Stock Pitch - ScS Group (LON:SCS)

ScS Group looks cheaper than ever amid resurgent post-lockdown trading but the shares initially fell by about 10% on the day of its most recent results. It seems as though the market can’t quite trust this furniture and floorings company, which has traded on notably low earnings multiples since listing back in 2015.

But the prospects certainly seem positive. Not only are customers getting back to physical shopping, some close competitors have either gone out of business or have reduced capacity as a result of lockdowns.

ScS trades at a discount to peers once you factor in the fact that it has nearly its entire market cap in cash on the balance sheet. The company has just reported FY21 underlying earnings per share of 41.3p, while brokers are looking for 30.8p of EPS in FY22 compared to a share price of around 270p. That makes for a PE ratio of 6.5x rising to around 8.8x the following year even before adjusting for cash.

The pressing question, though, is around the sustainability of this level of earnings. Shore Capital forecasts just 22.2p of earnings per share for FY23, for example - a marked drop that would bring the group back to FY17 levels of profitability.

So how long can present conditions persist, and what happens to the share price once pent up demand subsides and trading reverts to historic levels?

SCS was pitched to the Stockopedia Investment Club on the 5th October 2021 at a share price of 270p.

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Profile

About the Stock:

This is Scs (LON:SCS) , a furniture and floorings retailer that operates from 100 stores and nine distribution centres.

Its shares trade on the LSE Main Market and are currently priced at 270.5p. With 38,012,655 shares in issue, that makes the market cap around £102.8m.

Liquidity is acceptable for a small cap: a spread of about 100bps and an EMS of 2,000 indicates that about £6,000 can be reliably bought and sold at market prices.

The group has no debt or pension liabilities and cash of £87.7m, although £37m of this is customer deposits and the group says another £15m is retained as collateral for the credit insurance.

Still, if we take a prudent view of the cash pile as £35.7m (after deposits and collateral), that still gives a pre-IFRS 16 enterprise value of around £67m on FY21 revenue of £310.6m and profit before tax of £22.7m.

This cheapness is reflected in a Value Rank of 80, but the group also stacks up well in terms of Quality (90) and Momentum (71), meaning ScS qualifies as a well-balanced Super Stock with an overall StockRank of 95.

About the Opportunity:

The argument here is simply that ScS shares are too cheap. This low valuation paves the way for a potential ‘double whammy’ of multiple expansion and positive earnings surprises.

The group has spent much of its listed life looking ‘cheap’ however, so a catalyst might be required in order to realise value.

Demand-side catalyst: post-lockdown trends of working from home, house extensions, and house moves mean customers are buying more furniture. Meanwhile, Bank of England data suggests that household savings have increased markedly over the pandemic period.

This is visible in the company results: a lower proportion of customers are taking credit, while the corresponding average transaction value has increased.

The revised consensus sales forecast for FY22 is £373m, which is up 15% on FY20 and more than £50m higher than FY19 (the most recent undisrupted trading year). Forward visibility is also strong, with the order book rising from £60.6m in FY19 to £103.5m.

Supply-side catalyst: competition has reduced as a result of lockdowns. Harveys has entered administration, which puts c£160m of turnover back into the market. Oak Furnitureland has reduced its estate following a CVA. Many independents have struggled and there are fewer department stores now than in 2019.

Company-specific catalysts: Online has been a source of growth for ScS over lockdowns, although there are signs of this coming back a bit as stores reopen.

Digital sales have grown from £11.3m in FY17 to £46.9m in FY21. Management believes online sales can settle at c20% of turnover in the medium term by increasing the marketing budget here, which would be worth around £65m today.

The group’s smaller floorings offering also offers an additional route for growth. ScS entered this market in 2012 and has built up a 2.8% market share (it has around 9.8% of the furniture market).

There is also scope to expand into additional home products beyond furniture and flooring.

Taking these factors together, ScS hopes for sustainable growth beyond present favourable conditions.

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Business & Model

What is the company history & what does it do?

• 1894 - commenced trading in Sunderland as ‘Suite Central Sunderland’
• 1980 - grows to operate from eight stores in the North East of England
• 1993 - management buyout
• 2007 - grows to 95 stores nationwide
• 2009 - launch of transactional online website
• 2011 - introduction of interest-free credit
• 2012 - adds flooring; rebranded as ‘Sofa Carpet Specialist’
• 2014 - House of Fraser concessions launched
• 2015 - listed on LSE in January; three new stores opened
• 2016 - new store in Bromborough opened
• 2017 - Four new store openings
• 2018 - one new store opened
• 2019 - launched nYwhere app; exited HoF concessions
• 2020 - new store opened; launched new website.

Recent history

ScS’s suppliers had their funding lines cut and depended on the group to finance their working capital shortfall in the wake of the Great Financial Crash in 07-08.

Although ScS had maintained a net cash position, this was not enough. Its banking facility didn’t cover the shortfall and the bank refused to increase it, resulting in administration. It was then acquired by private equity group Sun Capital in July 2008, with Sun recapitalizing through a £20m cash injection.

Since then Sun has sold out, marking an end to this chapter. Investors may still be wary of a similar situation arising in future, though.

What is the business model? How does it make money?

ScS sells furniture and floorings at price points between £299 and £5,295 on its website and in 100 stores across the UK, distributing products from nine distribution centres. The average transaction value is £1,650 and customers have the option to use long-term interest-free credit.

Around 50% of its product comes from the UK, 10% from Europe, and 40% from Asia.

FY21 revenue of £324.5m comprised:

• £248.9m from Furniture (FY20: £219m),
• £28.7m from Flooring (FY20: £30m), and
• £46.9m from Digital (FY20: £19.1m).

An important characteristic of the group is its negative working capital business model.

• Customers pay deposits at the point of order and settle the balance before delivery;
• For consumer credit sales, the loan provider pays ScS within two working days of delivery, and
• Suppliers are paid at the end of the month following the month of delivery into the distribution centres.

This means ScS can hold onto cash for longer. It is an excellent cash generator for its shareholders and does not have to spend much on capital expenditure. Unlike DFS, it does not manufacture.

It regularly posts free cash flow well in excess of earnings per share and it has improved its net cash position from £21.1m at IPO to £87.7m today, despite paying out nearly £30m in dividends between FY15 and FY19 and selectively buying back stock.

In its annual report, management also spends time explaining the merits of its flexible cost base. Around 76% of its costs are variable (eg. distribution and marketing) and another 12% are semi-variable (such as payroll costs), giving it flexibility.

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Market & Competition

What is the state & size of the company's market?

GlobalData research suggests the furniture market was worth £2,462m in 2020 and could recover to as high as £3,383m by 2025. It values the flooring market at £1,403m and believes this can recover to around £2,064m by 2025.

If it maintained its current market shares, that would be £331.5m of furniture revenue and £57.8m of flooring revenue for ScS by 2025.

What is the company's strategy?

The strategy at ScS is focused on being a good furniture and floorings retailer. It’s focus is not so much on new stores as it is on optimising the existing estate of around 100 units and increasing sales density. It does say that it would like to add around two new stores per year.

The group recently looked into acquiring sofa.com, and it’s possible that other M&A opportunities might present themselves. It hopes to take market share in both furniture and flooring, increase its online business, and possibly move into additional products.

How does it derive its competitive advantage (if any), is it durable and is there evidence of one in the financials?

The balance sheet is a source of strength and allowed ScS to survive lockdowns while DFS had to raise funds, Harvey’s went out of business, and Oak Furniture Land exited a number of stores.

The group is now looking to use this cash pile to pay dividends to shareholders or make acquisitions in a fragmented market that has been significantly disrupted.

It is likely that the level of cash will reduce at some point as conditions normalise, but financial health should remain strong.

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Financials & Ownership

What is the record of growth & profitability?

Revenue has trended upwards over time, although 2020 was disrupted by lockdowns.

The earnings per share trend has also been broadly favourable, although not without a setback in 2015.

Importantly, cash flows are typically far in excess of reported profits at ScS with free cash flow conversion typically in excess of 100%.

Is there evidence of historic share dilution or buy backs?

Shares in issue have fallen slightly from around 40m to just over 38m over the past five years. Given the group’s cash backing, there is scope for further buybacks.

What is the ownership structure of the company and do management have stakes?

Directors have mainly been selling, although the big sales are from Paul Daccus, Sun Capital’s representative on the board. This is the major shareholder that rescued ScS from administration thirteen years ago.

David Knight, the outgoing CEO, owns 1,528,615 shares and Chris Muir, the CFO, owns 50,474 shares. A couple of other directors also hold shares, but there is limited skin in the game from a management perspective.

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Valuation

How does the relative valuation compare versus industry and sector?

Compared to peers, ScS looks cheap. Dfs Furniture (LON:DFS) trades on 0.64x sales whereas SCS trades at 0.36x. And, while DFS trades at 5.21x EV/EBITDA, ScS trades on just 2.99x.

Since the group has trades profitably as the number two in the market and benefits from a supportive near-term outlook, it can be argued that this discount is harsh and the valuation gap should close.

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Trends & Catalysts

Are there any significant macro trends that the business is benefiting from?

• Perhaps the primary dynamic in the short term is the reopening of the UK economy and a resumption of big ticket purchasing.
• However it remains to be seen how long these buoyant conditions last. At some point, trading may well revert to more historic levels, which could entail a fall in earnings.
• Consumer confidence is key for a company like ScS and there are concerns including inflation and supply chain issues.

Are there any catalysts that could drive a rerating in the medium term?

• Possible positive earnings surprises and a rerating of the share price multiple based on heightened demand.
• Its cash pile can be used for acquisitions or share buybacks. The balance sheet also makes it a potential bid candidate.
• Potential drivers of organic growth include online, furniture and flooring market share gains, and product range extensions.

Note that FY21 of the chart above is flattered by exceptional levels of online trading during lockdowns.

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Risks, Threats & Hurdles

What are the biggest risks, threats or hurdles that the business may face?

COVID-19 risk is receding and could prove to be a tailwind over the next year should the current levels of demand be maintained.

Supply chain - there are widespread reports of supply chain disruption, increasing lead times, price inflation, and freight costs/delays. This is of increasing concern to the market.

Interest rates - The group offers interest-free credit options on all products. Increasing rates or reducing credit availability could impact demand.

Competition - Intensifying competition, particularly online, could increase pressure on sales and margins.

Key trading periods - furniture retailing has historically relied on certain key trading days and periods, including bank holidays.

Lack of growth in store estate - ScS grew from eight stores to 95 between 1993 and 2007. Since then, however, the group has only increased that number to 100 (and has discontinued its House of Fraser concessions, which were marketed as a promising growth opportunity at IPO).

The group’s target is to open two to three new stores per year with over 20 potential new store locations identified.

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Recent Trading & News

Summarise the most recent trading statements and comment on them

Preliminary results, 5th October 2021

Trading since the start of the new financial year has remained strong, with two year like-for-like order intake growth of 11.9% for the nine weeks to 2 October 2021. One year like-for-like orders have fallen 21.0% as a result of the significant bounce following the lockdown in the prior year. We are delighted with the strong orders performance since the start of the new financial year. However, we are cognisant of the ongoing challenges we, and many other businesses, are facing with regards to the supply chain, including driver shortages, raw material increases and shipping costs and delays.

Full year trading update, 5th August 2021

Continued strong trading; full year performance for FY21 and outlook for FY22 ahead of market expectations… Despite our stores being closed for 17 weeks in the FY21 year, our full year like-for-like order intake was down only 6.5% on 2019… The Group's financial position remains robust, with cash at 31 July 2021 of £87.7m and no debt.

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Sentiment

What do the brokers currently think?

Brokers have upgraded their earnings forecasts recently.

What is private investor sentiment at the moment?

The wider community sentiment looks positive, with buys comfortably outweighing sells.

What would the person selling to us be thinking and who are they?

• Profit taking - shares have already more than doubled from their Covid lows of 128p
• Some might wonder how long strong trading conditions will last
• Supply chain issues are affecting the wider market
• Lack of recent store openings

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Conclusion

In these uncertain times it is increasingly difficult to value companies like ScS, which face a number of headwinds and tailwinds.

On the plus side, Covid has led to some competitors leaving the market or reducing their estates and ScS has a strong order book heading into the new financial year. But the wider market is suffering from supply chain issues and ScS is not immune here. Meanwhile there are questions over just how long these demand conditions can persist.

On balance, the SIC voted firmly in favour of buying shares in SCS on account of the valuation and near-term outlook

Has the club bought into a value share partway through multi-year upgrades, or will the current conditions prove to be transitory?