First and foremost, I am looking for a company that trades close to net asset value (NAV) and preferably below net tangible assets (NTA, in other words, excluding things like goodwill and brand value). Furthermore, there must be an investment angle that ordinary investors have overlooked in their analysis, leading them to inadvertently miscalculate the intrinsic value of the company.
Put simply, we are aiming to invest in a company where the risk-reward ratio is weighted heavily in our favour and one that should provide significant upside as when the rest of the market discovers the valuation anomaly. When that happens, the gains can be significant, as loyal followers of this column over the years will know.
For instance, London Forfaiting(25 April 2003) and Estates & General (16 January 2004) both succumbed to bids shortly after I made a strong investment case to buy their unloved shares using this approach. Walker Greenbankwent on to produce a 150 per cent return by the time I advised banking gains 18 months later. And if you bought shares in Telford Homes and MJ Gleeson in the autumn of 2010, you are now sitting on gains of over 30 per cent in both companies. The same process uncovered value in small-cap broker WH Ireland (Broking for success, 27 July 2011), a company I continue to rate a value buy and a holding that is well into profit despite the slump in small caps last year.
Dressed for success
The latest cash-rich value small-cap that my technique has uncovered is Moss Bros (MOSB: 39p), a market leader in the hire of formal clothing and branded suits. I don't think investors have fully grasped the transformation the company has undergone in the past six months - but they may well don once Moss releases results for the year-end January 2012 on Thursday 29 March.
The company's insiders have certainly been sending out a clear signal to investors as chief executive Brian Bick bought 160,000 shares at the end of last year at 32.75p; chairman Debbie Hewitt increased her beneficial holding with an identical purchase; and non-executive director Maurice Helfgott purchased 30,000 shares at the same price.
It’s easy to understand why they are so bullish. In a pre-close trading statement in mid-December the company revealed that the turnaround in the business has been quite dramatic. Underlying sales since the end of July had shot up over 10 per cent and had increased over 13 per cent for the financial year as a whole. With costs tightly managed, this means the 161-year old company will return to profitability; analyst John Stevenson at brokerage Peel Hunt is pencilling in an underlying pre-tax profit of £500,000 for the 12 months to end January 2012 on revenues of around £100m.
But it is in the current financial year that the growth will really kick in; Peel Hunt predicts a trebling of pre-tax profits to £1.7m on sales of £106m, driven by formal hire, retail sales, online sales and more cost savings.
Growth drivers
The formal hire business has been growing at an annual rate of over 10 per cent in the past couple of years and produced record sales in the first half to end July 2011. The aim is to drive annual sales up from around £16.9m at present towards the company's medium-target of £25m.
Moss Bros has a 50 per cent share, and its competitors are fragmented - they're mainly independent retailers. One benefit of this dominant position is that the company has been able to raise selling prices by an average of 8 per cent in the past year, but not at the expense of volumes. So as these higher prices feed through on an annualised basis into the first half of this year (the skew effect of the wedding calendar means that two thirds of hire sales fall into this period) then profits will get a boost. And this is a hugely profitable line of business to be in; gross margins were over 80 per cent on the £11m of revenues in the first half of last year.
The formal hire business will also receive a boost later this year when, for the first time ever, customers will be able to place hire orders online from a new Moss Bros single integrated web platform which will incorporate the retail and bespoke businesses. Currently, the hire website only provides product information and store details and has no facility for transactions. A 'click and collect' service can only attract sales, but that’s not all as the other benefit of the online investment is that Moss Bros can now target direct marketing more effectively by better utilising the valuable amount of data it has on its customers.
There are growth opportunities on the retail side, too. Moss Bros currently controls around 6 per cent of the UK's suit market from its 139 stores, of which 33 are outlet stores, and has been trialling a refurbishment programme ahead of an extended roll-out over the next four years. The cost of each store refit varies from £40,000 to £240,000 and combined with the relaunch of the company’s own brands and streamlining of third-party brands, this will help drive revenues and enhance margins.
There is also potential to drive revenues up by rolling out the retailer’s bespoke suit service at a relatively low cost of investment. The bespoke offering is currently in six Moss Bros stores, but analyst John Cummins at brokerage WH Ireland believes "there is potential for up to 50 stores to offer the service, depending on the success of the pilot stores."
Cost savings
The potential to grow profits doesn’t end there as there is obvious scope to further cut costs and boost the bottom line by reducing the company’s £20m annual rent bill. Currently, Moss Bros has 12 stores that are loss making - down from 23 units in the prior financial year and 40 stores the year before - and these could be closed as leases expire. In fact, over a third of the leases on the whole estate are up for renewal or expiry in the next three years, which creates an opportunity to reduce overheads. Given the general weak trading backdrop in retailing, and the number of empty retail properties across the country, Moss Bros is in a very strong position to either renegotiate lower rents with landlords or alternatively exit sites and relocate to ones which enjoy better footfall.
For a business with high operational gearing, and where the rent bill alone represents 20 per cent of revenues, it is easy to see that a small reduction in the rent bill over the next few years will have a dramatic effect on profits. To put the potential cost savings here into perspective, Mr Cummins notes that "rents that have already been renegotiated are on average 20 per cent below historic levels".
A value proposition
When the retailer sold its franchise on 15 Hugo Boss stores and 8 Cecil Gee stores last year in order to focus on the core Moss Bros brand, it transformed the company’s balance sheet and analysts expect net cash to have risen to around £24m by the end of January 2012. The book value of the company was £35m at the end of July, but the retailer is also sitting on property worth £13m - so in effect its market value of £36.5m is completely backed by cash and property alone.
Strip out the cash pile and you're left with a business forecast to have made cash profits of £5.1m last year, valued at a miserly £12.5m. The undervaluation is even more anomalous if you consider that cash profits are expected to rise to over £6m in the current financial year to January 2013 - enough to fund annual maintenance capital spend of £2.1m and still leave a further £3.9m to expand the business without eating into the £24m cash pile. Investment on this scale in refurbishments would boost profits and in turn create a virtuous circle where these incremental profits can be recycled into new refits.
Moss also has the benefit of carried-forward tax losses of £3.2m and will not be making any tax payments on profits for another two years. And on a standard earnings basis the shares are far too lowly rated: strip out net cash of 25p from Moss Bros share price of 39p and the shares are priced on a very modest 8 times WH Ireland's EPS estimate of 1.6p for the 12 months to January 2013.
Finally, the shares are knocking on the door of a major chart break out if they can rise above 40p - a level which capped two previous rallies last summer and autumn. Needless to say, I rate the shares a strong buy and I have set a realistic three-month price target of 55p, which if hit will provide us with 40 per cent upside.
