We have been fortunate through this season’s half yearly reports. Our two largest positions – Seek and The Reject Shop (see Eley Griffith’s view on this stock below) reported incredible results and their shares surged. And while we’d love to own every extraordinary company for our clients, limited pockets prevent us from doing so. This is a tale of one extraordinary company that we haven’t purchased and another, in the same industry, which many think is extraordinary.
Playing house
Australians love their homes and they love buying them. Indeed, so ingrained into our culture is the purchase of a home that it is as much a right of passage as turning 21. In response, homemaker centres have been popping up everywhere, catering to the great Australian dream. Build it – large warehouses on cheap industrial land, filled with furniture and decorations – and people will come.
Furniture retailers in particular helped drive this model as people rushed to upgrade their houses and then proceeded to spruce them up. But ultimately, furniture is a cyclical industry, sensitive to the economy and dining settings seemed to be the furthest thing from consumers’ collective minds following the global financial crisis.
As demand for furniture ‘faded’ (pun intended), so did the number of retailers in the market. In fact the furniture market reportedly contracted by 6.8% from July to December 2012.
Two furniture retailers that have survived and even grown are Nick Scali and Fantastic. But over the years their performance has differed. This can best be seen by looking at the charts of their intrinsic values – Figure 1 and Figure 2. If you can plot and forecast intrinsic values, you can get a pretty good handle on where the share price is going to go. You don’t really need to bother forecasting shares prices at all, because over the long run, prices tend to follow valuations.
As you can see from Figure 1 and Figure 2, Nick Scali’s intrinsic value has risen at the rate of about 4% per annum, but is forecast to rise by over 20% in the next couple of years. Fantastic, on the other hand, has seen its intrinsic value rise at less than 1% over the last decade and is forecast to rise by about 10% over the next two years.
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As the 2013 half-year reporting season approached, the situation looked bleak, particularly for leading furniture retailers such as Nick Scali and Fantastic Furniture. But it is during the tough times – when the tide is going out – that you see who is swimming naked. The latest results from these two players make for a very interesting tale.
The best place to sit
Nick Scali is a family run business that is held in high regard within the industry. The company primarily operates two brands. Nick Scali Furniture caters to the middle market with a focus on quality products, while Sofas2Go is tailored to budget conscious customers. Nick Scali customers pre-order the majority of the furniture selected off the floor and this helps the company maintain a gross profit margin of more than 60%.
Fantastic Furniture, on the other hand, is known as the ‘Package Deal King’ and the company focuses on value-for-money ‘bundles’. It operates a different business model to Nick Scali. Its stores are located in industrial centres in order to appeal to a value-conscious consumer and to sell on a larger scale at lower margins. The company also sells higher margin sofas through its Plush brand, mattresses through the Original Mattress Factory and designer furniture through Dare Gallery.
Nick Scali was the first of the two companies to report its HY13 results, increasing sales by 17% – a simply remarkable result in the context of a weak retail environment. The growth can be largely attributed to the company increasing its store network from 32 to 36 during financial year 2012.
What was more surprising was like-for-like sales growth of 4.7% (like-for-like sales excludes new stores sales, helping to assess the performance of existing stores). While management expect this growth to normalise at around 2% over the remainder of 2013, they did note that sales orders in January were very strong, which augurs well for the second half of the year.
With their results on fire, Nick Scali laid down the gauntlet for Fantastic Furniture, and several analysts and brokers on our panel expected robust results.
The other side of the couch
Fantastic Furniture increased its store count from 128 to 133 during 2012 but the results were anything but fantastic. Sales increased by 2.5%, while like-for-like sales increased by just 1.8%. Plush, Fantastic Furniture’s second largest division, experienced a decrease in like-for-like sales of 6.1%. What’s more, the company only added one store to its network during the half-year period.
Management uncovered a range of issues from inventory through to the structure of support functions, and there is a very real risk that the company will be forced to scale back Plush. Even Fantastic’s outlook statement starkly contrasted Nick Scali’s. Management reported that sales for January and early-February were slightly below the prior corresponding period.
The ability of Nick Scali to produce such impressive results amid an industry consolidating is a testament to the quality of the company. While Nick Scali is hoping to use this momentum to support future growth, investors should be aware that this growth is unlikely to be repeated. Management at Nick Scali are very thorough when it comes to identifying new store sites, and they have commented that finding suitable locations is getting tougher and tougher. In a population of just 22 million people, maturity and old age comes early for retail businesses.
The future for furniture
The furniture market remains weak and management are cautious about the outlook.
The moral of this tale is that investors should be focussed on companies that can generate sustainable value growth during any stage of the economic cycle. Fantastic Furniture has actually been a good performer these past few years, and it is likely to bounce back after confidence returns to the property market. Many will buy the shares and do very well. But momentum is not our caper.
When we’re looking for quality companies, we prefer those with management that embrace the challenges and solve the issues. We cannot say it better than Anthony Scali; “Nick Scali Furniture does not believe standing still is the right approach. Complaining or demanding protection from government does not address the issues or lead the way for the future of retail. By embracing these challenges and looking to the retail trends of the next decade, not the last, Nick Scali Furniture has refused to stand still.”
This attitude is also reflected in the company’s quality and performance scores. As I regularly discuss on Switzer TV on Sky Business, ranking companies in terms of quality from A1 for the best and C5 for the worst, using a proprietary selection of ratios really helps us identify the best businesses. Figure 3 reveals Nick Scali, despite having limited opportunity and a tough retail environment, has produced an enviable track record of business quality and performance.
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The final step for any investor when building a portfolio is to purchase these high quality businesses when they are at substantial discounts to their estimated intrinsic values. As Figure 1 revealed, that is not the case just yet.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
Also in the Switzer Super Report
- JP Goldman: The worst of the downgrade cycle is over [4]
- James Dunn: The Magnificent Seven – the banks, TLS, WES and WOW [5]
- Penny Pryor: SMSFs move markets [6]
- The Eley Griffiths Group: What we love about The Reject Shop [7]
- Paul Rickard: Question – Will the government intervene with Graincorp? [8]