JUNO INVESTING ©

Nick Scali: Sitting Pretty for Now

JUNO INVESTING ©
Nick Scali: Sitting Pretty for Now

 

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AUTUMN 2017

By Mike Ross

Nick Scali is a company that ticks a lot of boxes for investors looking for solid fundamentals. The company has consistently grown earnings per share for the best part of a decade, and has achieved a long-term return on equity in excess of 30 per cent. 

Double-digit earnings growth is forecast over the next few years and the company has a solid balance sheet. The stock does not look too expensive on a price-to-earnings ratio in the mid-teens. However, it’s also important to consider that Nick Scali has been a beneficiary of the booming housing market for some time. Its seemingly modest valuation may be due to concerns around the sustainability of this trend. 

The business

Nick Scali is a furniture retailer in Australia with 50 stores across all states. The company’s namesake offering is positioned at the upper end of the mid-market, comprising 45 of its 50 stores and its customers are generally second, third or fourth home buyers as opposed to first home buyers. The remaining five stores are branded Sofas2GO and are positioned at the low end of the market. 

The business model is capital-light, with low inventory risk for a retailer because its stores are effectively showrooms where the customer places an order, putting down a deposit. There’s a ten-week turnaround for the product to be sourced from the company’s manufacturers in China, Malaysia and Vietnam, then delivered to the customer. The ten-week sales order cycle means the company has good visibility to future revenue.

Nick Scali has managed its marketing spend to a fixed percentage of revenue so, as the company has grown, a larger marketing budget has been effective in driving increased foot traffic into its stores. This has proven particularly effective in the Australian furniture industry because of its fragmented nature. There are many smaller operators who naturally have much smaller marketing budgets than Nick Scali. 

The growth

Increased market share has helped drive like-for-like store sales at Nick Scali’s stores. The company recorded like-for-like sales growth of 10.1 per cent for the six months to December 31 2016 after achieving 11.1 per cent in the year to June 2016. 

The company recently confirmed that double-digit same-store sales growth had continued to the end of April and that it was on track to grow net profit after tax by around 40 per cent in the 2017 financial year. 

Looking ahead to the 2018 financial year, the company will also benefit from the ramp-up of a store roll-out program. The company will open five stores this financial year, with plans to open another seven next year. This year, the company is not cycling many new stores previously opened, so profit growth has largely come from strong same-store sales and keeping costs under control. New stores will underpin the company’s growth next year so it is less reliant on same-store sales growth to grow profits. 

Expanding the range

Nick Scali has also focused on increasing sales of non-lounge items, such as rugs and casegoods.
In addition to driving same-store sales growth, these items tend to have higher gross margins than lounges. 

A new distribution centre in New South Wales should also help introduce efficiencies, as the previous centre was running over capacity.

The company is highly cash-generative and with its solid net-cash balance sheet, it could consider acquisitions to continue growth. Management has identified Britain and New Zealand as attractive growth markets with similar characteristics to Australia.

The company is also considering the future of its Sofas2Go brand, which has not been expanded for some time. The lower end of the furniture market is more commoditised, so I expect management to discontinue this part of the business. 

Management with skin in the game

Most investors place a lot of value on high management ownership as it means the interests of those driving the business are aligned with minority shareholders. Nick Scali fits this bill. Chief executive Anthony Scali owns 27 per cent of the business, having increased his stake from 16.7 per cent in 2016 after buying shares from family at AU$3.80 per share. The shares are now hovering around AU$7.20.

The risks

The key risk for Nick Scali is the Australian housing market and how a drop, or a slowing of growth, might affect consumer spending. The talent of its management should not be discounted, but there’s no question that the company’s success since the
global financial crisis has been pushed along by the housing boom. 

The wealth effect of consumers sitting on paper or realised housing profits helps all discretionary retailers, but particularly those selling products to go into those homes. 

The other housing-market-related risk is housing turnover – the rate at which homes are bought and sold. Theoretically, a company like Nick Scali should sell more products when people are buying more houses. However, the company has managed to outperform in recent times even though listing volumes in Australia are at their lowest levels in a long time. The fact that Nick Scali has been able to generate such high sales growth in this environment supports the view it’s taking market share from its competitors. 

The other risk to consider is the shift to online sales. Amazon’s recent confirmation of its entry into the Australian market has led to declines in the share prices of many retailers. Furniture should be less exposed to this risk because shipping costs are higher for heavier, bulkier items. Online retail sales thrive on the ability to return products at a reasonable cost to the retailer. For higher-value goods, consumers also place more importance on the ability to try, see and feel before they buy.