Description

Fnac Darty is one of Europe’s largest electronics and appliance retailers, with leading market share in France.  Fnac was originally spun off from Kering in June 2013 (see 8/28/13 VIC writeup) and acquired Darty in April 2016 . While electronic retail is a competitive industry, Fnac Darty has successfully stabilized its revenue base and has a €130m cost saving opportunity from merger synergies.  Current 7.7x EV/EBIT is surprisingly depressed given consistent execution on goals and positive free cash flow over the last several years.

Thesis rests on the following pillars:

1. Significant merger-related cost savings opportunity

2. Low single-digit revenue growth via modestly positive comparable sales, adding new stores via franchisees

3. Dominant ticketing franchise in France, 50%+ market share likely worth €350m+

4. Trough valuation despite solid track record of achievement

Company information

Pro forma for acquiring Darty, Fnac Darty is primarily a French retailer of electronics and home appliances.  This is a strategic improvement from prior Fnac, as the publishing segment is now 17% of revenue (40% pre-Darty) and is in modest secular decline.  Consolidated market share in France also gives Fnac Darty improved negotiating terms with suppliers. They are the key French retail partner for all electronic manufacturers, similar to Best Buy in the US.

A more granular view of revenue by product category shows the reduced impact of categories in secular decline, particularly CD/DVDs and to a lesser extent books.

Fnac Darty has leading market share in each of its categories, which provides a strong negotiating position with suppliers.  As the #1 electronic and book retailer in France with over 20% market share, Fnac Darty represents 20-40%+ of its suppliers’ portfolio, enabling industry leading purchasing terms.

While Amazon is a formidable competitor, suppliers have an interest in having a viable retail alternative to sell their products.  Most prominent manufacturers (Apple, Google, Microsoft, Samsung, etc) have shop-in-shops at Fnac Darty stores. They also collaborate on new product introductions, such as Fnac’s recent 3 month exclusive with Google Home.  

€130m merger synergies

As part of the “Confiance+” plan, released in December 2017, management has identified €130m merger related cost synergies.  This is a key element of achieving 4.5-5% mid-term EBIT margins. Savings will come from:

• Purchasing synergies (benefits of scale noted above in Company section)

• Eliminating dual overhead between companies

• Continuous culture of efficiency

In addition to the opportunities listed driving 4.5-5% target margins, Fnac Darty recently announced purchasing alliances with Carrefour, which could be additive to profits.

Growth opportunity

Fnac Darty is not a high growth business, but they do have some levers to pull to offset the secular declines in publishing and CD/DVDs.

• New store openings are primarily franchise.  Company seeks to double franchise base to 400 stores in the next several years.

• Continue replacing square footage in declining product categories (Publishing) with growing verticals (kitchen, kids, smart home, etc)

• Continue growing loyalty card member base (repurchase rate 2x typical shopper), expand offering outside France

• Experimenting with Fnac shop-in-shops at Darty (and vice versa), kitchen shop-in-shops, implementing best sales and aftermarket service practices between each company

• Continued benefits from French policy changes such as allowing shopping on Sundays, more flexible labor laws etc.

Although revenue should modestly grow, the main reason to own Fnac Darty is EBIT from cost synergies and strategic benefits of merging France’s #1 and #2 electronic retailers.  The aforementioned €130m cost opportunity on a base of €282m LTM 6/30/18 EBIT is substantial.

Ticket business

This is an underappreciated aspect of Fnac Darty, which for some reason the company does not highlight.  Fnac is the leading ticket company in France, akin to Ticketmaster in the US. They no longer break out financials for this business, but several years ago it generated roughly €50m revenue and €15m EBIT.  Since then, Fnac's ticketing market share has modestly increased from 50% to “greater than 50%”, so it stands to reason financial performance has improved. Given ticketing businesses multiples (CTS Eventim is closest comp, 23x EBIT; LYV and EB also attractive), Fnac ticketing could potentially be worth €350m+ in a sale (~€15m * 23x).  Ticketing used to be a traffic driver for stores, but as this business continues to migrate online that aspect has faded. I do not see why it needs to be owned by Fnac Darty if shareholders ascribe little value to it. Ticket businesses have inherent network effects--local markets are very difficult to penetrate, so Ticketmaster or Eventim would likely welcome the opportunity to buy the leading player in France.  If Fnac Darty insists on owning ticketing, they should highlight its value to investors.

Key misconceptions

Electronics retail is a competitive business, but the implied threats may be overstated at current valuation.  Over the last 5 years, Fnac Darty has done an excellent job improving the service offering while reducing costs.  Still, some items of investor concern (and why they should be manageable) are below:

• Amazon will destroy them.  Amazon is a clear threat, but Fnac Darty has stabilized revenue in recent years, largely due to several factors:

• Strong loyalty program, (Fnac+ 7m members total, 5.3m in France pay €49/yr) is a real competitive differentiator.  Fnac+ loyalty membership has grown 75% from 2010-17. Offers free delivery, priority checkout lines, in-store discounts, discounts with partner retailers, among other benefits.  Loyalty members comprised 64% of Fnac FY16 revenue.  

It seems unlikely that a well-capitalized company with over 7m people (and growing) willingly paying an annual membership fee is going to disappear in the near future

• Pricing is also in-line with Amazon after accounting for discounts.

• Invested in online ordering and omnichannel options several years ago, deep infrastructure enables offerings including 2hr delivery in most cities; continue developing capabilities

• Omnichannel is 45% of FY17 online orders, indicating customers find benefits of in store service and pickup

• Renowned service offering at both Fnac and Darty, associates have real product expertise.  End to end service offering (product advice, financing, delivery, installation, warranty, repair, etc) appeals to many customers.  Management doubling down on investment in employee training.

• Fnac is a well regarded cultural meeting point in France.  Stores regularly host concerts, exhibitions and reading events.  1,302 events in FY17 (323 in Paris, 979 in regions)

• Among brick and mortar, Fnac Darty appears best positioned to compete with Amazon.  It trades at a discount to many peers despite being the most advanced online offering.

• Publishing is falling off a cliff.  Although the category is in secular decline, the rate is more modest for books.  France is a more reading focused society than US--e-readers only have 2.5% share, versus estimates of mid/high-teens in the US.  CDs/DVDs are a small and shrinking portion of mix. The company has aggressively replaced selling space with new product categories including toys, kitchen, DIY and others over the years.  This will continue.

The Darty acquisition greatly reduces publishing mix as well as the likelihood of a price war in France, yet Fnac’s multiple has declined since 2016

• Volatile industry.  I do not have great French data, but Best Buy’s investor day slides addressed this general concern.  The data below is for the US market, but should be directionally similar for France. Fnac Darty has economic sensitivity, but electronics have grown faster than many other areas.

Ownership

Fnac Darty is relatively closely held.  Ceconomy (24.1%), SFAM (11.3%), Vivendi (11.0%), DNCA Finance (3.9%), Edmond de Rothschild AM (2.8%), Norges Investment Bank (2.4%).  Ceconomy became a shareholder in July17 when it purchased the Pinault family’s stake for roughly €450m. SFAM is a French insurer and bought an 11% stake in 2017 as an investment.  Vivendi got involved at €54/sh to facilitate the purchase of Darty, and has effectively exited via hedge at €91/sh as of July 2018. SFAM requested a board seat in May 2018, but was denied due to “insufficient time to vet conflicts of interest.”  Given recent share price performance, SFAM or another suitor could re-engage before the May 2019 annual meeting. In recent years, informed shareholders have invested in Fnac Darty at valuations well above the current multiple. Recent share price deterioration has been far in excess of reported results.

This shuffling of the main shareholders may be partly responsible for recent weak share performance, maybe not.  I have not found a great explanation for recent months’ price decline.

Other risks

The fundamental risk is that potential synergies are far overstated.  Although anything is possible, this is unlikely, as they were identified by current CEO Enrique Martinez, who previously ran Fnac’s Iberian Peninsula (2010-12) and subsequently French (2013-2017) businesses.  He is well versed in operations, and I have spoken with Fnac partners over the years that spoke highly of Martinez well before he took the CEO role. Aside from missing cost goals, other potential risks include:

• Amazon becomes more aggressive in France, establishing retail foothold

• Economic weakness / French political turmoil impairs consumer sentiment

• Seasonality, as ~33% of revenue during Q4 holiday shopping period

• Not very liquid relative to size

Competitors

Pro forma for the Darty merger (much lower editorial mix), the business is very comparable to other global electronics retailers, yet still trades at a discount.

Based on the investor presentations and results of peers, Fnac Darty appears to be among the leaders in investing in digital capabilities to transform its business for how people are likely to shop in the future.  This is difficult to quantify, but provides increased confidence in long-term business value and ability to adapt in a dynamic retail environment.

Fnac Darty provides very good detail on the business in its presentations, but Best Buy’s 2017 investor day presentation is also useful for understanding Fnac’s strategy, as they are pursuing a very similar approach.  (http://s2.q4cdn.com/785564492/files/doc_financials/2018/InvestorDay/Investor-Day_Final_Print.pdf)

Valuation

DCF value of €92/sh, assumes 1.5% long-term revenue growth and EBIT margins improving to 3.9% by 2023, using 9% WACC.  By comparison, consensus FY18-20 EBIT margins are 4.3%, 4.6%, 4.7% and revenue 1.4% CAGR. To repeat, Fnac Darty has guided to 4.5-5.0% mid-term EBIT margins.

On an EV/EBIT basis, Fnac is trading at a multiple last seen when Fnac revenue was declining, viability versus Amazon was uncertain and the company faced a strong direct competitor in Darty.  Current multiple below 8x (before expected synergies) is also a discount to BBY 10.1x LTM EV/EBIT.

As mentioned, the above 4.0% EBIT margin is below mid-term guidance of 4.5-5.0% (€90-€102/sh).  

Current EV also includes €151m 6/30/18 pension deficit.  Rate sensitivity is roughly €75m per 50bps.

Lastly, note in valuation: €497m cash balance at 6/30/18 is seasonal trough.  €775m at 12/31/17. Did not adjust to midpoint for conservatism.

Fnac Darty trades at 10% FCF yield.

Optionality

• Consumer spending improves due to benefit from France tax cuts

• Monetize, or otherwise highlight value of ticketing business

• Significant improvement in vendor product innovation (VR, other new segments) driving store traffic

• Improved investor recognition of its strong Marketplace capability (akin to Amazon 3rd party reseller program); company seeks to 3x over medium term

• Monetize consumer data to sell to advertisers as Fnac Darty combined is #2 e-commerce retailer in its markets (19.9m monthly unique visitors)

• Higher interest rates reduce pension obligation

• Aggressively repurchase shares (authorized 10% of capital outstanding)

• Acquired

Conclusion

Fnac Darty is a very well-run electronics retailer with leading market share in France.  At below 8x EV/EBIT, it trades at a depressed multiple with a 100-150bps additional margin opportunity while continuing to aggressively invest in the future.  Fnac Darty is by far the best positioned retailer in France to compete with Amazon and all other online retailers. As the company continues to deliver on its cost targets and increase operating profit, share price should follow.

Catalyst

No specific catalysts, but the company has its Q3 revenue call October 18th.  I will be speaking with company the following week.