Bargain Shares 2024: A transformation that's being materially underrated

In chapter seven of The Intelligent Investor, the seminal 1949 work by Benjamin Graham, the father of value investing explains: "If we assume that it is the habit of the market to overvalue common stocks that have been showing excellent growth or are glamorous for some other reason, it is logical to expect that it will undervalue – relatively, at least – companies that are out of favour because of unsatisfactory developments of a temporary nature. This may be set down as a fundamental law of the stock market, and it suggests an investment approach that should be both conservative and promising." Graham's theory, as mentioned above, was that a strong balance sheet will usually see a company through any short-term difficulties and provide a "margin for safety".

Naked Wines (WINE), an online wine retailer with 792,000 subscription customers in the US, UK and Australia, offers exactly that and is a potentially lucrative recovery play, too, after the share price plunged more than 90 per cent from an all-time high of 914p in 2021.

The major issue is that the number of active ‘Angels’ customers who pay monthly subscriptions has fallen from a peak of 1mn in 2022 to just shy of 0.8mn as the boom in customer sign-ups that started during the Covid-19 pandemic petered out. Given that Naked Wines’ cost base has been aligned to a much larger business, capital tied up in stock – the group supplies more than 2,000 quality wines from 293 independent winemakers across the world – is out of kilter, too.

Radical action and a back-to-basics approach was needed and that’s exactly what the management team under chairman Rowan Gormley has been pursuing. The plan is to turn Naked Wines back into a cash generative, profitable business earning a decent margin. Although results for the financial year to 31 March 2024 will reveal a sharp fall in profits, as our table highlights, there are encouraging signs that a strong recovery in the profit and cash position could be on the cards in the new financial year.

Rightsizing the business

For starters, negotiations with wine producers should reduce current inventory levels of £163mn down to £115mn-£130mn by April 2025, releasing up to £50mn of cash from stocks. Future inventory intake to April 2025 is £60mn-£70mn below the forecast cost of goods sold, highlighting the potential to unwind capital invested in stock and to boost the cash position.

Critically, costs are being taken out of the business, too. In fact, the directors announced a few weeks ago a new target to reduce the annual run rate of selling, general and administrative expenses in the 2024-25 financial year to £30mn-£33mn. That is £7mn less than previous guidance and well below the £42.6mn expenses incurred in the 2022-23 financial year.

The news prompted analysts at joint house broker Investec Securities to upgrade operating profit estimates by £2mn to £6.1mn for 2024-25, and by £1.7mn to £8.6mn for 2025-26, noting that there is upside potential to these forecasts, assuming the rate of recovery in repeat customer attrition continues.

In the latest quarter, customer attrition rates declined to 33 per cent, an all-time low, a reflection of stabilisation in the UK customer base and improved retention rates in the US and Australia. The recent third-quarter trading update also revealed that sales per repeat customer had edged up and new customers acquired in the three-month period had risen by a third on the same period in the prior year.

Although the 1.4 times payback of Naked Wines' investment in new customers over a five-year period hardly gets the heart racing, management has been targeting higher near-term cash payback through liquidation of excess inventory and improved utilisation of operational capacity. It’s a sensible trade-off to make until the operational cost base and inventory levels are reduced to a level consistent with a 0.8mn customer base.

Interestingly, the board’s guidance is for adjusted operating profit of £2mn-£6mn for the 12 months to 31 March 2024, based on a 12 to 16 per cent contraction in annual revenue. It should easily be at the top end of that range, given that Naked Wines has delivered cumulative operating profit of £5mn-£7mn in the nine months to 31 December 2023.

Solid balance sheet

Importantly, Naked Wines’ balance sheet provides the management team with the asset backing to execute its recovery plan.

Not only are you getting a free ride on non-current assets of £27.9mn, half of which are hard assets (receivables and property), as Graham desired, but current assets of £228mn exceed Naked Wines’ total liabilities by a healthy £61mn margin. That margin is more than 29 per cent higher than Naked Wines’ market capitalisation of £47.3mn. Importantly, a liquidity ratio of 1.7 times highlights the ability of the group to pay its debts.

Furthermore, as stock levels are reduced – as mentioned, inventories of £163mn account for almost three-quarters of current assets and could be reduced by £50mn within 14 months – Naked Wines will become less reliant on borrowing facilities to fund its working capital, thus saving on finance charges. In turn, this will enhance returns to shareholders. Cash balances of £33.8mn exceed gross borrowings of £30.9mn, so the group is in a small net cash position, but the financial position could improve no end as stock levels reduce to a level proportionate with the smaller size of the business today.

In fact, the bumper free cash flow (FCF) that is set to flow into the business explains why analysts at Investec Securities predict a nine-fold rise in net cash to £28.4mn (44p) by 31 March 2025, increasing to £39.7mn (53.6p) in April 2026. Naked Wines’ market capitalisation is only £47.3mn.

The forecast profit recovery certainly catches the eye: Investec is pencilling in 79 per cent higher pre-tax profit of £6.1mn in the 12 months to 31 March 2025. This implies the shares are rated on a forward price/earnings (PE) ratio of 9.8, a multiple that falls to 6.7 the following financial year, assuming Naked Wines achieves analysts’ newly upgraded pre-tax profit estimate of £8.8mn.

On a Bargain Shares rating of 1.29, Naked Wines looks a classic Graham recovery play and one that has potential to double in value. Buy.