Stockwatch: lessons from this small-cap insolvency

How should we interpret the appointment of administrators at this online retailer, and what can we learn from the experience? Our companies analyst offers his thoughts.

Does the appointment of administrators at Studio Retail (LSE:STU) chiefly reflect mishaps with stock handling that have jeopardised corporate solvency? Or is it a straw in the wind, as banks toughen their lending criteria? 

This £100 million online retailer across fashion, home and leisure, toys and gifts, suspended its shares yesterday at 115p, having warned on 31 January of a working capital shortfall.  

Encouraging tenor on trading and prospects 

That update a fortnight ago cited Christmas trading up 18% over two years - in other words using the pre-Covid comparator. Adjusted pre-tax profit was guided possibly at £30 million for this financial year to 26 March.  The CEO asserted “solid fundamentals” in the business model: “We will continue to drive the long-term profitability and success of the group.” 

The fact that supply chain disruption and inflationary pressures were expected to continue implies a re-appraisal of working capital needs beyond a short-term issue of funding excess stock, the latter apparently a result of pre-Christmas socialising having been compromised by Omicron. 

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Studio Retail is the old Findel group whose stock has traded sideways pretty much since the 2008 crisis, in a range of 150p to 300p over the last five years until liquidity concerns saw a drop this year.  

Yet institutions normally astute enough to avoid wipe-out stocks are left holding: Schroders has nearly 19%, Ennismore 6% and Miton almost 3%. Barely two weeks ago, Frasers Group (LSE:FRAS)– controlled by Mike Ashley – raised its stake from 27% to close to 29%. 

Shock lesson about liquidity versus profit 

Studio had said on 31 January that surplus stockholding required funding “while this good-quality stock is sold through to customers”.  Then yesterday’s “notice of intention to appoint administrators” cited a £25 million short-term loan required “to fund surplus stockholding which it believed was sufficient to enable it to sell through the stock to customers”.

This appears substantial, considering Studio’s last-published balance sheet on 24 September showed £53 million of inventories, down from nearly £70 million in 2020. 

It is tricky to speculate from the outside whether stock management has been worse than presented – as happened two years ago at Ted Baker (LSE:TED)– or banks have tightened their criteria generally. But the loan has not been forthcoming. 

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The announcement made no reference to sounding out shareholders as to a placing; but “to protect the interests of its creditors” it is moving to appoint administrators as soon as reasonably practical. 

It is a harsh but pertinent example of the way creditors sit above shareholders in the pecking order, and not even financial statement analysis or glowing profit forecasts can protect against equity loss in a liquidity crisis. 

Consensus had expected £28.6 million net profit for the current financial year, rising to £35.4 million in 2023. This was supported by the normalised operating margin rising to 13% at the interim stage, versus 10.5% in the first half of the March 2021 year. 

 I recall Ashley’s Sports Direct plc similarly owning an 11% holding in House of Fraser when that company appointed administrators in August 2018. The acquisition of House of Fraser for £90 million was how Sports Direct plc then re-named as Frasers.  But I doubt there will be anything left for shareholders here. 

Ironies of a reasonably robust interim balance sheet 

The current ratio (of current assets to current liabilities) was 4.5x and included over £18 million cash.  

If anything, the chief concern seemed to centre on £291 million trade receivables rising 10% year-on-year, versus £69 million trade payables, with the implication that the imbalance could imply difficulties in chasing money due and potentially bad debts. But it could just mainly reflect the business model. 

With no short-term debt, the company’s £264 million of longer-term debt had reduced by 8%; the resultant£4.6 million in net interest costs clipped 21% offthe £22 million operating profit. 

Intangibles constituted a modest 27% of £99 million net assets, but such was the extent of trade receivables that Studio’s asset-backing – and confidence in a net asset value per share of 114p – rested on their quality. 

Portent in 28 January’s Red Flag Alert Report  

I treat these quarterly reports from insolvency specialist Begbies Traynor (LSE:BEG) with a pinch of salt, having noticed quite a few negative ones that were not followed by recession. But while the last one cited only a 5% rise in UK businesses reporting significant financial distress (in respect of the fourth quarter of 2021 over the third), it did show that county court judgments more than doubled.  

Begbies declared this “a key early sign of future insolvencies as creditors are now actively using courts to recover debts”. However, you could say that is more a behavioural-motivational matter than a reflection of corporate health deteriorating. 

Profits recovering, albeit fundamentally weak cash flow 

Studio’s key third quarter to 24 December had been mixed, if overall just 10% below an “exceptionally strong” performance during the second national lockdown period last year. Product sales were up by 18% on the same period two years ago, and by 28% for the first 39 weeks of the financial year. 

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January had involved modest net margin erosion and supply constraints, but nothing disruptive. 

Yet the table shows an operating cash flow record materially weaker than profit, and capital expenditure requirements resulting in negative free cash flow. Studio has been unable to support dividend payouts. 

This is exactly why some investors – especially conservative pension funds – specify pay-outs as a condition of owning equity: not necessarily for income but to affirm a financially healthy business. If this business had had a stronger free cash flow profile, possibly the banks would not have declined the emergency loan – or it would not have been needed at all. 

Studio Retail Group
Year-end 26 Mar

Source: historic company REFS and company accounts.

Conspiracy theorists see gambit for takeover 

There is speculation that Ashley declined to support a share issue as it would be cheaper to get control via an administration process, even though it meant writing down or off Frasers’ 29% stake.

I incline, however, to a more modest realism. The fact is that a retail supremo has misjudged the situation, raising Frasers’ stake just prior to a financing crisis. For generalist investors there’s a lesson: you may not fully know what is happening going on at a company, hence the logic for diversification, especially among smaller companies that are typically riskier. 

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From my saved documents, I see I attempted a piece on Studio Retail a year ago, after announcements about strong trading and a strategic review “in order to maximise value for shareholders”. The options included a formal sale of the business. Somehow I gave up on it, probably because smaller online retailers of clothing and gifts have involved considerable woe – witness N Brown (LSE:BWNG) also Card Factory (LSE:CARD).  

Sometimes, you have to trust your gut instinct about a business, as to whether its stock can rate a conviction “buy”.

Institutions holding Studio would have been able to speak directly to the top brass, and probably felt reassured as a consequence. Being on the outside can foster better objectivity, however. You need only to recognise key essentials to survive and prosper in equities. 

Studio Retail will probably become just another small cap where investors lost out, as attention swiftly moves on. Yet its stock demise involves key realities to remember.    

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