Subscribe here...

Tuesday, 1 October 2019

Q3 Quarterly Return

Portfolio as at end of SeptemberBloomberg TickerPercentage
Rolls RoyceRR/11%
IG GroupIGG7%
Berkshire HathawayBRK/B7%
Card FactoryCARD5%
Crystal AmberCRS5%
Imperial BrandsIMB3%
Character GroupCCT2%
Spectrum Brands  0%
GBP Cash6%
Quarterly ReturnQuarterly Benchmark Return
Return Since InceptionBenchmark Return since Inception
Annualised Return since InceptionAnnualised Benchmark Return since Inception
Quarterly Leveraged ReturnAnnualised Leveraged Return

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.