1x EV/EBITDA and 2x P/E (ex-cash) is a valuation you would expect to see of a company with serious problems. But what if I told you this company has grown sales and profits in each year for the last 3 years in a row? Current dividend yield is around 7.5% which is a level you would expect of a company whose dividend is at risk. But what if I told you that free cash flow was almost 3x this expense in the last twelve months, and that cash on the balance sheet is around 70% of market cap? Surely this must be a small, illiquid stock trading in an emerging market. Truth is, that it is indeed a micro/small cap and the stock only does around $140k volume worth a day but this company is actually in the U.K.
ScS Group (where ScS stands for “Sofa Carpet Specialist”) is a U.K. retailer with a 9.6% market share in upholstery and 2.7% in floor coverings with 101 stores, 9 distribution centers and almost 2,000 employees. The company continues to grow and has set their target for 13% share in upholstery and 3% in floor coverings. In 2018 they were awarded “Best Flooring Retailer” from Interiors Monthly, and have a 5-star rating on Trusted Pilot with 148,000 reviews.
The company listed in 2015 and has since slowly but steadily grown and expanded margins. The company has no debt but does have operating leases with GBP 1m due within a year, GBP 28m within 2-5 years and GBP 137m after 5 years. The average store lease tenure has declined from 10 years to under 7 years in 2018.
I see the large cash position has a huge safety net for a company that could find itself in trouble in a recession. Cash is mentioned 98 times in the annual report and “Cash headroom” is a measure used by the company in its assessment of credit risk and liquidity. This can be linked back to the company’s history. Before we go there, it should first be explained that the company runs a negative working capital model. Each product is build-to-order. For cash sales, the company receives a deposit when an order is placed and the rest is settled before delivery. For consumer credit sales, the provider of the loan also pays the company before delivery, but product suppliers are paid a month later. Around 50% of sales are cash and 50% credit.
Suppliers take out credit insurance to protect their receivables against bad debts. Now if suppliers can’t purchase credit insurance, there’s a problem and this is exactly what happened to ScS Group in 2008. In the first-half ending January 2008, revenues was down -13% with same store sales down -15%. First-half operating profits and EBITDA were negative versus positive a year earlier. In May 2008, the company announced that same store sales for the last 8 weeks were down -14% while the bank holiday weekend was down -20%. In June 2008, the company announced that a supplier withdrew credit insurance for ScS (a furniture sector issue). A month later, shareholders were wiped out as Parlour Product Holdings (an affiliate of Sun European Partners – the European advisor to U.S. based Sun Capital Partners) purchased the company for GBP 1 and injected GBP 20m to stabilize the business.
In January 2008, the company’s cash position was GBP 15m (16% of sales) and declined to GBP 5m in May as they had to pay all their suppliers. This company generated FCF of GBP 8.6m in 2006 and even in the first half ending Jan 2008 still generated GBP 4.4m in FCF. Yet it needed a GBP 20m injection. A no brainer investment for Parlour who still owns 40% of the company and sits on the board (Paul Daccus is a non-executive director and managing director of Sun European Partners). So let’s take a guess at ballpark cash number the company would need in a recession/global financial crisis. First-half 2008 sales annualized are GBP 184m (ignoring that second-half sales are higher to account for the further decline that occurred). The company had GBP 15m and needed another GBP 20m so that makes it GBP 35m (or 19% of our 2008 sales number). Currently, the last twelve month sales were GBP 333m so if we apply our 19% stat we get to GBP 63m which coincidently is the current cash position that the company shows on its balance sheet. Another way would be to look at Cash to Payables ratio. In January 2008, this was 0.3x which led to trouble. Adding the GBP 20m injection results in a 0.7x ratio. Today, that ratio stands at 0.9x.
I’ve reached out to investor relations with a few questions, including what cash level would be enough. The CFO did come back to me with some helpful responses. Regarding 2008, Chris Muir mentioned “in 2008 we had c£17m of cash on the balance sheet but our suppliers were using credit insurance to obtain invoice discounting on ScS invoices at a sensible cost to the value of £22m. When credit insurance was pulled on the ScS name we were faced with funding the suppliers with the £22m… which we did not have.” Currently, credit insurance written on the ScS name is only £14m as suppliers have strengthened their balance sheets. In the last earnings release, cash net of deposits was £38m which easily covers the £14m so the company is much better prepared for an adverse scenario.
So you took the clickbait on valuation but the truth is we should net out deposits which obviously don’t belong to the company and are stated in the notes to the financial statements (1H19: GBP 25m). So the actual EV/EBITDA is 2.5x and P/E ex-cash is 4x (or 8x ignoring cash) which is still extremely cheap. Competitor DFS trades at 7x EV/EBITDA and a P/E of 13x. At SCS’ valuation investors really don’t even need the company to grow or improve margins. That’s just pure icing on the cake. But a hard Brexit may happen and according to the Bank of England a ‘disorderly’ Brexit could lead to housing prices dropping by 30%.
Transaction volumes appear flat with that 2016 spike due to buying before a 3% stamp duty surcharge for buy-to-let investors and people buying second homes. The chart below shows monthly data and gives the impression that volumes are more volatile than reality. In 2016 and 2017, the annual year-on-year change was actually zero, while in 2018 it dropped -5%. Savills reported in their annual report that commercial property turnover was down -5.3% in 2018 but still 1% above the five year average. People are taking longer to sell their homes with 28% on the market for more than 6 months and 8% over a year, according to Rightmove, while stock per branch is also up year-on-year. Brexit remains an issue that is likely suppressing the stock which reached a high of 265 in April and is currently around 210-220.
Buyer affordability has improved in both London and the UK in general as shown in the chart below. This stat is for the first time buyer and is based on mortgage payments as a percentage of mean take home pay.
In any case, Brexit is expected to be resolved this year, and regardless of what will follow ScS appears to have a strong enough balance sheet to make it through any type of crisis. Valuation is extremely attractive and we get paid a 7.5% dividend to wait. The biggest risk in my opinion is that the company is taken private. Parlour Product Holdings owns 40.2% and Artemis Investment Management owns 10.8%. Parlour though has already gone through the process so it may just prefer to wait and realize value over time. It certainly would hurt its credibility and make it more difficult to re-list in the future. These risks are all priced in and more with the stock potentially becoming a multi-bagger.
