In this week’s newsletter, I examine the progress of Tesco’s (TSCO) rehabilitation; run the rule over Revolution Bars Group’s (RBG) business model; and assess the fitness of SCS (SCS) to perform well if the economy holds up. I also give my opinion on the upcoming IPO of Smithson Investment Trust, and share my IPO investor checklist.
We discussed SCS in this week’s podcast and my analysis is included below as part of this article. Investors Chronicle Alpha subscribers can read the full report with the rest of the companies I've looked at here.
Furniture and flooring retailer SCS (LSE:SCS) continues to show that it is not all gloom and doom for companies in this troubled sector. By keeping a keen focus on customers and offering quality products across a different range of price points, SCS has been able to keep on growing whilst rivals such as DFS struggle.
During the last year, SCS was able to increase its sales slightly despite very poor trading in its 27 House of Fraser concessions. Whilst furniture sales were flat, flooring sales (just over 12 per cent of total sales) increased by 7.1 per cent and online sales by 22.6 per cent. House of Fraser concessions saw sales fall by 9.4 per cent.
A good control of costs saw operating profits increase by 10.5 per cent to £13.2m with operating margins improving from 3.6 per cent to 3.9 per cent. These margins are low, but are still higher than very big retailers, such as Tesco, are achieving.
The real strength of SCS is its ability to generate lots of cash flow. The main reason for this is that its business operates with negative working capital. In short it gets paid for selling furniture and flooring before it has to pay its suppliers.
Customers paying in cash pay a deposit and then settle the final balance before delivery. Sales made on credit usually see the loan provider pay SCS two days after delivery. SCS buys its stock on credit and only pays its suppliers at the end of the month following the month of delivery to its warehouse.
You can see above how working capital is a source of cash for SCS. Note the very large inflow in 2017 of £12.1m that came from deferring paying suppliers. Most of that reversed in 2018 as the bill was paid. That said, SCS still converted all of its trading profits into operating cash flow which is what investors want to see.
Although SCS has been opening new stores, its capex spending has been well controlled which has allowed it to generate lots of free cash flow and keep on increasing its dividends, last year by a very healthy 10.2 per cent. This is a company whose profit quality – as shown by its ability to convert its profits into free cash flow – has been good for the last few years and is expected to continue according to analysts’ forecasts.
Despite its good performance, SCS faces a difficult and competitive market that brings with it a number of risks. This business has quite a lot of fixed costs which introduces a reasonable amount of operational gearing and makes its profits quite sensitive to small changes in sales. Sadly, recessions do happen and it’s not unreasonable to expect profits to take a hit when the next one comes.
SCS is doing what it can to manage its risks. The company has an increasing amount of flexibility on its store costs and rents. When it opens a new store, it usually signs up for a ten-year lease with the landlord. The average length of its leases has been coming down from 8.4 years in 2016 to 6.8 years now. It may use this increased flexibility to close some of its underperforming stores.
The company also has a growing pile of cash on its balance sheet and no borrowings. Cash of £48.2m accounts for more than half the company’s market capitalisation at the time of writing. This gives the company lots of firepower to weather a downturn in trading, invest in its business and maintain its dividend payments.
Current trading looks to be reasonably encouraging with like-for-like orders up by 2.1 per cent during the first nine weeks of the 2018/19 financial year. The profit contribution from the House of Fraser concessions remains uncertain given the change in ownership of that business. That said, I think there is a case for arguing that consensus analysts’ forecasts may be able to nudge up a bit. Flooring remains a big part of the company’s plans for growth and continued momentum in this area could help profits keep increasing.
SCS shares have had a good last year with the share price up by nearly a third. At the same time, shareholders have received some chunky dividends. The shares trade on a one year forecast rolling PE of 9.2 times at a share price of 225p. However, if the valuation is adjusted for the company’s big cash pile (equivalent to 121p per share) then the valuation falls to just 4.2 times forecast rolling EPS. If the company paid an unchanged dividend, the yield on the shares is 7.2 per cent and is still more than twice covered by free cash flow.
If the economy holds up and trading remains reasonable then whilst cyclical and risky, the shares could still do very well from here.
Alpha subscribers can read my analysis of Tesco and Revolution Bars here.
