Nick Scali (ASX:NCK) is a furniture retailer operating in Australia and NZ and operates under a single brand, ‘Nick Scali Furniture’.
We recently reviewed the Company, not only to assess recent performance, but to gauge the likely impact on future earnings from tapering government stimulus and challenging macroeconomic indicators. In particular, the housing market and consumer confidence. We also looked at what threat is there from the increasing trend towards online furniture retailers. This is especially given that the Company has its own plans to expand its store network from 58 stores (55 in Australia; three in NZ) towards its long-term overall target of 80-85 stores.
Key Fundamental Drivers of Nick Scali
Strong Margin Performance
Nick Scali has shown an ability to grow gross profit margin, often in periods where sales have declined. The Company operates a 100% direct import model (with all products sourced from Asia). This allows NCK to achieve gross profit margin at ~60%, as it avoids wholesalers and importers. As the majority of imported products are sourced in US$, reductions in the A$/US$ exchange rate can have a negative impact on gross profit margin if cost increases are unable to be passed through to customers. NCK has shown an ability to mitigate the impact of a lower A$ via price increases, as well as reducing the Cost of Goods Sold.
In comparison to other unlisted furniture retailers, NCK has superior operating margins due to strong gross margins and tight cost structure. Occupancy costs are reduced by the eight properties that the Company currently owns.
Macro Factors Remain Broadly Supportive
The furniture market is closely tied to the housing market and consumer confidence, and is largely dependent on these two external factors. Declining housing turnover is likely to restrict demand in the coming months as settlements/moving lags housing sales by 8-10 weeks. NCK has historically navigated periods of declining consumer confidence very well in the past. A key factor underpinning this is that customers seeking premium furniture (to which NCK is materially exposed) are likely to delay purchases as opposed to trading down to discount retailers in times of declining consumer confidence.
Resilience to Online Competitors
Online furniture retailers have benefitted significantly from the shift away from traditional store visits to at-home purchasing. COVID-19 has forced some customers who had previously been in-store only buyers to purchase items online, whether to set up home offices or due to spending more time at home.
The threat for established furniture retailers is underpinned by the fact that brand awareness for online retailers remains low and the adoption for online penetration in Australia significantly lags that of other developed markets, in particular the UK and US.
We consider that NCK is well placed to counter the online threat from a number of factors:
i. Approximately 65% of Nick Scali’s products are made to order with typical delivery lead times of 9-13 weeks. While customers are increasingly prepared to purchase some categories without physically viewing the product (i.e. cabinets, desks, tables and chairs), this is not so much the case with certain products, such as custom-made lounges.
ii. NCK has its own online offering across all product categories, which was launched in April 2020 when stores were temporarily closed. The online store is already contributing positively to earnings. Moreover, margins in the online channel are above store-level margins of 23%.
iii. NCK’s online offering is not materially different to its traditional offering (NCK’s average online transaction value of ~$1,800 compares to ~$2,500 for its showrooms) and is at a higher price point than online competitors.
Competitive Position Supports Outlook for Nick Scali
The Company has provided guidance for 1H21 profit to be up by at least 50-60% when compared to 1H20. One factor likely to support NCK’s sales is supply chain issues across the industry. The Company reported that they experienced delays in supply chain from Asia of up to four weeks in March and April, which is likely to have also affected other furniture retailers. While NCK were able to get delivery lead times back to normal by early May, some competitors continue to struggle managing their supply chains. The resultant effect being that some customers have been disappointed by lead times provided by competing retailers.
Strong Balance Sheet Supported by Substantial Property Assets
The balance sheet is in a strong position, with a $29m net cash position ($63m in cash and $33.7m in borrowings). Strong cashflow conversion (96% of EBITDA) continues to be a feature of the business model.
The strong net cash position is supported by $74.5m of land and buildings at cost as at 30 June 2020. As ~70% of the properties (by book value) were purchased prior to calendar year 2017, the future value of these properties is estimated to be well in excess of book value.
The shares are currently trading on a 1-year forward P/E multiple of ~14x, which we do not consider demanding in light of the above factors. This is especially with EPS growth of over 25% in FY21. It is also worth noting that NCK is an attractive investment for those seeking yield, with the shares trading on a yield of over 5%. The attractive yield on ordinary dividends is augmented by the potential for the Company to pay further special dividends. This is given the strong cash generation of the business and substantial franking credit balance as at 30 June 2020.
NCK has traded well off the March lows. It still remains in an uptrend and the recent decline to the uptrend line now presents us with a good entry point. We would probably tolerate short term downside to about $7.50. NCK should now continue its uptrend and is likely to head to a new high from here.
Michael Gable is managing director of Fairmont Equities.
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