Small Cap Value Report (26 Apr 2016) - BOO

Good morning!

Sprue Aegis (SPRP) Meeting

Meet the management of Sprue Aegis (LON:SPRP) tomorrow (27 April 2016).

ShareSoc has arranged a meeting, as follows (click on the "Contact" link below to book yourself a place):

Sprue Aegis Business Review. The directors of Sprue Aegis have agreed to answer ShareSoc Members questions following the recent trading statement (profit warning) and after the results announcement on the previous day. This event will commence at 6.00 pm and last approximately one hour. It will be at the office of Tavistock Communications at: 131 Finsbury Pavement, London, EC2A 1NT. If you plan to attend please tell us by using the ShareSoc Contact page here: Contact - mention “Sprue Aegis Meeting” in the Comments box.

This seems an excellent idea. Well done to ShareSoc in taking the initiative. Well done also to SPRP management for being prepared to face private investors, and answer questions, so soon after a major profit warning. I'd like to see more such meetings, and maybe webcasts too, when difficulties arise at any company.

I often complain about the lack of specific information available to private investors, especially when there are problems at a company. SPRP is a very good example of how the bad news was actually handled very well - the company published specific guidance on its revised profit expectations, and has agreed to meet private investors to answer questions. ALL COMPANIES SHOULD DO THIS. Vaguely worded profit warnings, with no figures, are just totally unacceptable, which sadly is the norm from most companies.

Boohoo.Com (LON:BOO)

Share price: 48.75p (down 2.5% today)
No. shares: 1,123.3m
Market cap: £547.6m

(at the time of writing, I hold a long position in this share)

Results y/e 29 Feb 2016 - these are sparkling results, as expected. It's even more remarkable when you consider that all the growth is organic. There are not many big organic growth small-mid caps around at the moment, on the UK market. So the ones we do have, like BOO, command a considerable premium valuation, rightly so.

I've gone through the figures carefully, and skimmed some of the narrative. The numbers are more important to me than the narrative. Although I always carefully scrutinise the outlook statement, which is the most important bit of narrative to always read carefully.

The figures look terrific to me, I'm very pleased.

Some key numbers:

Comments on items I've highlighted above:

Revenue growth (all organic) of 40% is a remarkable result, and ahead of broker consensus.

Gross margin has fallen by 300bps to 57.8%, but this is a blended margin of (mainly) retail but also some lower margin wholesaling. The retail margin is 100bps higher, at 58.8%. This is a remarkably high gross margin, especially considering that the product price points are so low. The company has chosen to accept a reduced (but still very high) gross margin, in order to drive sales growth harder. Demand is elastic - customers are very price sensitive, so this is the right strategy in my view.

The high gross margin achieved shows the key strengths of BOO's business model - namely outstanding skill/experience at low cost sourcing, and very little slow-moving stock to clear at discounted selling prices, due to the "test & repeat" approach to stock purchasing. It's a fantastic business model, and very difficult to replicate (contrary to what some people (wrongly) think).

Another key point about margins, is that BOO adjusted its strategy in 2015/16 to cut selling prices (thus accepting a lower gross margin), in conjunction with a reduction in marketing spend from 13.2% of turnover, to 10.2% of turnover. This is a clever strategy, and it's clearly worked - boosting sales growth, whilst protecting the net profit margin.

Therefore one would be making a mistake to see the lower gross profit margin in isolation. It has to be seen in conjunction with lower marketing spend, thus giving a better overall result.

Rest of world sales are particularly strong, at +56%. Using constant currency, the growth is even higher, at 63%. Currency headwinds for sales growth should reverse this year, so we should see another year of very strong international sales growth. So BooHoo is an international growth stock, not just UK. So there's tons of growth yet to come, in my view - hence the high valuation is fully justified, in my opinion.

Going back to marketing spending, the 10.2% of turnover spent on marketing equates to a cash spend of £19.9m for the year. I really want to reinforce just what a huge number that is. It's greater than profit of £15.7m. This is very important for valuation, because the company is in effect over-spending on marketing now, to drive growth. However, several years down the line, the marketing spending will be reduced, as the business reaches maturity. At that point, the profitability will soar. Also, marketing spend is a massive barrier to entry - competition rarely gets off the ground, as they can't finance the losses needed to grow.

So one could argue that BOO is really making a much bigger profit - of around £35m, but it's choosing to spend about £20m of that profit on marketing. Of course, if it switched off that marketing spend, then sales growth would probably grind to a halt, or maybe even go into reverse. So it's overly simplistic to look at things this way. However, I reckon the marketing spend could probably be halved, so a reduction of £10m, without doing serious damage.

Therefore, to my mind, the underlying profitability at BOO is around £25m p.a., with £10m of that recycled into higher marketing spending, to drive faster growth. In that context, the valuation suddenly doesn't look at all outlandish, especially when you roll the figures forward a couple of years.

Note the other income of £1,392k this year (against nil last year). This is broken down as £359k being a gift from a Director for the benefit of employees (a very nice gesture), and £1,033k income from warehouse services provided to third parties - my guess is this probably relates to warehousing for PrettyLittleThing.com ("PLT")- another Kamani family business. As long as the services are charged on an arms-length basis, this is absolutely fine. Indeed, it benefits BOO by getting greater utilisation from its warehouse. I am concerned at the gigantic conflict of interest overall though with PLT. This needs to be resolved by it being bought by BOO, using the Call Option.

Here is the info on PLT from BooHoo's admission document (page 29):

The Company has entered into an option agreement (“PLT Option”) with Umar Kamani, Adam Kamani and Samir Kamani, pursuant to which the Company may, should it so choose, acquire the entire issued share capital PrettyLittleThing. The PLT Option lasts for a period of three years from the date of Admission, and the purchase price is the lower of either £5 million or the price otherwise agreed between the parties. Should the PLT Option lapse, the Company has the power under the PLT Option to require that PrettyLittleThing cease trading and be wound up immediately. In the event of lapse the Company shall also acquire, for the sum of £1, the domain name www.prettylittlething.com as well as any intellectual property owned by PrettyLittleThing (including any other domain names and trade marks owned by PrettyLittleThing). Further details of the PLT Option are contained in paragraph 15.6.1 of Part V of this document.

The date of admission was 14 Mar 2014, so this issue needs to be resolved in the next year, before 14 Mar 2017. My feeling is that BOO really has to exercise the call option, since that is in the best interests of the shareholders of BOO. It's not a family business any more - it's a publicly listed company, that has to act in the best interests of all shareholders.

Of course, bringing PLT into BOO would add considerable value to BOO, so everyone benefits that way. Note that PLT has achieved stellar growth in 2015, as reported here.

Note also the related party points on page 114 of BOO's admission document:

15.6 Related Party Agreements. In addition to those arrangements detailed in paragraph 14 of this Part V the Company entered into the following material agreements with certain related parties as follows:

15.6.1 Pretty Little Thing Option Agreement. Pursuant to a call option agreement dated 5 March 2014 between (1) the Company (2) Umar Kamani, Adam Kamani and Samir Kamani (“PLT Shareholders”), the PLT Shareholders granted an option to the Company pursuant to which the Company, at any time during the 3 year period following the date of Admission, can require the PLT Shareholders to either (a) transfer the entire issued share capital of Pretty Little Thing to the Company in consideration for the cash payment of £5 million or such lower sum as may be agreed; (less, in any case, PLT’s debt, plus PLT’s cash, in each case as at the date of completion of the transfer in accordance with the option agreement) or (b) procure that PLT ceases trading and take steps to wind up PLT, at which time it will transfer the domain name “prettylittlething.com” to the Company and all other intellectual property, to the Company for £1. The agreement includes provision to ensure the entire business of PLT is carried on by PLT and includes undertakings and warranties in favour of the Company. The PLT Shareholders have given a 12 months non-compete covenant in favour of the Company

I'd like to see this issue resolved, as it's an uncomfortable blurring of the lines between family interests, and listed company interests. It's important that the PLT call option does not turn out to have been a fig leaf to get the IPO away, with no intention of it ever being exercised. The core issue is family companies competing with the listed company - not good.

Fixed assets - note the big increase, from £10.9m to £21.4m, being mainly the big expansion of warehouse capacity to cope with growth. Also IT spend. All money well-spent in my view.

Cash - BOO has a lovely cash pile, of £58.3m, so a very soundly financed business. A big thumbs up from me here. I don't care if some people think this is inefficient. It's safe, and as the CEO of BOO said to me when I toured his office last year - "If you guys at Pilot had built up a big cash pile, your business would still exist today". A very valid point, as it actually went bust 3 years after I left.

Employees - note there are only 908 employees, to produce £195m turnover. That's highly efficient - about £215k in revenue per employee - far more than most bricks & mortar retailers manage.

Inventories - note how efficient the company is on this too. £18.7m in inventories, for a business that probably had a run rate of about £240m turnover at the year end, is pretty efficient - although of course inventories are stated at cost. It's a great business model - instead of having hundreds of shops with the same stock in them, fragmented, BOO has everything in one huge warehouse. A vastly better arrangement.

Although the downside is what to do with millions of garments that customers return. Most can be re-sold, but there must be a lot that can't, and end up requiring human intervention to inspect them, decide what to do with them, etc.

The returns rate for mail order/internet clothing sales is usually about 30%, but I understand that BOO is considerably lower than that, c.20% from memory. It's still a helluva lot of gear to process though.

Share options - there only seems to be 1% potential dilution, which is very modest.

Outlook - the good times are continuing by the sounds of it, although obviously % growth rates moderate over time:

We have had an encouraging start to the 2017 financial year and we currently anticipate sales growth of c.25% for the financial year, in line with current market expectations.  We will continue to look at opportunities to invest in incremental growth, which may impact margins on a short term basis, although we will look to maintain EBITDA margins at similar levels to the financial year just ended (in line with current market expectations).

I'm not worried by the comments about incremental growth at lower margins, as the company has demonstrated in 2015/16 that it can achieve the required bottom line result by skilfully juggling margins & marketing spend, to maximise growth.

It's good to see the company giving guidance on growth & the net margin (at EBITDA level). Again, why can't all companies do this? It's best practice, that sadly not many companies adhere to, so it's very pleasing to see BOO giving guidance in this way.

I think mgt felt stung by the criticism after the profit warning in Jan 2015, and have learned from that, that market expectations need to be kept in check. Better to under-promise & over-deliver, which I think is what they are now doing.

Above all, the stonking performance of the business in 2015/16 now means that the ghost of the Jan 2015 profit warning has today disappeared. This is a business which is now highly regarded in the City again, and rightly so.

Valuation - this is the tricky bit! Broker forecast for the current year is about 1.4p EPS. So at 48.75p share price currently, the PER is 34.8. That's going to scare off most of my readers here for sure! However, rapid growth companies do command very high PERs in the growth phase.

Earnings are forecast to grow by about 27% this year, so the PEG is a bit over 1, which is not excessive by any means, in my view. Look at the rating that ASOS (LON:ASC) had during its rapid growth phase - I can remember the PER being over 100 for quite some time.

BOO is a rare beast - a strong organic growth company, with international reach. Therefore this is likely, in my view, to be a very much larger company in say 5+ years' time. If sales really take off in the USA for example, the sky's the limit.

So personally, I'm not worrying about the valuation right now. It's expensive, because it has superb growth potential, compared with other UK listed companies. Some quite ordinary, mature businesses are rated at a PER of about 20 right now, so why should we baulk at paying 35 times for BOO, when it has the opportunity to double or triple in size over the next 3-5 years? Plus its growth is fully self-funding, as the stock-turn is rapid. So no funding requirement.

My opinion - I love it, this is a fantastic company. The shares are expensive on normal metrics, but that's because it's a wonderful growth story. Obviously if something goes wrong, then the shares would crash - as they did in Jan 2015. So these highly rated growth stocks are risky. Although so is everything - look at how bellweather Next (LON:NXT) has seen its shares crash about 40% in recent months.

Isn't it interesting how BOO doesn't mention any of the macro worries, and all the other excuses that other retailers have cited in recent months!? Funny that. The reality is that newer companies like BOO are just eating the lunch of older-style retailers. There's no problem with consumer demand, it's just diverting in different directions.

Am popping out for lunch now, will update further between 2-3pm.

Work-in-progress...am updating this article gradually. Paul.