Small Cap Value Report (25 Oct 2016) - SHOE, CPR, BMS, OTB, PDG, MPE

25th Oct '16 by Paul Scott

20 comments 17639 reads

Good morning!

In case you missed it,here is my interview yesterday with Exec Chairman, Ric Traynor, of insolvency practitioner Begbies Traynor (LON:BEG) (in which I hold a long position). I thoroughly enjoyed chatting to him, and reliving a few moments from my own experience of working in the sector, 25 years ago.

The next interview planned is with the CEO of Staffline (LON:STAF) (in which I also hold a long position) - so I invite you to submit any questions you'd like me to ask on your behalf using this link.

Shoe Zone (LON:SHOE)

Share price: 169p (up 18.6% today)
No. shares: 50.0m
Market cap: £84.5m

Trading update - this covers the 52 weeks to 1 Oct 2016.

The key paragraph is more positive than I was expecting, saying;

The Board expects pre-tax profit for the period to be broadly in line with expectations and marginally ahead of the prior year.

The business continues to have strong cash conversion and closed the year with an approximate net cash balance of £15.0m (2015: £14.2m).

Valuation - broker consensus EPS forecast is 17.5p, so assuming they achieve about 17.2p (based on "broadly in line" actually meaning slightly below), then after today's big rise in share price, the PER is 9.8.

Given that nearly 18% of the market cap is the company's own net cash balance, then the ex-cash PER is about 8.1 by my calculations.

Dividends - the yield is generous, with a payout of 10.5p forecast for this year, yielding 6.2%

Outlook - the company has not really said anything about the future in today's update, and has therefore completely ignored the elephant in the room - the devaluation of sterling. Since ShoeZone imports product from China, cheap plastic shoes, then its future deliveries are bound to be more expensive.

Competitors will also have to put up prices, to protect margins, and we simply don't know yet how consumers are going to respond. Clearly higher prices will reduce volumes sold, but we don't yet know by how much.

I think it was a big omission for the company not to say anything about this issue at all in today's update.

My opinion - this is the calm before the storm for retailers. Hence I reckon today's pop in the share…

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jraitt

25th Oct '16

Hi Paul,
You say "Since ShoeZone imports product from China, cheap plastic shoes, then its future deliveries are bound to be more expensive." yet yesterday in your piece you said that the CEO of G4M had said that the yuan had also devalued which took away much of the diference. Also by ordering more he could further save - although I guess musical instruments don't go out of fashion (do shoes?)

beatingmrindex

Hi Paul,

jraitt has a point and you might be suffering from some unconscious bias. :) They are cheap and cheerful shoes which are the lower end and will rise in price I imagine... Shoe is managed by guys who are very vested in the success of the business and like paying big dividends. (I hold and will continue to do so due to fantastic div payments)

TradeRyder

Also an update on movements with Gear4music would be appreciated!!!

stevem_2000

Gear4music chairman sold a portion of his shares yesterday. Possible trigger for the circa 10% decline?

Ajay_Gajree

RE: G4M, I believe DYOR guys? Not sure its Paul's job to give daily running commentary on any share! And personally a 10% decline was a buying opportunity in my view...

dmjram

Checking yesterday's article, the fall in the yuan made up only c1/3 of the difference. The pass through on shipping/distribution costs of the fall against the dollar will however be 100% with no mitigation.

Also of relevance is that ShoeZone's customers will in general have lower incomes. Indexation of in work benefits to mitigate inflation increases was cancelled in the last budget, which will squeeze them even more.

gus 1065

Hi dmjram,

I was in the midst of penning a similar response to yours about the relative extent of the yuan appreciation against the £ - you saved me the effort.

On the impact of currency fluctuations on UK prices and Shoe Zone (LON:SHOE) sales, I wonder if you are familiar with the economic concept of a "Giffen good"? The suggestion is that for the poor (who need shoes for themselves and their children as a basic necessity), as prices increase the demand for the poorer quality substitute (plastic vs leather shoes) actually goes up as they are priced out of buying the preferred but more expensive alternative. If a £ devaluation does drive up the price of imports in the high street coupled with a possible economic slowdown/rising unemployment there may perversely be an improvement in the sales figures (if not necessarily the margins) for discount retailers such as Shoe Zone (LON:SHOE) and the likes of £SPD

Gus.

c038644

I would agree this is a likely outcome. Look at the rise of Lidl and Aldi from the depths of the 2008 economic crash.

ExpectingValue

This would actually be an example of an inferior good, not a Giffen good

PJ0077

What's an example of a Giffen good, then?

Hi Gus,

Yes - studied the old Giffen good back in the mists of time. The classic example was the potato in the Irish famine.

Empirically there weren't (at least not a good few years ago!) any other examples. It takes a very strong set of circumstances for the demand curve for an inferior product to slope upwards, especially for goods which are consumed over a prolonged period.

In contrast Veblen goods which are the corresponding example at very high levels of income/prices exhibit quite good evidence of the upward sloping demand. Maybe Ferrari and Shelby dealers will become a good stock bet as the fall in the pound bites!

Mike

imranawan

Definition of a Giffen good and Veblen goods: http://www.investopedia.com/terms/g/giffen-good.asp

Takes me back to my Business Studies degree and an Economics module I studied, those were the days.

Perhaps - maybe - some luxury items fall into this category.

EDIT: actually no, this also isn't an example... as other posters correctly point out, these are perhaps Veblen goods. I'm not sure there are any that actually hold up in real life..

Hi EV.

Probably a fair cop.

If we were back in an economics tutorial I'd argue the toss with you. Strictly speaking (I think, it was a long time ago!), I recall that a Giffen Good is a subset of the more widely defined Inferior Good. Both have the perverse characteristic of demand increasing where price increases. In addition, a Giffen Good is one where a consumer buys more of a good where their income falls as well as the price going up. (As dmjram says the textbook example was the potato in the Irish famine in the 1840's. As unemployment went up incomes fell and in addition the potato blight made the cost of potatoes go up so the poor had to buy more potatoes and less (preferable) corn just to survive).

In the context of Shoe Zone (LON:SHOE) it is possible that £ devaluation would increase import prices which coupled with a recession/higher employment and concomitant decrease in earnings could arguably satisfy the two conditions for a Giffen Good, I.e higher prices and lower incomes.

Anyhow, as our good friend the Naked a Trader might say, Deal or No Deal is on the telly, so enough of this history and economics banter and back to the serious stuff!

Best,

Gus.

tabhair

Looking at Shoe Zone (LON:SHOE), I have to say I am kicking myself from not investigating further. I know we've seen so many IPO's implode after listing, maybe investors have a mental block in looking closer at them.

I read the annual report, it suggests that Shoezone have FX hedging in place, so that might suggest the lack of explanation in this update.

Purchases are made on a central basis and the risk is mitigated through using forward foreign currency exchange contracts.

Paul Scott

Hi jraitt,

Sorry if I confused you, and beatingmrindex with my recent comments on exchange rates.

The point I was making yesterday was this;

Sterling has devalued by 25% against the US dollar in the last year. Since goods imported from China & other Asian countries are usually billed in US dollars, then we might have expected prices to rise by 25% in UK shops for many goods next year.

However, the Chinese currency has devalued somewhat against the US dollar, therefore the sterling impact is more likely to be around 17%, not 25%. Furthermore, retailers are finding other ways to mitigate the price increases further.

So whilst these factors mitigate the problem somewhat, UK shop prices will still have to rise and by a considerable amount. I seem to recall Next said by around 5%, but I reckon that's likely to be one of the smallest levels of price increase. Think nearer 10-12% for most products made in the Far East, is my estimate.

This is the issue that ShoeZone will be grappling with, and indeed everyone who imports stuff from the Far East. So this is a widespread problem affecting all retailers, not just ShoeZone

There's no bias at all in what I wrote, nor any contradiction, I possibly just didn't explain things clearly enough (or people didn't read what I said carefully enough!) ;-)

This currency issue is likely to affect all non-food retailers, which is why I'm generally avoiding the sector.

Where G4M interests me, is that it's hoovering up market share at such a phenomenal rate (especially in sales to Europe, which of course won't have any problem over currency) that any slowdown from currency is only likely to trim their growth a little. Whereas for old style, UK based retailers with bricks & mortar outlets, the impact is likely to be far more severe in my view.

If retailers are able to pass on price increases in full, then their gross margin will be maintained, but sales are likely to drop by an unknown amount. Combine that with higher costs, from Living Wage, apprenticeship levy, compulsory pension contributions, business rates increases, etc, and the sterling impact is just the latest in a series of nasty headwinds for almost all retailers, not just ShoeZone.

I've commented in the same way about the impact of sterling depreciation on lots of retailers lately, so it's certainly not a case of me singling out ShoeZone in particular. I just don't think you can rely on broker forecasts generally for the sector, as in my view they're under-estimating the impact of price rises caused by weaker sterling, but time will tell.

So these PERs of 8-10 for retailers might look superficially cheap now, but I bet you they won't look so cheap this time next year, once the full impact of sterling's devaluation has fed through, and earnings have fallen, thus pushing up the PER. Caveat emptor with the whole sector, not just ShoeZone!

Regards, Paul.

Hi tabhair,

Shoe Zone (LON:SHOE) may well have hedging arrangements in place for this year, as most retailers do.
However, hedging only defers the problem. When the hedges expire, then cost prices will rise significantly, and that will force retailers to raise shop prices considerably. Consumers are bound to resist price rises, which will result in a fall in volumes sold. We just don't yet know how the numbers will combine, in terms of overall turnover. Fascinating times ahead!

Regards, Paul.

kenobi

Hedging only defers the problem, true, the challange is to work out what the exchange rate might be in 12 months or 18 months time, will we be over the worst ? will we have a deal with the eu ?

I doubt it personally, I think we'll only just be past Hollande and Merkle having had elections and perhaps going, and getting to the meat of the discussion. However the clouds might have passed somewhat if new leaders come in who are more inclined to do a deal, and less inclined to try to extract a pound of flesh.
all the above is of course a guess,

K

xcity

Thanks for the Begbies Traynor (LON:BEG) interview. I'm a holder and it just confirms my positive long-term view, though no short term fireworks are likely.

I'm struck by your idea that far east sourced products are likely to rise 10-12 %. For most retailers product costs are only part of the cost mix and not the major part either. And the other costs will be in sterling. This is specially true for the high street, though less so for Internet. There will also be pressure on suppliers to reduce their margins. Next may be better than most, but 5% or so seems a reasonable guess to me for the moment.
Of course, if volume falls, then prices might have to rise more but that is not a currency effect and increases the opportunity for lower cost retailers.

gguram

26th Oct '16

Hi Paul,
Could you please upload your comments on On The Beach (LON:OTB). Very interested to read your thoughts.
Regards
G.Guram

Small Cap Value Report (25 Oct 2016) - SHOE, CPR, BMS, OTB, PDG, MPE

Shoe Zone (LON:SHOE)

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Paul Scott

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