Stock in Focus: Is Shoe Zone a good fit?

Disclosure: Roland owns shares in Shoe Zone.

When investing in retailers, it’s important not to confuse product quality with investment quality. Take Shoe Zone, which floated on AIM in 2014. Although the firm’s business model is of the ‘pile them high, sell them cheap’ variety, Shoe Zone’s stock scores far more highly on the quality front.

As it happens, Shoe Zone is one of the most recent additions to my personal portfolio. I purchased the stock after the June interims revealed no new problems and quite decent results.

Nothing much has happened to the share price since then, despite the recent market volatility. This makes sense to me. Although Shoe Zone’s products are made in China, its customers are all in the UK, where the economy appears relatively stable.

Like Poundland, Aldi and other cheap retailers, Shoe Zone appears to have found a successful formula for high street growth. In this article I’ll ask whether this seems likely to translate into shareholder returns.

What about investment appeal?

Shoe Zone’s frugal appeal certainly stretches beyond its footwear.

Stockopedia gives the firm a StockRank of 87, with value and quality ranks in the mid-80s. This gives the firm a QV Rank of 95. As a value and income investor, I often use the QV Rank as an initial filter to highlight companies in which I might be interested, as they tend to fit my investing criteria.

Interestingly, Shoe Zone’s profit warning earlier this year has left the shares trading at almost exactly their IPO price. Thus investors can buy Shoe Zone shares at the initial offering price, but with the benefit of more information.

Good value

Shoe Zone’s ValueRank of 84 reflects an undemanding valuation, an attractive dividend yield and a respectable level of profitability:

In my view, the dividend yield, earnings yield and P/FCF are the key figures here. Shoe Zone’s modest P/E ratio and attractive dividend yield is backed up by solid free cash flow generation.

The earnings yield is one of my favourite ratios. It’s calculated as EBIT/EV, or operating profit divided by enterprise value. In my view, this is an excellent way of assessing a company’s underlying profitability, as it excludes interest and tax costs but includes the impact of debt on a firm’s valuation.

I tend to look for an earnings yield of more than 10%, so Shoe Zone fits the bill, especially as it has no debt and thus should have negligible finance costs.

One caveat is that in my opinion, Shoe Zone’s intrinsic asset value is minimal. The firm has a head office and warehouse, some trucks and around £28m of inventory. The stores are normally rented and production is outsourced.

Investing here is about profiting from the execution of an apparently profitable business model.

Low-cost quality

According to its website, Shoe Zone sells more than 20m shoes per year. In 2013, the average retail price was just £9.77.

Yet being cheap isn’t enough for either shoes or shares. Some quality is necessary. Shoe Zone’s QualityRank of 85 suggests that in financial terms at least, this isn’t an issue.

However, investors might wonder why the firm’s successful model hasn’t been copied by others, as it has with Poundland, for example. In my view, the answer to this is that the firm’s management is above average.

Shoe Zone is essentially a family firm. Chief executive Anthony Smith and his brother Charles, who is COO, control 55% of the stock. These large shareholdings should mean that the firm is run with a relentless focus on cost, cash generation and sustainable dividend growth.

After all, based on this year’s forecast payout of 9.45p, Anthony Smith’s 30.56% shareholding will generate a dividend income of £1.4m, dwarfing his £225,000 salary.

Shoe Zone’s performance in 2014 certainly suggests that costs are kept under tight control. The firm’s gross margin rose from 59.4% to 61.3% last year, thanks to “improvements in sourcing”. This is an impressive gross margin for a retailer, although last year’s improvements may have been helped by the strong pound and falling commodity prices.

In any case, the firm’s 61% gross margin dropped through to an operating margin of 6.1% in 2013/14, giving a healthy net margin of 4.6%.

This profitability is backed by a strong balance sheet and net cash, earning the firm a Piotroski F-Score of 7. I have no real concerns here, other than whether last year’s exceptionally good performance can be sustained.

Uncertain momentum

Shoe Zone’s trading appears to be heavily weighted towards the second half, which includes the spring/summer period (Shoe Zone’s financial year ends in October).

As a result, the firm’s first-half accounts, while broadly positive, didn’t really provide much of a clue about full-year prospects. Forecasts from the firm’s two brokers indicate that earnings per share are expected to rise by 12% to 18.1p this year, giving a forecast P/E of just 9.3. A dividend payout of 9.45p per share is forecast, giving a chunky 5.5% prospective yield.

Shoe Zone’s MomentumRank of 45 doesn’t really reflect this optimism. Although earnings momentum is reasonable, price momentum is poor.

With a chart like this, price momentum is very weak.

The impact of the firm’s April profit warning is still very much reflected in the price momentum factors. As we saw with Boohoo.Com recently, this creates a dilemma for investors. While the valuation may be attractive, the price momentum situation is not.

For me, this isn’t a big concern. I prefer to buy cheap and wait for something good to happen and see technical momentum factors such like the price relative to the 52-week high and the ratio of 50-day moving average (dMA) to 200dMA as secondary to fundamentals.

However, this is a case of DYOR. What’s comfortable and consistent for one investor may not work for another.

Outlook

In my opinion, Shoe Zone’s performance during the second half of this year is key. The way I see it, management credibility and investment appeal are both in need of a dose of boring consistency at the moment.

If Shoe Zone delivers, I’ll be happy to hold and enjoy the yield while sales inch higher. If not, I may sell. But that’s only my view. I’d welcome yours in the comments below.