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Sunday, 15 September 2019

Card Factory

I thought this would be a good time to take a look at Card Factory, the UK greeting card retailer, which has been a smallish holding of mine for a few years and sold off recently after a trading statement that didn’t seem too bad to me.  I think the market may have been spooked by the fact that net debt (c1.7* EBITDA) isn’t coming down; that growth in online slowed and that GBPUSD has taken another leg down, as a result of the growing conviction that Boris Johnson, our new PM, is willing to put the UK through a hard Brexit.  Card Factory has a sizeable exposure to the USD as it buys the raw materials for its cards business and most of the finished product for its non cards business is also bought in USD.

The original attractions for me were:

-      The sense that the company might have a low cost provider moat, which it does via a vertically integrated model, which allows it to price substantially cheaper than competitors.  Take a look at the annual report for more information – UK card consumers are very familiar with the attractions of Card Factory.

-      High returns on equity and operating margins compared to other retailers.

-      The notion that in a world of battered and bankrupt retail stocks, maybe the market had thrown out the baby with the bathwater and overly marked down a long term profitable company.

-      The knowledge that card buying is an emotional purchase that is an essential for any Brit when it comes to recognising key life events such as birthdays, Christmas, anniversaries etc. ie it’s a “forever industry” that is relatively predictable.

-      A capital allocation that appears appropriate – ie, to distribute pretty much all earnings, given the market is not growing, and capital requirements are not light.

So what’s gone wrong, given the share price has fallen over 50% from its highs?

Here are some relevant metrics:

Gross Profit  113126126118128
EBIT Underlying7985888379
Cash Flow from Operating Activities7579827386
Gross Profit Margin32%33%32%28%29%
EBIT Margin18%23%22%18%16%
Inventory Turnover5.945.565.355.925.13
Market Size (single cards)£1.3bln£1.3bln£1.3bln£1.3bln£1.3bln
Overall Market Share (value)17%17%18%18%19%
Overall Market Share (volume)31%32%32%32%32%
Number of Stores764814865915972
Stated target number of stores12001200120012001200
Revenue growth8%4%6%3%
Operating Lease Rentals3536394043
Lease cost per store        45,288         44,226         44,971         44,153          43,827 
Single Cards58%56%55%54%53%
Non Card Items40%41%42%44%44%
Christmas Boxed Cards2%2%2%2%2%
Revenues Per Store      462,435       468,796       460,347       461,311        448,560 
Store Wages5762697581
Store Wage Growth9%11%9%8%
Wages per Store        75,000         76,413         79,653         81,858          83,128 
Store Property Costs5760656668
per store        74,215         74,079         74,913         71,585          70,267 
Other direct expenses1617181921
FX&NLW Headwind157

One thing that’s clear to me is the business has been running to stand still.  It’s got great unit economics, and has been consistent in saying 1200 is its target market, steadily rolling out new shops at a rate of c50 per year.  However, sales per store have fallen, which indicates some cannibalisation of existing revenue, further evidenced by the fact that Like for Like sales have been low and negative at times.  Market share in the most profitable segment of single cards has not really grown over time despite there being over 25% more stores in 5 years.  The company claims that they time taken for a store to get to maturity is 5-6 years, but LfL growth over the last few years seems too low to bear this out.

Second, margins have fallen quite significantly.  Gross margins have gone from 32% to 29%.  Some of this is because the sales mix has shifted slightly towards the less profitable non card gift items the company sells as a complementary offering.  Some of it is because of the fall in GBP making COGS more expensive.

Operating margins have also fallen, due to required wage increases for the workforce, who are largely lowly paid shop workers – the UK recently established an enhanced version of the minimum wage called the “living wage” which has meant substantial raises.  Unemployment is very low at the moment, there are lots of unskilled jobs out there.

You would imagine that this NLW headwind is temporary.  Given it’s intended to reflect living costs, it should mean wage growth trends at or slightly consumer inflation of, say, 2.5% over time.  Given the pricing position CF has, you would expect it can incorporate this.   

How much of this margin compression is temporary?  Well I’m happy to assume that the FX headwind is indeed temporary.  Brexit has depressed the GBP hugely and it’s undervalued on nearly any historical or fair value measure.  Once the Brexit fiasco is over, one has to believe that the probabilities are that GBP will strengthen or, at least, not weaken.  However, there will still be a negative effect over the next year or so, given that FX hedges are designed to delay and cushion FX movements. 

One lever that can potentially be pulled is on store leases. CF is to be applauded in that its maturity profile is nice and short, and with rents plummeting, it can hopefully achieve some significant reductions going forward.  However, 

More worrying that these margin effects is that CF seems unable to take more single card market share, despite growing its number of shops.

Why could this be?  

Some possible theories are:

-      Customer don’t like the quality and value proposition as much as they used to.  However, this doesn’t seem to be the case given that Card Factory publishes the same survey in its annual report every year which shows customer love it.

-      The company just isn’t coming up with compelling designs in the same way as it used to, leading to customers shopping elsewhere. Again, this seems unlikely given CF has a dedicated design team constantly churning out ideas, and its vertically integrated business model means it has the flexibility to quickly turn ideas into product.

-      Competition from other shops.  I don’t buy this, given the well documented difficulties of other card chains.  Clintons went bankrupt a few years ago and WH Smith’s attempt to roll out a card chain rival - Card Market – swiftly stuttered to a halt.  In the last week, news was released that Clintons is up for sale. It has been shrinking to profitability over the last couple of years and the article quotes “Pressure from online rivals”  The one thing I am unable to assess is how much market share is going to non-card retailers like supermarkets.  It’s interesting that Card Factory are experimenting with rolling their offering out in Lidl, which could obviously dilute margins, but might be an interesting new outlet.

-      What of online?  This is the thought I find most intriguing.  Card Factory has been extremely slow to the online party, although developing that offering is one of the four pillars of its strategy.  It doesn’t even have an app yet, which is kind of crazy in 2019!   Is this part of some sort of cunning strategy?  I doubt it. 

-      Now, Card Factory has published industry data showing that the shift to online is extremely slow, but it IS happening.  If I am liking the convenience of buying cards online, and personalising them, and I do, then plenty of other people will be thinking the same.  The main online competitors, which are Moonpig and Funky Pigeon, have deep pocketed owners and it is hard to assess just how (un) profitable they are, given their card economics are obscured by other product, and they are private companies.

-      As that trend continues and perhaps accelerates, CF will need to make tough decisions in terms of its store base and how it advertises its online offering.  Ultimately, the strategy has to be multi-channel, but it’s not clear whether the management team has the gumption to execute this.


Card Factory is fantastic at what it does, which is a vertically integrated, low cost, physical card retailing model.  But the problem is that the overall market isn’t growing, and the company seems to be pushing at the limit of what it can do on the physical side, albeit it’s experimenting interestingly with retailing in Lidl and Australia.

Online sales are too low to draw any sort of inference on whether it is successfully migrating to an online model.

At an EV/EBIT of 9-10, with operating margins possibly having troughed, and large amounts of capital being given back, this doesn’t scream “sell”, but neither is there a reason to buy more, until it’s clear that the business has got the grips with the online bleed and the physical store base is not being grown in a value destroying way.  Otherwise, it’s a deteriorating business.

Monday, 8 July 2019

Q2 Portfolio Returns and Book Recommendation

First – can I recommend to you “The Joys of Compounding” by Gautam Baid.

It’s a fantastic summary of all the aspects of the philosophies of Buffett and Munger – from the power of long term mindset and compounding, to where to find interesting investments (eg spinoffs), to some of the broader philosophies – reading, self-education, stoicism and giving. 

You could give this book to anyone who wanted to understand why you are such a devotee of two old men from the mid west and what a “Value Investor” really is and this book would explain probably better than you could.

It brilliantly summarises all the various resources – books, transcripts, twitter – that you have probably followed over time, into one book that you could really use as a first port of call for Value Investing Resources – check it out.

I also really enjoyed watching the Markel meeting at Omaha recently – a great refresher on that company:

Onto my portfolio returns this month.  I am feeling a lot better after my disaster with Flybe, because I was lucky enough to own Leaf Clean Energy in my “leverage portfolio”, which won it’s US state supreme court appeal and went up c500%.  I got the idea through looking at the Crystal Amber (UK mid cap activist) portfolio, and seeing a risk/reward that seemed to make little sense.  that Co incidentally I read in the book I mention above that markets tend to underestimate litigation assets and this is what I experienced in this case. 

Leaf Clean has reversed out the losses from Flybe and, additionally, most of my holding was in my tax-free ISA account, whereas Flybe was not.

I’m trying to transition the portfolio to reflect my decision to be a lot more conservative in my investing, looking for a lower return, and targeting higher quality assets – the quality of Howden Joinery is well known, and I expect to hold it for a long time.  If it can successfully roll out it’s model in France, then there is a long runway.

I am also selling Coty and accepting a permanent loss of capital.  In hindsight, I got into a “Story”, where I thought that I was buying a high quality equity stub that could cost cut it’s way to a great return, having acquired a portfolio of cosmetic and beauty businesses.  The owner (JAB) had a big name Chairman (Bart Becht from Reckitt Benckiser) and I wanted to believe they could be like another 3G in a long term stable business.  However, I didn’t do any further diligence and deserve the pain of losing a big chunk of my investment.  What prompted the decision was the realisation that even if they execute on their newly published turnaround plan, then they will still be an extremely levered business.  So I’m out.

Tuesday, 4 June 2019

Falling Retail Rents: Double Whammy

I found this article below very interesting:

It seems to me that for those retailers that survive their "apocalypse" some relief may be on hand in the form of lower rents.

As well as the link above, I recently listened to the Pets at Home call, where they were talking about achieving 30% rent reductions, and others are achieving similar numbers.

What I hadn't appreciated is the additional benefit that when rents come down so, at some point, do business rates.

If you own a business where the shops remain profitable today, it seems to me there may tailwinds for years to come...

Sunday, 2 June 2019

New Investment: Howden Joinery at 14.5* forward earnings

New Investment: Howden Joinery

My last post was full of pessimism but owning a piece of Leaf Clean Energy has helped me to recover from a crisis of enthusiasm and confidence. It’s gone up around 600% since I bought it and this has been in my ISA, which is extremely helpful:

The lesson learned has been to slow down, work towards the minimum return I need to achieve the life I want (8%) and try and apply principles which were obvious and what I knew anyway, which is that I shouldn’t invest in anything I don’t understand, that are “safe” and have a high quality and somewhat unique business model.

My problem with the above is that as I have a strange anchoring bias to low P/Es, I have struggled to convince myself to pay the extremely high multiples on offer for high quality businesses.

But I do need to force myself into this world and I’m going to start with what I think is a high quality business, returning bundles of cash, where the P/E is not sky high.  That’s probably because the growth prospects are not proven and stellar but I’m happy to own this low risk stock with no debt.

Howden Joinery – the annual report lays out the business model very well and the investment case is well known to the value investing community:

Howden Joinery screens very well as a Magic Formula stock.  As a believer, I should be happy to buy it “blind”.

But it’s so much more than that.  It’s a wonderful shareholder friendly business with a unique, hard to replicate, business model, where all parties in the eco system benefit.  It’s debt free, ROCE is high, and kitchens aren’t going to become obsolete any time soon.  At 14.5* forward earnings, coming off a decent trading statement, it just needs to keep doing what it’s doing because.

The key risks to the investment are an erosion of competitive advantage – see the performance indicators below.  A UK recession will reduce profits and share price but one should really be prepared to buy into that.

What are the performance indicators I need to watch?

-      Gross Margin as an indicator of pricing power. If margins are falling, it could be an indicator of increased competition.  If they are going up, it could be an indicator that revenue increases are coming via pricing, not volume, which may not be sustainable in the long term.

-      Any change in metrics like working capital to revenue or receivable to revenue.  This is especially interesting because the business extends credit to its customers. Could this have the potential to blow out during a recession?

-      Any information on the roll out into France. It’s good that the group has settled on France as the next country to benefit from its full attention in terms of a growth strategy.  It’s still not at all clear what sort of runway or economics it might benefit from.  

-      Evidence of competitors evolving their business models such that they can erode Howden’s competitive advantage.  Key ones are Benchmarx (owned by Travis Perkins), in particular, and Magnet (owned by Nubia).  Benchmarx appears to be struggling to grow its branch network at the moment.

-      While the new CEO appears to have the right background and qualifications, any sign of a deviation from model or strategy.