Description

EXECUTIVE SUMMARY:

• Buy SPLS 10.75% Senior Unsecured Notes due Apr-27 (ZS0031519) in 78c area
• B2B distributor of Office Supplies (46% of revenue) and Pro Categories (54%), mostly in the US  >>>  SPLS has NO RETAIL STORES
• After a steady multi-year rebound from Covid-lows, fundamentals are poised to reach “refinanceable” levels in the next twelve months
• SPLS’ PE backer (Sycamore) is strongly incentivised to support their investment if needed, and has been buying these bonds on the open market
• 45% total return (35% YTC) if refinanced at par one year prior to SSN due Apr-26 (ZS0031501)
• 13.8% current yield while waiting
• Attaching at 4.5x (FY24E), detaching at 5.5x  >>>  expect this to be down to 4.3-5.3x in the next twelve months
• The 7.5% SSNs due Apr-26 also look like attractive risk/reward from here
• 7.9% current yield and 12.7% YTC if refinanced at par one year prior to maturity
• Attaching at 0.0x, detaching at 4.5x (FY24E)

THESIS:

• Earnings are growing

• Business hit hard by Covid (supply chain issues, operational disruptions, demand decline)
• Having fallen from a pre-Covid high of $1.006bn in FY19, Adj. EBITDA bottomed in FY20 at $573m and has since steadily rebounded
• Adj. EBITDA +20% / +20% / +9% YoY in FY21A / FY22A / FY23E
• GM only reached “normalized” levels in 3Q23
• At 3Q23, management guided $70m of cost actions executed and another $30m of additional opportunities (i.e. $100m of EBITDA upside in NTM from cost saves, o/w 70% already executed)
• 3Q23 LTM Adj. EBITDA was $875-880m
• Annualization of cost initiatives and GM normalisation should underpin earnings momentum over the next twelve months
• We have NTM EBITDA at $970m
• Management have communicated that they see a path back to $1bn+ Adj. EBITDA

• FCF outlook is healthy

• Expected EBITDA growth combined with stable capex, interest, tax and other should drive $150m+ of FCF generation in FY24
• We expect SPLS to remain FCF generating beyond FY24

• Leverage is coming down

• Secured-Unsecured leverage peaked at 7.5-9.3x in FY20
• Since then, it has steadily declined to 6.2-7.7x / 5.3-6.4x / 4.8-5.9x in FY21A / FY22A / FY23E
• Combination of FY24 EBITDA growth and FCF generation should take Secured-Unsecured leverage to 4.3-5.3x in FY24E

• Positive outlook is underpinned by substantial element of recurring revenue

• SPLS often sells to customers through multi-year contracts
• 70% of revenue has a recurring element
• Within this recurring revenue, SPLS has 95% annual revenue retention
• Another 15% of revenue comes from certain services (e.g. managed printing) where SPLS has also historically achieved 95% retention rates

• SPLS should reach “refinanceable” levels in the next twelve months
  • 4.3-5.3x Secured-Unsecured leverage
  • >2x interest coverage
  • >3% FCF : Net Debt yield
  • Line of sight to another 0.25-0.5x deleveraging in subsequent twelve months (FY25)
• By end FY24 we think the following credit metrics are achievable:
• Based on our experience in credit markets, we believe that these metrics (combined with business momentum) should unlock the HY / Leverage Loan markets for a regular-way refi in H2’24 / early 2025
• At 3Q23, management communicated H2’24 as their target refi window and have guided ~5.5x as target total leverage for a refi

• Value covered - we believe SPLS is worth at least 9x EV : EBITDA, and see upside to that

• By comparison, the SUNs are attaching at 4.5x, detaching at 5.5x 
• We expect this to be down to 4.3-5.3x in the next twelve months
• Key Office Supplies competitor GWW trades at 16.9x EV : FY24 EBITDA
• Many other distributor businesses (listed peers and precedent M&A) trade at >9-10x (e.g. see 3Q23 company presentation, p28)
• ODP trades at 6.3x EV : FY24 EBITDA but we see that as a downside case / floor given their substantial retail exposure
• ODP has 980+ retail locations
• Meanwhile, SPLS has no retail stores

• Sponsor likely to support a refi (although we don’t expect that this will be needed)

• Sycamore bought SPLS in 2017, injecting $1,555m equity at the time
• We estimate that Sycamore has since reduced its cash equity exposure to $84m
• In doing so, they have successfully de-risked and created significant optionality for themselves
• Sensitizing equity values at various EV multiples and EBITDA levels shows Sycamore’s significant asymmetry:

• If our EBITDA and EV multiple assumptions are remotely right, then Sycamore appears to own a very valuable option in SPLS
• Our base case is that SPLS will be “refinanceable” in the next twelve months, even without an equity injection from Sycamore
• However, a 0.5-0.75x equity injection likely guarantees refi execution in 2024 / early 2025
• This would be a reasonably immaterial amount for Sycamore relative to their potential equity upside
• Injecting $0.5-0.7bn to protect $3b+ of potential equity value seems compelling to us
• If getting a regular-way refi does require an equity injection, we expect that Sycamore will be willing to provide one
• Note: in the last year or so Sycamore have been buying SUNs themselves, which they would be able to equitize to facilitate a par refinacning (similar to what the sponsors did in Brand Industrial)

BUSINESS:

• B2B distributor of Office Supplies (46% of revenue) and Pro Categories (54%) – mostly in the US
• Founded in 1986, bought by current owner Sycamore Partners in 2017
• This is not a retail operation (that was carved off into a totally separate company in 2017)
• SPLS has NO retail stores
• Office Supplies: notebooks, pens, paper, ink & toner etc
• Facing modest secular decline due to declining usage rates and digital shifts
• Pro Categories: janitorial / sanitation, breakroom supplies, tech, furniture etc (GDP grower)
• GDP grower, many categories considered non-discretionary
• Was just 38% of sales in 2013, 47% in 2018 and now 54%
• 70% of revenue has a recurring element, selling through multi-year contracts (achieves 95% annual revenue retention on this)
• Pre-Covid: 22% Gross Margins, 9%+ Adj. EBITDA margins and 30%+ ROIC
• Serves 50%+ of Fortune 100 and 200k+ mid-market businesses
• Customer relationships often structured via multi-year contracts or annual membership programs
• Top 10 customers historically <4% of sales
• Top 100 customers historically <11% of sales
• No industry exposure >15% of sales
• Operates 35 FCs and employs 3k+ sales associates
• Core strategy is to consolidate fragmented market and grow organically in Pro Categories
• Office Supplies competitors: ODP, WB Mason and 1.5k+ regional re-sellers
• Pro Categories competitors: WW Grainger, long-tail of regional re-sellers

RISKS:

• US Recession

• Customer base primarily comprises SMEs
• An economic downturn could lead to demand decline which could negatively impact SPLS earnings

• Capital Markets 

• SPLS is targeting a refi in H2’24
• The company is somewhat dependent on capital markets remaining accommodative through FY24

Catalyst

• Regular-way refinancing in H2’24, or shortly thereafter

• TL-1 matures Sep-24
• Likely they will be able to organically address this
• However, could provide an ideal opportunity for the company to execute a full refinancing

• Continued EBITDA and FCF growth leading to deleveraging and rerating of credit risk ahead of refinancing
• Potential additional bond buybacks and/or equity injection from Sycamore in advance of H2’24 regular-way refi process