Many of you replied to last week’s note about my more upbeat view of the Australian economy and Australian equity market with questions about the two discretionary retailers I mentioned we owned in the AIM Global High Conviction Fund, Harvey Norman (HVN) and Baby Bunting (BBN).
Thankfully both stock prices have advanced since that note with Gerry Harvey delivering an upbeat AGM outlook and Baby Bunting seeing its first analyst research since listing from respected retail analysts at Morgan’s and Morgan Stanley. Both those research notes were positive with 12-month price targets above the prevailing share price.
At the macroeconomic level I believe all the factors are in place for strong Christmas spending in Australia, with the key variable being full-time employment growth since the change of Prime Minister. I believe that will be confirmed around February in the economic data for the period and retailer earnings reports for the period.
The great investor Peter Lynch believed that some of the best investment ideas you see are with your own eyes in everyday life. I also believe in that approach as I have written in these notes on many occasions.
Today I want to expand on the investment case for Baby Bunting (BBN), a newly ASX listed retailer that I have had plenty of personal experience with as a customer.
I’m sure all parents reading this note would agree that we all tend to overspend on the “nursery” in the lead up to a birth. This is particularly so around the first child.
According to retail analysts, the addressable market for baby goods retailing in Australia is around $2.3 billion per annum. Yes, $2.3 billion per annum.
The industry as a whole remains very fragmented with Baby Bunting being the largest specialty player with an estimated market share of 9%. There are many smaller scale independent operators and the industry is ripe for consolidation. If anything, the baby goods sector has been somewhat of a cottage industry with the top 10 players having less than 25% market share.
Baby goods is a defensive industry. The good news is that Australian birth rates continue to grow (population growth). Baby goods sales tend to track population growth closely. BBN is increasing its share of a structurally growing industry. In fact, BBN is now the largest specialty retailer of baby goods in Australia by store numbers (33).
BBN plans to grow to 70 stores and has invested heavily in both systems and supply chain, which is crucial in any large scale store roll out programme.
Morgan Stanley believes this will translate to FY15-FY18 EPS CAGR of 27%. “The organic store rollout should help deliver sustainable mid-teens sales growth and consistent ROIC improvement. As new store economics are highly attractive. A four-year store maturation profile is key to driving comp store sales growth above industry growth and inflation, while modest gross profit expansion and cost base leveraging drive EBITDA margin expansion to 10% over the next 5 years”. Morgan Stanley forecast all of these growth drivers to be funded from operating cashflow, driving EPS well above market.
Morgan’s believes “it’s only just begun”. There are not many listed retailers with similar levels of store footprint upside. Based on BBN’s long-term store target of 70+ stores, the group is less than 45% of the way through its rollout potential. Not since JB Hi-Fi’s IPO in 2003 has a similar store growth been on offer. Most importantly, BBN has invested ahead of the curve in relation to its store rollout. We expect the company is well placed to leverage this investment in coming years.
It’s also worth noting that less than half of existing BBN stores are less than 3 years old. Given a BBN store typically takes around 4 years to reach maturity of sales, 45% of existing store sales being less than 3 years old provides another strong opportunity for sales growth. The benefit comes through in what is known as like for like sales.
Anyone reading this note from Victoria would most likely know the Baby Bunting brand better than readers in QLD and NSW. The company’s heritage is in Victoria and the Victorian footprint is currently the strongest. BBN has strong brand awareness in Melbourne and Adelaide which can be replicated in the northern states once the rollout fills out the store footprint. One of the key attractions of BBN is how they are currently underexposed to NSW and QLD, which as rectified by store rollout, will drive sales growth.
Another attraction is balance sheet strength and the ability to self-fund the store rollout. Usually fast growth stories also have associated high gearing levels through capex heavy rollout stage, yet BBN is exactly the opposite with net cash of $4.6 million and NO DEBT.
The final attraction is management and shareholder interests are strongly aligned. BBN senior executives are highly incentivised to deliver strong earnings growth for shareholders over the long-term. While base wages are low (good thing), if management achieves +25% EPS CAGR and TSR OVER 5 YEARS, 4% of the groups issued capital will be issued to senior management. This is a big prize and strongly aligns management interests to shareholder interests.
I really like the management incentive structure, it’s like a performance fee structure. It’s also worth noting management currently own 3.7% of the issued capital of BBN and did NOT sell a share in the IPO.
The stock has performed well since IPO (+71%), with an initial burst then consolidation and profit takers (staggers) took profits. That process of staggers selling to long-term believers such as myself is now complete and I think the register is now very sticky.
This BBN investment thesis is a classic price to growth idea. On short-term P/E multiples BBN is not cheap, but if it does deliver on growth forecasts (or better) the stock will prove a cheap structural growth stock.
Let’s look at the investment arithmetic (forecasts).
[1]On a current and future PEG ratio less than 1x, I believe BBN will prove cheap. Structural growth is hard to find, particularly in Australia, and when you find it you should pay a short-term P/E premium for it. However, P/E premiums are misleading if the growth is delivered.
I have great confidence in BBN’s future growth prospects, and while it’s only been listed for a short period, I think it will prove a solid medium-term investment.
However, I must stress to you all that BBN is a small cap company. The current market cap is around $250m. If you join me in owning BBN shares make sure it is an appropriate weighting in your portfolio to reflect the fact it is a small cap company. I leave you to judge that for yourselves.
All in all I think BBN has all the attributes that should deliver share price appreciation and better than market total returns over the next few years. The macro drivers are in place and BBN management is highly leveraged to deliver strong growth outcomes for shareholders.
I encourage you to visit a BBN store yourselves in the next few weeks and see if you agree with my opinion that this company could well be a category killer in the structurally growing baby goods sector.
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.