Description

ScS Group plc (“ScS” or the “Company”) can currently be purchased for 10x headline (current year) EPS. Net of £1/shr of net cash, the shares trade for 5x current year EPS. The Company is growing, on both a LFL basis and with respect to overall square footage, and generates ridiculous returns on capital w/ROICs around 40% and ROEs approaching 30%. The dividend yield is 7%.

The business is not without risk. This is a U.K-based consumer facing retailer. Comps have slowed in recent reporting periods. The Company went through a bankruptcy proceeding during the global financial crisis. This is a micro/small cap with average daily trading volume of US$500k. However, in my view, these risks are more than priced into the stock, and with a recent upswing in the share price and a new house broker, the liquidity constraints may become incrementally less restrictive.

ScS sells sofas and flooring (roughly 90/10 split, respectively) from 100 retail locations across England. In addition, the Company operates 28 sofa department concessions within House of Fraser locations. The Company’s roots were as a family-run business in the northeast of England. Nationwide expansion began following an MBO in 1993. The Company was taken public in late 1997, and by 2007 the store base had grown to 95 nationwide. Current CEO David Knight came on board in 2002. The Company went through a bankruptcy in 2008, subsequently emerging following a capital infusion from Sun Capital. The business was re-IPOed in 2015, and notwithstanding some interim volatility since then, the current share price has meandered between 140p and 240p, despite continuous marked improvement in the underlying financial performance.

ScS’s bankruptcy is worth discussing, as it didn’t follow the traditional playbook (overly aggressive expansion, excessive leverage, etc.). ScS runs a negative working capital model. The majority of sales are made-to-order, so ScS typically collects an upfront deposit from the customer and then transmits the order to one of its suppliers. The supplier delivers the sofa, ScS collects the balance due from the customer, and then ScS typically pays the supplier 1-2 mos later. While this model is great for ScS from a cash flow and ROIC standpoint (since suppliers and customers are funding the working capital), it is not ideal for the suppliers as they are required to effectively finance the manufactured unit until they receive payment from ScS. Most of the suppliers fund this working capital requirement through a form of credit insurance, i.e. discount factoring. As the financial crisis reached its nadir in 2008, the credit insurance lines were withdrawn, leaving the suppliers unable to fund their businesses. ScS had a supplemental £10mm pound credit line with Barclays, and turned to this line to bridge the liquidity squeeze; however, when they went to draw the line down Barclays effectively pulled it, pushing the Company into bankruptcy. At this point, Sun Capital stepped up with a capital injection of £20mm as part of a prepack, and in return got 90% of the equity. The existing management team (which was retained) got the remaining 10%.

Since emerging from bankruptcy, ScS has made a few changes to the operating and financing model in order to minimize the risk of a repeat of the 2008 liquidity squeeze. First off, they have lowered overall supplier reliance on credit insurance. In 2008, sales were £188mm and the aggregate credit insurance was £22mm (12% of sales). Currently, with a sales run-rate of £350mm, aggregate credit insurance is just £15mm (4% of sales). So, overall exposure to this financing channel has been reduced drastically. In addition, the Company now has a committed £12mm credit line. In combination with the reduced reliance on credit insurance, management feels confident that they have enough finance access to carry them through a downturn of similar scale to what occurred in 2008.

ScS’s customer focus is firmly on the low-to-middle segment of the upholstered furniture (sofas, chairs) and flooring market. The Company’s customers are price sensitive, and both marketing and advertising is designed to ensure that customers know they are getting a good bargain. The Company gets strong customer satisfaction ratings, and is the only 5-star (Trustpilot) rated sofa or flooring retailer in the U.K. Historically, the business was focused on private label merchandise, although in recent years it has begun to expand its branded offerings from manufactures that include La-Z-Boy and Parker Knoll. ScS has a diversified supplier base, and in most cases is the top customer for its suppliers. It works closely with suppliers on both product sizing and design, in order to ensure that input costs allow for it to deliver products within a price range that makes sense for its retail customers. Retail locations are generally outside of central urban areas in order to keep rents reasonable.

Management believes that there is room for at least another 20 retail locations in the U.K., which provides a growth trajectory for the next five years. Comparable store sales have been impressive, and with one exception have consistently comped positive since the Company re-IPOed in 2015. The only negative comp over this period was in the back half of fiscal 2017 (a 0.7% LFL decline): a half-year period during which it was lapping a prior year comp of +21%. There has been some market concern recently over general U.K. consumer weakness resulting from Brexit; a trend confirmed in recent months by competitors Carpetright and Debenhams. However, the Company’s recent trading statement confirmed that it continues to post positive LFL sales in the most recent 26-week period, and it appears that it may actually be benefiting from broad consumer weakness as higher end customers trade down into the ScS target market.

The Company’s House of Fraser concessions provide an additional avenue for growth. The ScS/House of Fraser relationship was initiated in 2013/14. House of Fraser is a higher-end department store, and ScS has been rolling out management of furniture and carpet departments within House of Fraser locations. This gives ScS an opportunity to drive growth in a capital efficient manner, while also providing it with an avenue to migrate part of its business upscale. The House of Fraser business has now turned EBITDA positive, and should be a tailwind for consolidated operating margins going forward. As a result of ownership changes, there has been meaningful management turnover at House of Fraser in recent years. This has led to a lack of focus from House of Fraser management with respect to the ScS relationship. A permanent CEO was recently appointed at House of Fraser, and ScS management has noticed a distinct positive change in the tenor of the relationship. Moreover, somewhat volatile House of Fraser comp performance has turned positive in recent weeks.

ScS is covered by three sell-side brokers. Their estimates are simplistic and, in my opinion, overly pessimistic. Consensus has top line growing 3% per annum over the next few years, with operating margins flat. The Company should be growing its store base by at least 3% per year (3-4 new locations), so a 3% aggregate top line growth projection implicitly assumes no like-for-like growth, and gives no credit for potential new House of Fraser concessions. An assumption of flat operating margins is likewise conservative. Over the past two years, management has expanded operating margins from the mid-2% range to the mid-3% range. Admittedly, British pound volatility has the potential to drive gross margin headwinds to the extent the pound depreciates meaningfully, because although ScS sources much of its product from within the U.K., many of its suppliers do indeed source product internationally (particularly from Asia). However, as mentioned previously, management works closely with suppliers to modify product designs in order to ameliorate these headwinds. Moroever, operating expense levels should continue to be leveragable and, in fact, the Company currently has multiple technology initiatives underway to streamline both the sales (POS) effort, as well as internal order flow, which to-date has been largely paper-based. Management believes that they should be able to improve EBITDA margins by roughly 100bp (from currently 5% level) within the next 1-2 years. To the extent they achieve this, it would obviously have an outsized positive impact on earnings.

Operating management is solid. CEO David Knight has been with the company since 2002. Although he was at the helm when the Company declared bankruptcy in 2008, I consider the circumstances around that to be fairly unique, and am comfortable that the risk mitigation they have subsequently put in place limits the likelihood of any recurrence. CFO Chris Muir has been on board since 2016. I have found him to be both capable and responsive. In aggregate, the senior management team owns over 5% of the outstanding equity. Executive Directors of the Company are required to build and maintain a shareholding equivalent to 100% of base salary; this is a fairly progressive (i.e. shareholder-friendly) requirement by U.K. standards.

There are a few soft catalysts that I believe could ultimately help move ScS shares in the right direction. The Company recently changed its house broker from Investec to Shore Capital. With a market capitalization of just £85mm, it was difficult for the Company to get the attention that it needed from Investec. Shore is more focused on small cap names, and should be better positioned to introduce ScS to potential new investors. I also expect that we could see some combination of an increased regular dividend, as well as a possible special dividend, over the near-to-medium term. Management’s recent trading update implies that earnings should continue to progress favorably, and even fairly draconian downside assumptions would imply that the Company is currently overcapitalized.

Sun Capital continues to own over 40% of ScS today, after having sold a bit over half of their original stake in the IPO. With the 10-year anniversary of their investment approaching, it is worth considering when and if they make look to liquidate their remaining stake. It’s possible that the recent share rally might make Sun more amenable to exiting their position. Although Sun has deep expertise in the retail sector, they have not historically been particularly active in the U.K. As such the ScS investment is something of an outlier for them. While an announcement of Sun’s departure would likely initially be met with a negative share price reaction, I believe that it would ultimately be a positive as liquidity is likely a major driver of the shares’ persistent discount to intrinsic value. What’s more, given the size of Sun’s holding and the requirements for insider share sales in the U.K., any sale is likely to be a managed offering. This minimizes the likelihood that Sun simply sits on the offer for an extended period, liquiditing their stake in slow motion and keeping a lid on the stock.

ScS’s outsourced manufacturing model, as well as the aforementioned negative working capital cycle, make it extremely efficient from a capital investment perspective. As a result, ROICs are around 40% and ROEs around 30%. Note that these returns assume that a majority of the cash stays in the Company to provide a combination of downside protection in the event of a downturn, as well as peace of mind for the Company’s suppliers. In addition, the negative working capital cycle ensures that free cash flow typically exceeds reported net income. Current sell-side consensus has the Company doing £0.23/shr for fiscal 2018 (year ending Jul 2018) and £0.24/shr for fiscal 2019. I expect both revenue and margins to come in ahead of the low bar set by the sell-side for 2019, driving EPS towards £0.26. At today’s price of £2.27/shr, ScS trades at 10x current year EPS. Net of £1/shr cash, this multiple drops to 6x. On an EV:EBITDA basis, ScS trades at 3x. ScS’s closest public competitors, DFS Furniture plc, by contrast, trades at an 11x P/E and >6x EV:EBITDA, despite showing deteriorating financial performance (i.e. both EBITDA and earnings are declining), carrying a levered balance sheet, and posting far inferior returns on invested capital.

Over time, I expect that ScS’s strong performance and attractive valuation should help the Company garner a better trading multiple. In the meantime, shareholders are being paid a 7% dividend as value continues to accrete to the equity.

Catalyst

Continued SSS growth, margin expansion, additional House of Fraser concessions, special dividend