Small Cap Value Report (Wed 9 Jan 2019) - SOS

Good morning, it's Paul here.

To get you started this morning, please see yesterday's completed report here. I added new sections on the trading update from Staffline (LON:STAF) , and also reviewed the disastrous results from (privately owned) fast fashion website, Missguided.

Today's big news is the Q3 (Oct-Dec) trading update from Sosandar (LON:SOS) which is my largest personal holding, so I'll be focused on that first thing.

EDIT: I spent the whole day working on Sosandar, and was too tired to do any more writing in the evening. So I got an early night, and have resurfaced early on Thu morning, to continue writing about Weds other share announcements of interest. These are now in Thursday's report here.

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Sosandar (LON:SOS)

Share price: 32p (before market open)
No. shares: 116.2m
Market cap: £37.2m

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

Trading update

Sosandar is an online-only womenswear fashion brand. It launched in autumn 2016, and floated on AIM via a reverse takeover (of a cash shell called Orogen) in Nov 2017, at 15.1p per share. It is based in Wilmslow, with logistics out-sourced to Clipper. IT is also out-sourced, using Magento software. The founder joint-CEOs have a fashion magazine background, having founded & edited Look magazine. This is my largest personal shareholding, which I am treating as very long term - backing great management basically, with a big opportunity to fill an under-served niche.

Today's update covers the seasonal peak trading of Oct-Dec 2018 (Q3 in Sosandar's financial calender, with a 31 Mar 2019 year end)

I've just come off the phone to management, as I wanted to ask some questions & incorporate them into this report, hence the delay in posting this.

Main points;

Revenue - Q3 revenues were £1.6m (up 209% on the prior year comparative) - very good growth, but personally I was hoping for a figure nearer to £2.0m, so my expectations got a little ahead of things. Memo to self: don't get over-excited over short term numbers.

Growth rate - I queried the deceleration in revenue growth from H1 (+407%) to Q3 (+209%), with management this morning, who made the following valid points;

• Tougher prior year comparatives from Q3 onwards reflect that the IPO proceeds, which kicked in during late 2017, enabled a surge in marketing spend & hence sales.
• Growth rates of 400%+ are mathematically impossible to sustain, so were always anticipated to reduce in percentage terms, as the business grows (as reflected in broker forecasts)
• Today's beat is against forecasts which had already been raised recently (late Nov 2018)

Forecast revenue - next year's broker forecast (FY 03/2020) suggests about 118% revenue growth. So Q3 this year growth of 209% is still way ahead of that.

The house broker has today upped its forecast for FY 03/2019 from £4.15m, to £4.35m. This is the second revenue upgrade in 2 months. I make it the 5th revenue upgrade since the company floated, when it originally forecast £3.0m sales for this year.

Allowing for a bit of out-performance in Q4, then this means the actual outcome for FY19 is likely to be revenues c.50% higher than the original plan at IPO. It's not often that you come across that level of out-performance from an AIM float, is it?! It's still early days though, and the numbers are small for now - remember that Sosandar only began trading in late 2016.

Q3 YTD revenues - come out at £3.44m (being £1.84m reported in H1, plus Q3 of £1.6m reported today).

Therefore, the upwardly revised broker forecast of full year £4.35m implies Q4 forecast revenue of £0.91m (43% down sequentially on Q3), which should be comfortably achievable in my view.

Rather than getting over-excited with my own forecasts (which proved too optimistic), in future I'll work on the assumption that broker forecasts are sensible, and mildly conservative. Indeed, we have a nice pattern emerging of brokers repeatedly raising forecast revenue, and the company then modestly beating increased expectations. That's the ideal scenario actually.

Seasonality - bear in mind that womenswear sales are highly cyclical. So Q4 (Jan-Mar 2019) will see a sequential quarter-on-quarter drop in revenues, from the peak in Q3 - hence why the forecast allows for this drop. Although the year-on-year Q4 performance should still be triple digits % up. So this is all as expected.

Given that the company is growing so fast organically, the precise seasonality is difficult to predict. Also, management explained to me that they can affect seasonality by the timing of marketing spending. This is a very important point, which I'll expand on in the cash burn section below.

In a nutshell, Sosandar's seasonality goes something like this;

Q1 (Apr-Jun) - busy
Q2 (Jul-Sep) - quieter
Q3 (Oct-Dec) - very busy (seasonal peak)
Q4 (Jan-Mar) - quieter

Gross margin - at 53.3% in Q3, is up strongly from prior year (500 bps increase), but down on the 55% reported in H1. I queried this, it's because;

• Christmas end of season sale tends to be bigger than summer sale, and
• Product mix - e.g. coats & boots have high cash margin, but lower % margin

Looking back at previous broker notes, the forecast gross margin for this full year is 53.5%. So the company is tracking slightly ahead of this overall, year to date.

Therefore, there is nothing untoward with the small drop in gross margin from H1 to Q3, it's just normal seasonality, is as expected, being in line with forecast.

EBITDA loss - is down on last year, but no figures are given. It's in line with expectations, so no surprises either way.

The latest broker forecast is for an EBITDA loss of -£3.4m this year.

An eCommerce fashion company has to run at a loss in the early stages, because it costs money to build a team of people that create a bespoke range of clothes. Also, customer acquisition costs (marketing) are paid up-front, but then generate a stream of future profits.

The company took the (correct) decision to accelerate growth, with increased marketing spend, once it became clear some time ago that celebrity & customer reactions to the product designs was so positive.

Returns rate - the industry average for eCommerce fashion is c.40% customer returns. Traditionally, mail order fashion used to have a 30% returns rate. eCommerce is just the same as mail order, but using a website instead of a catalogue.

Customer habits have changed in recent years, with people now over-ordering, and sending back what they don't like. Garment fit is also the main reason for returns, as we're all different shapes & sizes. This is the big advantage that physical shop retailers have - the customer tries on garments in-store, and only buys things they like & which fit. So returns are much lower (typically c.5%)

Sosandar's 52% returns rate in H1 did raise some eyebrows, as being rather high. Management said it would reduce in Q3, which it has, to 49%. Still quite high. I discussed this with management today;

• Industry average of 40% includes menswear, which is lower than womenswear. As Sosandar only sells womenswear, then they just have to live with a higher returns rate, which is not abnormally high for pure womenswear
• The company is doing everything it can to manage down returns, but forecasts assume returns rate continuing at or around the current level

Sosandar's high average order value, of over £100, combined with 53%+ gross margin, means that it makes a sufficiently large cash margin on each sale, to absorb some marginal extra postage & handling costs from customer returns. Contrast this with low end fast fashion companies, which often just bin very cheap returned items, apparently.

The company doesn't see returns as a major problem, if the returned products can be re-sold. This is what happens - returns come in & are usually dispatched back out again to a new customer, immediately, if in as-new condition, which they nearly all are (more mature, affluent customers don't tend to abuse the returns policy)

Net cash - is reported at £4.6m (at 31 Dec 2018).

Placing - as we know, there was a top-up £3m placing at 32p in Oct 2018, details are here. The dilution was only small, increasing the share count from 106.8m to 116.2m, so dilution of only 8.8%. I don't have a problem with small, top-up placings, which dilute less than 10%.

The company told the market at the time, that the placing was done due to institutional demand. Not a good phrase, as private investors usually scoff at the use of that phrase - as it's so widely misused - especially when Directors want to sell off personal shareholdings.

However, in this case, the phrase is absolutely true. A couple of institutions approached Sosandar, and offered them £3m in new funding. The company pondered the offer, and agreed to it, because the dilution is modest, and it helped de-risk the business model. The growth rate had been deliberately accelerated, which necessarily required more cash, so it all fitted together rather well.

I think some private investors have misunderstood this, hence why it's worth clarifying. In any case, investors shouldn't fear small fundraisings, at companies which are out-performing. Institutions queue up to put money into situations like this.

Cash burn - not explicitly stated in the Q3 update, but it's dead easy to work out.

Cash was £2.6m at 30 Sep 2018, plus the placing of £3.0m, gives £5.6m cash available, of which £4.6m remains. So £1.0m cash was burned in Q3.

If we deduct say £0.1m for fees relating to the placing, then underlying cash burn from operations in Q3 was about £0.9m. That strikes me as unexpectedly high, so I queried it with management today.

The main reason is that Q3 is the biggest period in the year for marketing spend. What Sosandar does, is to target marketing spend to busiest times of year, in order to get the best return from that marketing spend. So they described the Q3 marketing spend as "massive". This has led to very successful recruitment of new customers, which then have a very long & valuable lifetime value. However, they don't expect to get an immediate, in full, payback on the cost of customer acquisition.

Q4 is seasonally slow, so the marketing spend is being turned right down, resulting in lower cash burn. Spending then rises again in March & April, to drive summer season sales.

Marketing spend is also fine-tuned to reflect product intake - i.e. they only spend on marketing when there is plenty of new stock available, and not so much at end of season clearance time.

Therefore the key point to understand is this - cash burn per quarter is not linked to sales/margins alone. The very high, variable, discretionary, marketing spend, is the major factor affecting cash burn.

So if you (as I initially did!) took the £1m cash burn in Q3, multiplied it by 4, to get £4m annual cash burn, and then thought, gulp, they're going to run out of cash in early 2020, then you've got it completely wrong!

The broker forecast assumes £4.1m cash at 31/3/2019, so cash burn in Q4 is implied at £500k.

As an aside, Sosandar presently pays cash on delivery to its factories. So there is cashflow upside in future from it moving to 30-day payment terms. Stock turn is very rapid too, worth bearing in mind. These points mean that the business should be able to continue expanding rapidly, without requiring additional cash for working capital.

Broker forecast is for net cash to bottom out at £3.6m at end 03/2020, and then start rising, to £6.0m at end 03/2021. Therefore, on current forecasts, which look perfectly credible to me, the business has plenty of cash headroom. Bulletin board chatter to the contrary, is just the usual nonsense that can safely be ignored, because people haven't done proper research.

Note that the company's policy is to reinvest surplus funds from out-performance into accelerating growth further. Therefore, don't expect profit/losses to deviate much from forecasts, even if sales do out-perform - this is a deliberate (and sensible) policy, to drive the business as hard as they can.

As regards overheads, I'm told that the main people infrastructure is now in place. Management speak very highly of their team. The business model is outsourced - what's great about this is management can focus on what they do best - product design, sourcing, and marketing. Plus customer service, etc. Contrast this with other retailers, where a great deal of management time is spent battling logistical problems (shops, warehouses, and IT, etc). Sosandar has a huge advantage in having outsourced everything. The relationship with Clipper Logistics (LON:CLG) is, I believe, working well.

Marketing & KPIs - a bit more detail on this. A lot of the company's marketing channels are almost free (email, some social media, and celebrity endorsements). So news today of its customer database being close to hitting 100k is very encouraging. Regular emails are sent out, being product-orientated, and drawing on the founders' extensive fashion magazine experience. 

Top quality photography is another stand-out feature of Sosandar. It's not just selling clothes, it's building an aspirational brand, hence these things matter.

Paid-for marketing (e.g. Facebook, etc) and more traditional marketing channels (non-internet) cans be measured precisely, in terms of return. Hence the money is focused on the channels which give the best return.

Repeat custom - this is absolutely key to understanding the upside case with Sosandar. A lot of eCommerce companies have to constantly spend on marketing, to drive one-off purchases. The beauty of Sosandar, is that it is achieving extremely high levels of repeat business. Therefore marketing spend to attract new customers, in many cases results in loyal, returning customers, who can in future be contacted at little to no additional cost.

Therefore, instead of running to stand still, Sosandar's marketing spend is genuinely building a growing, and loyal customer base. That should result in big future profits, once the business has achieved greater scale. Although as with any fashion brand, the business is only as good as it's current stock. If the buyers get the styles wrong, then customers can rapidly lose interest. 

Sosandar's conversion rate (website visits into completed sales) is impressive, at 3.47%. This indicates motivated customers, wanting to buy.

This is the best bit - 57% of all transactions are repeat customer orders. Think that through. Given how fast the business is growing, it's quite astonishing that 57% is already repeat business. This is proof that Sosandar is achieving very high levels of customer satisfaction, and that customers are returning to purchase more. This should result in continued rapid growth - because the core customer base is growing fast, and is loyal, once they've bought their first item, coming back for more. The lifetime customer value could therefore be enormous, given the wide demographic.

My opinion - my initial reaction this morning was of slight disappointment. I had imagined that the company could be heading for c.£5m sales this year (way ahead of broker forecast). I got a bit carried away, sorry about that.

It now seems likely that the company is heading for c.£4.5m sales this year. Broker forecast (revised up, again, by £200k today) is now £4.35m, but the company has established a great track record of seeing forecasts raised, and then modestly beating the upwardly revised figures. Hence why I've reined in my own ideas, to c.£4.5m revenues for this year.

Next year should be £9-10m revenues, and losses roughly halving to c.£1.6m (broker forecast). Then profits thereafter. With a 53%+ gross margin, and rapid growth, the operational gearing should be very exciting.

The marketing spend is driving new customers, who then typically become repeat customers. What could be better than that?

Put it all together, and this is a tremendously exciting long-term opportunity, in my view.

Short-term, how do you value it? The "it's ridiculously overvalued" commentators are, without exception, superficial in their views. They've not done thorough research, and don't understand the business model, from what I've seen. Although it's always worth checking negative comments, to see if they might have a point.

I'm not really interested in the short term share price. For me, this is a future multibagger, and what happens to the share price between now and then, is neither here nor there. I tend to put a lot of my eggs in one or two baskets, and watch those baskets like a hawk. Hence the level of detail in today's report!

There are no guarantees of course. Something might go wrong, or wobble, along the way. That's the risk with all equities, isn't it. The outlook for the company looks excellent, and I think management are so good, and executing so well, that I'm very happy to keep this as my largest real world portfolio shareholding.

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I was too tired to do any more writing, after spending the whole day on Sosandar. However, the rest of Wed's news is now in Thu's report here.

Regards, Paul.