Interactive Investor

Stockwatch: a consumer discretionary stock for tough times?

14th December 2021 13:12

Edmond Jackson from interactive investor

Our companies analyst assesses prospects for this small-cap portfolio of quality brands if consumer spending is squeezed next year.

Surveys suggest UK shoppers face the biggest price increases in more than 30 years this Christmas, and moreover, that consumer prices have yet to reflect the true level of inflation upstream in industry. The coming year will also herald rises in council tax and national insurance, yet the Bank of England freezes like a rabbit in the headlights over interest rates. It argues that inflation is transitory and wage increases will not become ingrained. 

If that is the case, a scenario of modest wage deflation needs to be taken into account for 2022 investment tactics. Food being a first priority for consumers, how ‘discretionary’ are other goods and services likely to be for spending?   

A sound portfolio of household brands 

UP Global Sourcing Holdings (LSE:UPGS) is an interesting example – both for current decisions on stocks and in light of historic experience. This £170 million consumer products group – known as Ultimate Products – is a portfolio of household brands sold into various retail chains and online stores across Europe.  

After falling from about 90p to 40p with the onset of Covid-19, this small-cap business had soared nearly fivefold to 230p by last June, but has since traded volatile-sideways to 190p. As with many other consumer discretionary stocks, the market divides on whether to lock in gains or buy the drop.  

With the help of acquisitions, over 50% earnings growth is expected for UP's current year to 31 July, albeit with only (as yet) mid-single-digit growth in 2023. £12 million to £13 million net profit implies a price/earnings (PE) ratio of around 13x, and a 7p dividend indicates a 3.7% yield. 

In recent weeks, Ennismore, a generally astute hedge fund manager in European small cap, has raised its stake from 6.6% to 7.3%, in other words buying the drop. Given that small caps are illiquid for institutions, the implication is that Ennismore is looking beyond current macro fears, prioritising UPs quality of operations. 

2017 to 2018 showed a genuine setback 

Before considering the groups set-up, let me revert a few years, as past experience has possible relevance to consumer demand prospects now. 

Having floated in March 2017 at 128p, UP twice traded over 220p that summer, then plunged to near 30p by May 2018. A September 2017 update cited the overall environment for general merchandise having become tougher, with wage inflation running behind general inflation. It said: Consumersdiscretionary spend is under pressure and confidence is therefore lower…which is inevitably being reflected in purchasing behaviour.” Retailers were consequently also exercising caution in buying the kind of non-food items UP supplies. 

This update suggested that revenue growth for the year to July 2018 was unlikely”; then reality manifested as a 20% fall, with net profit down 23% (see table).  

Wage deflation was chiefly blamed, hurting consumer discretionary spending as food purchases were prioritised. Weaker sterling also meant higher costs for imports and intensified competition among suppliers as retailers tried to limit price increases. 

Obviously, the fallout from Britains decision to leave the EU impacted consumer confidence and currency. But will wage deflation this time around be significantly less harmful for discretionary spending?  

UPs diversification has reduced business-specific risks  

If you hold consumer discretionary stocks, you effectively believe those managers have created a set-up reasonably able to withstand headwinds, such that it is unwise to sell on macro fears. 

UP, for example, has diversified across country and product exposure, with investors enthusing over last summers £34 million acquisition of Salter, the UKs market leader for bathroom and kitchen scales.  

This was part-funded by a £15 million placing at 210p; it’s unclear whether that conveyed a bull market in small caps topping out, or implies 190p in the market now is even better value. If Ennismore participated in the placing, then it might naturally recognise an opportunity to average its buying price. But would you take the same approach with fresh money, at this point?  

In fairness, UP offers a mix of essential maintenance products besides discretionary spending. Its brands include Beldray (31% of sales, in laundry, floor care, heating and cooling), Salter (21%, in kitchen and bathroomware), Russell Hobbs (12%, licensing cookware not electrical appliances), Intempo (5%, in audio), Progress (5%, in cookware), Kleeneze (2%, in laundry and floorcare) and Petra (small domestic appliances). 

Nearly a third of sales are international, chiefly in continental Europe, where Novembers annual results cited a 4% revenue increase; however, Germany was up 27% (only to £3 million though). Despite exporters generally moaning about Brexit, UP says these European prospects remain very encouraging, with Germany a particularly exciting opportunity”.

Possibly, and considering managements overall initiatives, this perspective distinguishes the way this group may outperform in the months and years ahead, at least in relative terms. 

Strong reputation established with supermarkets 

The last financial year showed this segment enjoying 32% revenue growth to £37 million (27% of the total), driven by the Salter, Beldray and Russell Hobbs brands. This part-reflects UPs capability in design and its relations with external manufacturers – notably with personnel in Asia to ensure swift time-to-market of any new product.  

Its main sales channel, however, is discount retailers at 38% of sales, which are typically still expanding their stores. Potentially, this is another positive for UP to negotiate in what could be challenged times ahead, if such stores enjoy greater custom. 

Online sales represent 15% of sales, where growth has been hindered by freight constraints and the need to prioritise retail relationships with stock as it has become available. Management sees this as a momentary pause…the fundamentals are very strong…” and still targets online sales to double to 30% of the group total in the medium term. 

It has continued to invest in inventory and new product development; and been proactive in shipping and maintaining the supply chain, building a competitive advantage. The extent of UP’s monitoring is such that any raw material or component delay is quickly picked up. 

Thus around £17 million is targeted to be added to 2023 sales, with Salters 20% operating margin potentially helping the group operating margin up from 7.4% to around 10%. Management also sees scope for further value-accretive acquisitions. 

UP Global Sourcing Holdings - financial summary
Year end 31 Jul

  2016 2017 2018 2019 2020 2021
Turnover (£ million) 79.0 110 87.6 123 116 136
Operating margin (%) 8.5 7.2 7.0 7.3 7.9 7.4
Operating profit (£m) 6.7 7.9 5.8 8.9 9.1 10.0
Net profit (£m) 4.9 5.6 4.3 6.4 6.6 7.3
Reported EPS (p) 6.0 7.1 5.2 8.0 8.3 9.1
Normalised EPS (p) 6.0 8.2 5.2 8.0 8.3 9.1
Earnings per share growth (%) 37.1 38.0 -36.7 53.0 4.1 10.0
Return on total capital (%) 164 70.3 54.2 62.9 55.9 19.3
Operating cashflow/share (p) 4.5 12.0 -2.5 5.8 19.7 11.4
Capex/share (p) 0.8 1.5 1.0 0.9 0.8 2.8
Free cashflow/share (p) 3.7 10.5 -3.5 4.9 18.9 8.6
Dividend per share (p) 0.0 5.1 2.7 4.1 4.0 5.0
Covered by earnings (x) 0.0 1.4 1.9 2.0 2.1 1.8
Cash (£m) 0.1 0.1 0.1 0.1 0.3 0.1
Net debt (£m) 9.9 5.9 12.8 17.9 7.2 21.6
Net assets (£m) 1.2 6.8 8.8 11.6 13.4 32.1

Source: historic company REFS and company accounts

Overall good, other financial ratios 

Although return on total capital has dropped from over 50% to below 20% – despite 2021’s return on equity at 32% – these are good figures helped by low capital intensity and working capital of around only 10% of sales.  

This is explained by bank debt up from £4 million to near £19 million to help pay for Salter, plus £3 million deferred consideration, resulting in net gearing of over 60%.   

The table shows a generally strong free cash flow profile, despite last years fall in operating cash flow. This enables roughly half of earnings to be paid out and a prospective yield of around 3.75% despite the stocks rise since 2020. 

CFO has not just splashed out £300,000 buying shares 

A Director Shareholding RNS can be interpreted as UPs retiring CFO making a genuine purchase at 196p. But a 2 November announcement set the context for the 147,722 shares involved to be transferred to him by the Employee Benefit Trust.  

At least he now owns £1.1 million worth, and his replacement from next April – currently CFO at the similar-sized Franchise Brands (LSE:FRAN) – looks to have a decent record. 

I am struggling presently to rate this stock a conviction ‘buy’, due to its 2017/18 experience. Yet its underlying strengths are worth watching as a potential buy, especially if consumer discretionary stocks drift in months ahead. Hold. 

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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