Author Topic: SCS - SCS Plc  (Read 3190 times)

samwise

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SCS - SCS Plc
« on: January 14, 2020, 10:20:21 AM »
Second largest sofa retailer in UK.

If I count all cash as excess I get EV/ FCF = 2

If none of the cash is excess, I get p/FCF = 5 (no debt)

FCF has been higher than income for a while.
P/E is 8.5.

No debt, lots of excess cash. Which is weird for a business 25% owned by private equity. Their biggest competitor carries some debt. I havenít seen this amount of cash sitting around except in family companies or in Japan.

ROE is 28% (with cash), which is because of a negative working capital model: customers pay a 50% deposit, get the sofa in 8 weeks, pay the rest before delivery, and the supplier gets paid a month later.

This model produces good ROE, but caused a liquidity squeeze in 2008, and SCS went bankrupt, rescued by private equity. The same management is in place now and they keep talking about the resilience of the business, which they seem to measure by the cash on the balance sheet. While I can see the comfort it provides them, I doubt this is sustainable in a public UK company.

There is a VIC writeup from a couple of years ago, but the author seems to have sold his holdings.

I donít expect anything quick. There will no only slight growth with UK gdp and inflation, although management has been talking of a few more stores forever. Until  then you have the 7% dividend yield.

Has anyone else looked at this name, or shopped there?
« Last Edit: January 14, 2020, 10:53:35 PM by Parsad »


WneverLOSE

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Re: Scs - scs plc
« Reply #1 on: January 14, 2020, 10:54:45 AM »
I took a 15 min look at their annual report so I might got it wrong but it seems that they are really the subprime retailer of sofas.
50% of their customers buy using financing they offer with a 1 year no payment and a zero percent interest after (and they really push it hard, you can see in the store pictures in the annual report the posters in the store).

ROE is too high in my opinion, if it could be sustained I would take a plane to the UK and start my own competing sofa store, I suspect that if you take away the credit they offer (and get payment immediately since they use 3rd party lenders) ROE would be much lower.

so basically you have a company that is not growing much in a not growing sector, selling for 9 times earnings that I suspect will be hit hard in the next recession / credit crunch, seems fairly valued to me (but again, what do I know about the UK and investing (I am down 10% YTD  :P))


samwise

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Re: Scs - scs plc
« Reply #2 on: January 14, 2020, 07:06:32 PM »
8.5 P/E is with cash included in market cap. If itís all excess cash then the P/E is 3.

Itís useful to spend 15 minutes on the competition too: DFS. Whose sales are 3 times bigger. DFS is at 15 P/E. with debt.

They have the same negative working capital model, but keep no excess cash. ROE would be amazing (except that they also have a lot of goodwill). But it serves to demonstrate that the sofa retailers in UK all have this business model. It also shows that you can run this model without the excess cash.

The ROE has lasted a long time. My best guess is itís because suppliers of furniture and credit are too fragmented and commodified. There are also advertising advantages of scale ( as I recall, scs spends 7% of revenues on advertising). These guys also seem to be tremendous operators with non-stop focus on costs. They are able to make it work in their current format, but it doesnít travel well to a different demographic. Some sofa stores within House of Fraser (which looks like a department store) were not successful. So donít catch that plane to the UK just yet :)

Agreed that they are the dollar store of sofas. Sofas are big ticket discretionary purchases, so sales would fall in a recession. I donít have any evidence that we are at peak earnings either.

ROE on the financing might be lower, as I am sure is the ROE for suppliers. But unless their bargaining power is changing it will remain that way.


Cigarbutt

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Re: SCS - SCS Plc
« Reply #3 on: January 29, 2020, 08:40:43 AM »
Interesting idea (to compare). I would not invest in SCS before having a deeper understanding of the competitive dynamics in the UK. The negative working capital model seems to be shared but the fact that it is shared does not eliminate the risks, on an absolute basis.

Some thoughts:
--The positives:
-SCS has been able to maintain and even slightly increase its market share (upholstery sofa segment) in a deeply competitive market and was able to maintain margins doing so.
-They show high gross margins (not so great with the administrative costs).
-They have improved working capital management.

--The negatives:
-Despite the above, their net margins have remained quite low and SCS has relied on inventory turnover to achieve relatively high returns on capital.
-They rent a significant part of the retail properties. In a way, there's nothing wrong with that but the actual accounting does not reveal the capital commitment (that will change next year with the new lease accounting rules). The reporting changes will not change the substance of cash flows but will show better the necessary capital to run the business (the return on asset numbers will go down). Leases are not debt and offer some flexibility but funding the retail space (operating or financial) is a form a semi-fixed financing.
-They have improved free cash flows over the last few years mostly through decreased inventories and higher payables which did not seem to impact sales or profitability in a negative way but I don't think it would be reasonable to expect more gains from this part. Profitable growth in market share is likely to be difficult.
-Looking at the 2019 annual report, they show ending inventories at 19.2 which appears (from a North American point of view) to be very low compared to sales (333.3). I also think that they have stretched payables to the limit (56.6) compared to sales. I would say such a divergence between low inventories and high account payables means that even a slightly tougher retail environment would result in suppliers getting tighter on credit and bringing the two numbers closer together means that the excess cash (57.7) may not be excessive if they want to keep some flexibility going forward. A typical 5-10% cash cushion versus sales may be OK in this type of business under normal circumstances but their supplier-funded model IMO requires a much higher balance in order to deal with unforeseen credit developments.
-Also, they describe reinvesting in their stores but capex appears to be low versus depreciation over the years. Are they maintaining a "fresh" look to their stores?
-Today, they announced that the CEO is retiring. Maybe that was part of the plan but leaves the following question unanswered: where to next?

--Additional neutral comments
-They focus on the lower end of the segment with a high level (about 50%) of free interest offers (risk borne by third parties) which can work fine in most circumstances.
-They have grown their online sales but this has remained relatively low which tends to confirm an opinion of mine that, for these large-ticket discretionary purchases, most people will appreciate an online search but will actually complete the sale in store.
-They've chosen to distribute dividends versus using the funds to buybacks which appears, so far, to be a neutral value proposition.

samwise

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Re: SCS - SCS Plc
« Reply #4 on: January 29, 2020, 09:24:33 PM »
Thanks for sharing your thoughts CB.

I mostly agree. The big difference is the excess cash. otherwise 8/9 x PE is sort of ok in the UK market currently. (Car dealers are at 7, banks like lloyds are at 6-7, when adjusting for rolling off legal expenses). but a PE of 3 is excessively cheap.

A lot of what you describe is part of the business model: high turnover, low margin (lower gross margin than DFS means value for customers) and low investment in store Capex all point to a bargain shopping model. They seem to be in lower end strip malls (? although I don't understand the UK terminology here). Inventory is almost all just the sofas in the store for display. The customer's sofa shouldn't spend much time in inventory.

They do have risk from wayfair or other online competition, although it's good that they are targeting online sales, or atleast enable online window shopping before the final purchase. I think I read that >80% people have researched their sofa(s) before they come to the store. But most prefer to finish the sale after sitting down. That could change, as online shopping preferences in other categories have changed. Good for them to keep a foot online. Ultimately Wayfair will offer pretty much the same services and same products, same deliver by truck (or Parcel?). So it's hard to see how wayfarer beats them on anything except rent and showroom costs. In this light their recent changes make sense: to manage delivery from a central office with central call centers, to insource their website design and rebuild it to allow easier online browsing and shopping. If sales move online, they will be in a decent position to depend less on their stores. But they will still be stuck with their leases for unto 10 years: "The Group continues to ensure a low average remaining lease tenure on our store portfolio by ensuring low tenures on existing lease renewals and on new stores. This provides the Group with increased flexibility to exit or relocate stores where required. The majority of recent leases entered into are 10 years in length.". So the risk really depends on the speed of transition online.

On the effect of leases. You could capitalize them and thin of them as financing charges, but then you should remove the rent deducted from operating income. It's too complicated for me to try to be that exact. And if this was going to alter the investment decision I just wouldn't do it. Instead, I take comfort in their statement from the annual report that 76% of their costs are variable or discretionary. Rent is not: "Rent, rates, heating, and lighting make up the remaining £36.2m (11%) of total costs (2018: £36.5m; 12%)." So it seems they would not suffer much in a downturn. But this is based on faith, their financials don't really go back far enough for me to see this. And I don't know how to dig up their pre-bankruptcy reports from the UK equivalent of Edgar. Anyone who can help? I couldn't navigate company house.



As for how much cash is excess. Perhaps best to remove the 14.6 million which is customers deposits. That leaves 57.7-14.6 ~= 43 million that is the companies and not the customers. EV = 92-43 ~=49. NI=11. FCF = 17. They should be able to buy 50% of their market cap with the excess cash. Or less if they run the price up.

Now for the main issue: "A typical 5-10% cash cushion versus sales may be OK in this type of business under normal circumstances but their supplier-funded model IMO requires a much higher balance in order to deal with unforeseen credit developments."

Thats absolutely how they think. They believe that they need the cash for resiliency, and their own experience in 2008 bears this out. If that is true, then DFS will go bankrupt in the next credit crises because they haven't kept the cash around. Instead they have debt. So one of these companies is wrong. Or SCS has not been able to get a credit line which they can trust even in a credit crunch, while DFS has got it. DFS is three times bigger, but I am not sure that the credit market is that split in the UK.

they did buybacks recently when the PE owners did a secondary. Maybe the start of a trend.. but I won't complain about a 7% dividend.
I think they were one of the bidders for sofa.com but walked on price. If all the cash becomes goodwill like at DFS, it's probably not the best outcome, but won't be too bad as long as they are disciplined. Buying back stock would be the best outcome, or just dividending out all the excess cash.

The competition in the UK sofas seems intense, but top 5 retailers control ~53% market share. Thats much more concentrated than furniture suppliers and customers. That seems to be the source of their bargaining power and the negative working capital model. Not sure if there are barriers to entry, but the concentration in the industry definitely points to that.

Thanks for flagging the CEO leaving. Will have to see if there is a new direction. Hopefully the next guy won't be as scarred from 2008 and actually buyback stock with the cash. Otherwise we keep clipping 7% coupons. Even in a Brexit blow up the cash should help them. If they return the cash I'll sell and move on, assuming prices are still ~9x earnings.

Cigarbutt

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Re: SCS - SCS Plc
« Reply #5 on: January 30, 2020, 07:25:47 AM »
^That is a strong answer. Again, I will not compete with you as a buyer in the UK furniture retail market but the competitive dynamics are interesting and the discussion helps with the buying or renting issue for stores, the negative cash flow model as well as the growing online presence.

I just spent a few minutes on DFS and I see your point of view better.

Sales: DFS almost 4x
Free cash flow potential: DFS about 3.5x
(DFS is slightly different with some vertical integration, a Netherlands presence and interest expense and the past shows some noise, so just an estimate)

The market has clearly rewarded DFS as a leveraged consolidator (I doubt significant economies of scale are available after a certain reach) as market cap (equity) is 6.5x.
For DFS (debt+market equity) over (market equity) is 1.33 whereas for SCS it is less than one if we agree that there is excess cash on the balance sheet. It's interesting because, as a contrarian, I would put a higher price on financial flexibility (or a much lower price on the lack thereof).

I could see how the market values of both may converge. Please give follow-up in due course if applicable.

DollarKing

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Re: SCS - SCS Plc
« Reply #6 on: January 31, 2020, 01:48:14 AM »
I have hard copies of the 2003 - 2007 annual accounts. (These reports seem to have been removed from the internet.)

And some newspaper financial magazine articles on SCS from this time. (I'll PM any images of annual report pages if anybody is serious.)

The quantitative valuation put forward here is correct, except how the sofa business really works seems to be missing. When a new store is opened the local sales are great, promoted by local TV advertising, along with the initial free rental period on unit leased, the first few months produce a terrific profit and great cash flow. A great first year for all new stores is baked in. Then the store goes straight to break even at best.

This format is destined to fail. As it becomes harder to find and open new stores. Along with the ever increasing number of 'dead' stores. This business runs on fresh air and a pray. One small blip in sales now and its over.

More stores have to be opened to maintain this flywheel effect. This is not unique to the sofa business at SCS. The directors understand this fully. The guys still running this Ďbusinessí have made out very well though, administration or not, no problems for them.

There is zero free cash in this business. The entire cash balance is fully off set by what is owed to the sofa manufacturers for orders already placed. Every single penny of spare cash has been paid out as dividends.

(and the directors seemed to have missed their recent period in administration and complete shareholder wipe out from the ĎOur Historyí pages of the recent annual reports.)

Also a financial journalist from the UK, Richard Beddard wrote several articles on SCS before administraion, singing its praises on a valuation basis, he lost bundle, but he owned the mistake afterwards to his professional credit.

(Please excuse my basic and blunt writing style I've never been good at it.)

Cigarbutt

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Re: SCS - SCS Plc
« Reply #7 on: January 31, 2020, 06:00:24 AM »
^You seem to almost imply some kind of Ponzi scheme which is a step further than questioning earnings quality.
I don't plan to spend much more time on this but, outside of the smallish concession business (which has been discontinued), the number of stores went from 96 in 2015 to 100 in 2019 which would tend to go against your thesis, given the pattern of free cash flows over the same period.
However, if considering a long position here, i would try to get more 'color' ('colour' if you prefer British English) concerning the lease arrangements, especially for the early years.
BTW your writing style is fine (keep those comments coming) and despite your flywheel concerns, i continue to see them as a company with two personalities: aggressive on the sales side with a negative working capital model and conservative (relatively) on the cash cushion side. Not exactly a tight parallel but in the same spirit of somebody being avidly competitive for investment opportunities while being able to maintain a cash balance of 130B or so at the head office. It can be confusing at times.

Edit:
https://www.valuewalk.com/2011/06/late-sell/
Interesting going-back-to-the-future potential circumstances.
« Last Edit: January 31, 2020, 06:10:06 AM by Cigarbutt »

DollarKing

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Re: SCS - SCS Plc
« Reply #8 on: February 01, 2020, 02:56:53 AM »
I don't mean to suggest anything illegal by the directors. They just understand perfectly the quality of these earnings.

The 96 to 100 store count between 2015 - 2019 may be slightly misleading. Were there any closed? Just a couple of good openings a year can produce wonders. The scale of business at a new store can be a multiple of the revenue just eighteen months later, with superb initial operating leverage.

Nowhere in the annual reports will you find the scale of sales at new stores.

I'll try to post one of my favourite images below which may illustrate better the scale of what I'm attempting to explain.

This show SCS with increasing total sales, at the same gross margin, yet paradoxically a collapse in the profit and the cash balance.

(It should be used on a MBA course to see if any students can work out what is happening. All the information needed is on the one page.)

Cigarbutt

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Re: SCS - SCS Plc
« Reply #9 on: February 01, 2020, 04:49:36 AM »
^It looks like our opinion is similar but here are some nuances.
I think the model can still make sense but you have to make sure that the model can go through cycles (if you believe cycles still exist) and manage to achieve adequate returns on capital over the complete cycle. The numbers you show would tend to indicate that today's cash cushion is larger (cash over equity was 1.34 at the end of their 2019 year). It would be interesting to see the pattern of their inventory and account payables (to suppliers) numbers around 2006-7-8. From the link (from the repenting journalist), it is implied that what caught SCS off guard in 2007-8 was the sudden disappearance of credit insurance available to suppliers (which was a salient feature of the period) and the episode simply revealed that credit risk has to be borne at all points of the cycle. Some furniture retailers can benefit from these credit episodes by surviving and increasing market share. However, these transitions may require some kind of reorg (new capital and debt to equity swap). I was involved in such an episode around 2007-8 with The Brick, a CDN furniture retailer whose business was more than selling sofas although this was a significant segment. They managed to pull through (with outside help) and think that they could have done better if management had completed the potential MBA case study that you refer to (but then there wouldn't have been this opportunity...). But I would say that the model can make sense although it requires that you wear a suit when the tide goes out.