricing.

          Initially, you may not think of selling candles and diffusers as a great business but the economics of this business and the execution since management reorganized the business in 2015 is impressive to say the least.  dusk has a multi-year track record of steady like-for-like (LFL) store sales growth (~9-10% CAGR since 2017), a loyal, growing customer base (>56% of revenues come from paying loyalty program members, which grew at 16% CAGR from FY18-20), and expanding operating margins and FCF.  

dusk’s impressive pre-announced 1H21 PF EBIT of $27M and my $10-$13M 2H21 EBIT estimates imply a FY21 PF EBIT of $37-40M and revenue and EBIT growth over FY20 of ~50% and ~300%, respectively. Understandably, the market views this growth rate as unsustainable and the EBIT figure as potentially unrepeatable for FY22 due to the pandemic-aided boost in consumer spending in household comfort products, but at the current price I believe a reduction in EBIT for FY22 is more than priced in. Even though FY21 has experienced strong tailwinds from consumer spending preferences and government stimulus, dusk was firing on all cylinders before any of these tailwinds emerged.  If dusk is able to retain a material portion of new customers and resume it’s prior operating trajectory, I believe shares are still trading at a ridiculously low forward EV/EBIT multiple of 3 or 4x, whereas Fair Value is 10 or 11x EV/EBIT, representing upside of 100%+ in addition to sizable dividend payments, with the potential for further upside with continued execution and/or if the stock re-rates at an even higher multiple.  

In addition to a more than attractive valuation on an EV/EBIT basis, I believe upcoming dividend announcements for 2021 and 2022 could be another catalyst for shares to re-rate higher. Looking past 1H21 due to non-recurring IPO-related costs and the March 2021 dividend announcement only covering 11/1/20-12/31/20, if dusk produces $30M in EBIT for FY22, at a payout ratio at the middle of management’s target of 70%, the dividend would be $.23-.24 per share or an implied yield of about 9%.  Dividend-seeking Australian investors would no doubt jump on an eye-popping dividend yield anywhere near 10%, providing a catalyst for shares to re-rate higher.

I think dusk is a high-quality business selling for a deeply discounted valuation.  I believe dusk has sizable upside based on either relative valuation (4x EV/EBIT vs. 10x for comps), dividend yield (implied yield of 8-10% for NTM), or simply on an absolute valuation basis.  Here are some of the key takeaways:

• Capital-light business with strong FCF

• Attractive unit economics and scalable business model

• Experienced management team with a good track record that didn’t sell any shares in IPO

• Strong culture and pedigree shared with other highly successful Australian retailers 

• Good reinvestment opportunities for at least next 3yrs

• Differentiated business model with high gross margins and flexibility to demand trends

• Attractive valuation on an absolute and relative basis (4x EV/EBIT or 5-6x EV/FCF)

• Tailwinds heading into 2H21 from AUD/USD exchange rate

Reasons for mispricing

• IPO completed just prior to the holidays (Nov 2020) when prevailing sentiment with vaccine news was overwhelmingly positive and a sense that pandemic-related buying trends would quickly subside

• Financials not showing up yet on Factset, Bloomberg, CapIQ, and other platforms

• Incredibly strong trading update for 1H21 showing further acceleration of pandemic-related spending trends released right around Christmas

• No explicit dividend announcement, only target payout ratios provided in prospectus

• Uncertainty around where post-pandemic normalized revenues will land
  

Financials

dusk’s revenues are seasonal with roughly 60% of annual sales occurring in the July-December half year and 40% occurring from January-June.  Within each period, Christmas and Mother’s Day are both important holidays which generate a large portion of revenue.  dusk has grown Revenue from $74.4M in FY18 to $109.9M in LTM Sep20F as seen below.  The key drivers of revenue growth are net store openings, growth in existing store sales (both from volume and average transaction value (ATV)), and growth in online sales.  Prior to COVID-19, LFL sales growth was driven roughly equally by growth in ATV and growth in transaction volumes.  Since dusk reopened stores in May 2020, the majority of LFL sales growth has come from increased transaction volume. dusk’s rewards program data indicates the main reason for the growth after May 2020 is new customers and they’re seeing this trend continue.  This is encouraging for the sustainability of these revenues going forward because the more of these new customers dusk can keep the greater portion of these new revenues they’ll be able to maintain.

Due to dusk developing all of their products in-house and having them produced by Chinese contract manufacturers, they generate very healthy gross margins of roughly 65%.  Notably, they’ve been able to maintain roughly 65% gross margins by negotiating for volume discounts and implementing select price increases despite the majority of their COGS being in USD and the AUD depreciating against the USD steadily from FY18 to FY20.  This AUD/USD headwind has recently turned into a tailwind since mid-2020 as seen in the 3yr chart below.

If this tailwind persists, gross margins could easily tick up to 67% going forward.  Although full 1H21 financials haven’t been released yet, SG&A growth has lagged revenue growth each year leading to good operating leverage, which should only accelerate for FY21 ignoring non-recurring IPO-related costs.  Considering dusk’s vertically-integrated model and their comparable peers, I think a 20-25% normalized EBIT margin is sustainable as they continue to scale.

dusk is a highly cash-generative business as well with EBIT being converted to FCF at a very high rate, only reduced by the relatively small net capex needed to open new stores or upgrade existing stores.  Because of this, cash has already started to quickly build on the balance sheet with their net cash balance at $33.5M on 12/31/20 and no debt.  The latest Pro forma balance sheet provided with the prospectus contains lots of adjustments with pre-IPO dividends, IPO costs, and some WC adjustments so the first post-IPO balance sheet released with 1H21 earnings should be much cleaner, but the fact they ended 12/31/20 with $33.5M in cash despite having only $5M in cash per the 6/28/20 PF BS shows both how great 1H21 results were and how quickly EBIT is converted to FCF.

Valuation

I believe EV/EBIT is the best metric for valuing dusk, as EBITDA will be misleading going forward due to new lease capitalization accounting treatment of capitalizing and depreciating leases.  If dusk is valued on an EV/EBIT basis on estimated FY21 EBIT of $37.8M and EV of $130M (mkt cap of $163M less $33.5M net cash), the multiple is a ridiculous 3.4 EV/EBIT.  But I think it’s reasonable to look to FY22 where the revenues should normalize and pandemic-related buying patterns return to a more normal state.  If FY22 revenues drop by 10% from $150M for FY21 to $135M for FY22, I think dusk could still earn $28-30M, and the EV/FY22EBIT multiple would still only be 4.3x. I think fair value for DSK is 10 or 11x EV/EBIT based on the below comparables and the quality of their business and growth prospects.  Please see page 9 and 10 for further discussion of my estimates for FY22 and a more detailed model. 

I think dusk’s short history as a public company and a simple lack of awareness are the main reasons for the depressed valuation among other factors.  Some of these factors include: 

• IPO completed just prior to the holidays (Nov 2020) when prevailing sentiment with vaccine news was overwhelmingly positive and there was a sense that pandemic-related buying trends would quickly subside

• Financials not showing up yet on Factset, Bloomberg, CapIQ, and other platforms

• Incredibly strong trading update for 1H21 showing further acceleration of pandemic-related spending trends released right around Christmas

• No explicit dividend announcement, only target payout ratios provided in prospectus

• Uncertainty around where post-pandemic normalized revenues will land

Australian Specialty Retailer Comparables

Some quick notes on the above comparables:

• SSG: an Australian specialty retailer of personal grooming products.  It’s obvious why they’ve likely experienced strong tailwinds from COVID-19 but also seems obvious to me they will face massive headwinds going forward as people return to their now even more beloved hair-styling professionals.

• LOV: Lovisa is a fast-fashion jewelry retailer in Australia as well as Europe, NA, and Asia.  They haven’t experienced as strong of a pandemic bump but the market seems happy to look past current headwinds as their business should rebound quickly as consumers begin socializing again.  LOV has also earned much higher multiples by showing it’s model can expand internationally outside of Australia and NZ and with very attractive GMs.  Perhaps in a few years if international expansion begins to work, dusk could attain a similar multiple re-rating.

• ADH: Australian home furniture and homewares retailer.  I think ADH is the best comparable to DSK but there are still some key differences in vertical integration and capital needs.  ADH has also enjoyed strong tailwinds from COVID-19 due to the nature of their products, but unlike DSK their products seem more likely to be one-off purchases whereas many of DSK’s products have a consumable quality and are more likely to be repurchased.  I’d be willing to bet DSK will fare better than ADH post-pandemic.

Business

dusk’s largest product categories are candles, diffusers, mood reeds, and homewares which are all developed in-house and their retail locations are in suburban malls across Australia (118 locations as of 11/13/20).  85-90% of revenues come from physical stores (all of which are profitable and new stores have a ridiculous payback period of

While prevailing sentiment has mostly soured on physical retail, I believe dusk’s category of home fragrance products are more effectively sold in a physical retail setting vs. online.  Not surprisingly, customers like to be able to smell and visualize how a product will fit in their home and may value guidance from store staff in selecting the right product or fragrance.  Also, dusk’s products are often purchased just-in-time for gifting or personal indulgence where immediate satisfaction is valued by the customer.  Due to the unique nature of their products, rather than being a threat, I see online sales as a complimentary channel where customers can initially browse and select products in store and follow-up with refill or similar fragrance products online based on their prior experience and taste.  Importantly, dusk’s products and fragrances can only be purchased through dusk in-store or online, they don’t sell through any third parties.

I believe dusk has a strong culture which has been influenced by their connection to BBRC and Catalyst, which I discuss further below.  As a retailer of home fragrance products which can be purchased in a variety of formats: department stores, local retailers, online, etc. I think dusk’s culture and focus on the customer is what sets it apart.  Like ADH, dusk’s customer loyalty program (“dusk rewards”) is an important part of this, customers pay $10 for a 24-month membership that includes exclusive offers and discounts.  Not only is this a nice stream of high margin revenue, but it provides dusk with valuable customer data, enabling them to quickly adapt to consumer tastes and take full advantage of their vertically integrated business model.

dusk’s CEO, Peter King, implemented a significant transformation in 2015 by closing its own Australian manufacturing operations and outsourcing production to suppliers in China as well as outsourcing warehousing and distribution to a third-party.  The dusk rewards program and online channel were both relaunched and re-engineered during this transformation. 

By outsourcing manufacturing and logistics, dusk’s capital needs were greatly reduced and more focus could be directed towards effectively opening locations as well as understanding and providing superior value to the customer. Thanks to this capital-light business model and successfully negotiating an increase in landlord contributions, dusk’s typical store opening requires capital of around $210,000 and has an average first year contribution of $281,000, for an impressive payback period of less than 12 months.

In addition to the attractiveness of new store locations, dusk’s existing stores average FY20 store contribution margin was about $320,000 per the prospectus and each has a well-incentivized store manager and assistant store manager as well as seasonal employees as needed.  Store managers’  incentive pay is tied to dusk rewards member sign-ups, leading to 1 in 5 customers joining. As outlined by management, a total of 150-160 stores is likely the “ceiling” for the Australian and NZ market which translates into a roughly 33% greater total store footprint than they currently have, so likely a few more years of opening 10 stores per year which is about the same pace as FY18-FY20.  I don’t like to forecast too far into the future, but with reasonable LFL sales growth, growing online sales, and 30 additional stores, it’s not hard to imagine dusk producing $180M in sales and $45-50M EBIT for FY24. 

Competition

dusk’s competitors are mostly either small independent candle shops, online home fragrance companies, or large department stores.  With nearly 25% market share of the Australian home fragrance market, dusk has established itself as the largest, most organized, and most recognizable brand in the space.  I also think their business model has distinct advantages over their competitors and now that their brand is established, it would be tough for anyone to supplant them.  The small independent candle shops lack the scale to effectively source product at low costs as compared to dusk and making the jump from an independently-owned candle shop to multi-store chain would require significant investments in overhead and developing a successful scalable business model.  dusk’s larger competitors, department stores, are not focused on this segment and are dealing with countless other issues stemming from changes in consumer spending behavior.  Their burdensome cost structure and outdated value-proposition as compared to online shopping likely means they will continue to struggle.  Online home fragrance retailers and general online retailers like Amazon will be able to carve out a niche in the home fragrance space but lacking the ability to have customers evaluate different products in-store is a key weakness in selling a product that is typically purchased on impulse, personal indulgence, or just-in-time as a gift.

One very interesting comparable business I came across when trying to think of a small footprint specialty retailer here in the US located in suburban malls is Bath & Body Works (“BBW”).  L brands’ (NYSE: LB) two remaining flagship brands are Victoria’s Secret and BBW and based on their pre-pandemic plan to sell Victoria’s Secret for only $525M vs. LB current EV of ~$20B, the value of BBW is over 90% of LB’s total value.  Since it’s not a standalone public company and it was more of a household name 10-20 years ago, it’s easy to overlook how great of a business it is.  Despite largely saturating the US market years ago and limited international expansion, BBW has continually delivered revenue and operating income growth over the past 5 years as seen from the slide to the left in their latest investor presentation.  Interestingly, one of their most successful product categories over this time period has been home fragrance products. 

        I think BBW is a valuable example of how good of a business even a mature specialty retailer with brand recognition can be over the long-term.  I won’t argue dusk’s brand recognition is anywhere near BBW, but investors are able to purchase dusk at an earlier stage in its growth cycle, albeit in a smaller market, with similar and perhaps better unit economics, because of their vertical-integration, at only 3 or 4x EV/EBIT vs. an EV/EBIT of 16x for BBW.

Future Expansion

The growth picture beyond the Australian and NZ market is cloudier but management is evaluating potential english-speaking foreign markets where they could initially enter with a beachhead strategy before expanding further.  Although dusk hasn’t expanded outside Australia or NZ, some of the other BBRC-connected retailers have successfully entered foreign markets including the UK, US, and elsewhere.  I believe dusk management will be able to take advantage of their connections and knowledge through other BBRC-related retailers in order to increase their likelihood of success in expanding outside Australia and New Zealand.

Another potential complementary product for dusk that is only briefly mentioned in the prospectus is cannabidiol (“CBD”).  Just recently, Australia passed legislation to allow the sale of CBD products with the oversight of a pharmacist and without a prescription.  Dusk likely won’t be employing a pharmacist in each of it’s locations just to sell a little CBD oil, but management is reasonably confident Australian regulators' next step will be to loosen regulations further in the next couple years which could allow dusk to sell CBD oil or other CBD-related products in their stores. CBD oils would fit in very well with their other wellness-centric product offerings and could lead to a material increase in ATV or foot traffic to their locations that would further increase customer acquisition.

I also appreciate dusk management keeping relatively quiet about the potential of adding CBD as a new product category as they could easily increase short-term interest in the stock with fluffy press releases around potential CBD products.  They’ve already met with CBD suppliers and have deals ready to sign so they can act quickly if/when legislation passes. This, along with the rest of my due diligence, leads me to believe management prefers to underpromise and overdeliver.

Management

 Total insider ownership is about 42% with management holding about 10% and Catalyst and BBRC holding the remaining 32%.  Peter King (4% owner) has been dusk’s CEO since 2014 and has a background in senior leadership and product development with Australian retailers and most recently as Marketing Director at Levi Strauss.  Interestingly, while at Levi Strauss, Peter worked closely with Nick Coe, Bath & Body Works’ CEO from 2011-2020.  dusk’s other management team members and directors include:

• John Joyce (Chairman, 4% owner): experienced in senior management roles across a range of retailers including CEO of Rebel group and Managing Director at Aldi.

• Trent Peterson (Director): PE and investment management experience. Managing Director of Catalyst Investment Managers and is also a director of ADH and SSG.

• David McClean (Director, 2% owner): former CEO of ADH from 2002-2016, still a director at ADH. 

• Kate Sundquist (CFO since 2017): experience as CFO at two other retailers and controller at Philips Lighting and Finance Manager at GE.

While most of the information on management is limited to the prospectus, as dusk has only been public for 3-4 months, their track record to-date has been impressive especially since Peter took the helm in 2014.  Importantly, their board of directors has valuable experience in the Australian retail sector, specifically with fellow BBRC holding Adairs (ADH).

Culture and Background

dusk was founded in 1999 as a home fragrance specialty retailer and was acquired by Brazin Ltd in 2004, when it had 41 stores.  In 2006, Brazin Ltd was taken over by BBRC, the private investment company founded by Australian billionaire retailer Brett Blundy.  Blundy and BBRC’s track record in Australian retail is impressive and revolves around a strong culture and strategy found among their many current and former holdings:

• Lovisa (LOV) (BBRC holds 40%): Leading fast fashion jewelry-retailer with over 400 stores across Australia, New Zealand, Singapore, Malaysia, South Africa, Spain, France, the USA and the United Kingdom.  Lovisa also has a vertically-integrated business model to enable quick responses to changing customer trends, through which it develops, designs, sources, and merchandises 100% of its Lovisa branded products.  Prior to the pandemic, Lovisa grew revenues 15-20% per year and more than doubled EBIT since 2015. LOV had FY19 sales of $250M, GMs of 75-80%, a current EV of $1.4B, and FY19EBIT of $53M for an EV/EBIT multiple of ~26x if we assume the market is willing to look past any negative impacts for FY20 due to the pandemic.

• Adairs (ADH) (BBRC holds small position): Australia’s leading specialty omni-channel retailer of home furnishings in Australia and New Zealand (160 locations) with a differentiated proposition combining on-trend fashion products, quality staples, strong value and superior in-store customer service.  BBRC purchased a majority stake of ADH in 2007, with Catalyst (a PE firm and common partner of BBRC) acquiring a majority from in 2010, and ADH IPO’d in 2015.  Adairs has an important customer loyalty program called “Linen Lovers”, in which members pay $19.95 for a 2-yr membership that provides exclusive offers, discounts, and events. Adairs has grown revenues 5-20% per year and nearly doubled EBIT since it’s 2015 IPO.  ADH sports GMs of 57%, an EV of $800M, and FY20EBIT of $62M for an EV/EBIT multiple of ~13x.

• Sanity (previously privately owned by BBRC): Blundy built Sanity into Australia’s largest music retail chain from a single store in Melbourne in the early 1980s with a strong focus on great service and great value.  Blundy’s most important principle he drilled into all of his staff is the customer comes first, always. 

• Bras N Things (privately owned by BBRC): specialty retailer of women’s lingerie and sleepwear founded in 1987 by Blundy and others that is now Australia’s leading lingerie retailer with over 170 stores in Australia, New Zealand, and South Africa. 

The common values of BBRC’s businesses are outlined in a 2016 BOSS cover story on Blundy and seven of his proteges as “Blundy’s 10 Cultural Commandments”:

1. CAN DO ATTITUDE

2. CUSTOMER SATISFACTION AND PERFECT SERVICE

3. RESPECT

4. CONTINUOUS IMPROVEMENT

5. COMMUNICATE, COMMUNICATE, COMMUNICATE

6. COSTS ARE THE ENEMY

7. ACCOUNTABILITY

8. TEAMWORK

9.  TRUST

10.  INTEGRITY

Estimates for FY22

With some basic modeling, an estimate of 2H21 results, and assumptions for FY22 revenues including a 20% sales drop, 10% sales drop, and 5% sales increase, I’ve included an estimate for where FY22 financials could land.  I consider estimate B most likely but the uncertainty coming off such a strong FY21 as to where the top line could land is definitely high.  But I think the current valuation gives more than enough margin of safety to accept this uncertainty and realize the probabilities of where FY22 may land certainly skew towards a drop in sales, I think a drop in sales of over 20-25% is unlikely.

• Downside case: For FY22 Estimate A, I’m projecting a drop in sales of 20% from projected FY21 sales, little to no benefit from AUD/USD tailwinds, and a slightly lower SG&A presuming there is some room for cost containment if sales were to in fact drop 20%

• Base/Slight upside case: For FY22 Estimate B, I’m projecting a drop in sales of 10% from projected FY21 sales, slight benefit from AUD/USD tailwinds, and SG&A roughly in line with prior-year trends.

• Upside Case: For FY22 Estimate C, I’m projecting an increase in sales of 5% from projected FY21 sales, a larger benefit from AUD/USD tailwinds, and SG&A roughly in line with prior-year trends.

On the surface level, I think it’s easy to say when pandemic-related buying trends subside, home comfort-related products will experience a drop in demand and therefore dusk’s revenues will suffer, but on the other side of the coin, there are factors working in dusk’s favor that will help dampen that drop in demand going into FY22:

• 20 of dusk’s stores in Melbourne (17% of their store total) were closed for almost 3 months in 1H21 (8/2-10/26), barring more unforeseen circumstances, dusk should have all stores open for the entirety FY22

• dusk’s target is to open 5 more stores by mid FY22, store openings are usually targeted to occur prior to Christmas, their strongest period.

• dusk is rolling out a new e-commerce platform in April 2021, Magento.  This new platform will allow subscription-based purchasing for candles, oils, and other consumables and will help dusk better organize and efficiently use the rich data from their dusk rewards program.

• While it’s no guarantee the AUD/USD tailwinds remain for FY22, as it stands the AUD/USD exchange rate should be a nice boost to FY22 gross margins.

Conclusion

Overall, I think dusk is a high-quality business selling for a deeply discounted valuation.  I believe dusk has upside of >100% based on either relative valuation (4x EV/EBIT vs. 10x for comps), dividend yield (implied yield of 8-10% for NTM), or simply on an absolute valuation basis.  Given high equity valuations across the world, dusk’s simple to understand business model, excellent profitability and cash flow, and attractive valuation on either a relative or absolute basis present a refreshingly straightforward opportunity with an asymmetric risk/reward.

Risks

• Changes in product mix due to consumer demand trends could help or hurt ATV and are hard to forecast

• Excess cash on the balance sheet could be misused for an acquisition that turns out to be a bad fit

• Although it won’t happen overnight, a well capitalized and organized competitor like Bath & Body Works could enter the Australian market and begin to take market share

• Further expansion in New Zealand or in other jurisdictions could fail

Catalyst

I believe once financial data starts showing up on screens and there is more widespread investor awareness to the opportunity the relative undervaluation will begin to close. In addition, I believe upcoming dividend announcements for 2021 and 2022 could be another catalyst for shares to re-rate higher. Looking past 1H21 due to non-recurring IPO-related costs and the March 2021 dividend announcement only covering 11/1/20-12/31/20, if dusk produces $30M in EBIT for FY22, at a payout ratio at the middle of management’s target of 70%, the dividend would be $.23-.24 per share or an implied yield of about 9%. Dividend-seeking Australian investors would no doubt jump on an eye-popping dividend yield anywhere near 10%, providing a catalyst for shares to re-rate higher.