Interactive Investor

Stockwatch: long-term value vs near-term risk

12th April 2022 12:10

Edmond Jackson from interactive investor

Our companies analyst assesses the outlook for two cheap cyclical small-cap stocks, and asks how well they could weather an economic dip.

Last week, I looked in detail at prospects for Epwin (LSE:EPWN) the building materials manufacturer, and in the same vein it is interesting to consider two other small-cap cyclicals: furniture retailers ScS Group (LSE:SCS) and DFS Furniture (LSE:DFS)

Both de-rated sharply from last summer as furniture ran into supply chain issues, and now there are fears around discretionary consumer spending. 

Just as with Epwin, received wisdom is to avoid cyclical stocks in the early stages of a downturn and buy instead in the depths of recession, even when figures are dire: they are an accurate discounting mechanism. 

But how different is this scenario from the current fuss over an inverted yield curve for interest rates (where long-term money costs more, despite seemingly greater uncertainties) predicting recession soon?  

What such data reflects is the current state of market sentiment: as the old adage says, the market has predicted nine of the last five recessions”. 

Strong cash flow profiles can mitigate downside risk 

I am always alert to companies with strong cash flow profiles, partly because private equity does not fuss about timing when buying entire businesses. Indeed, it seems more vigorous than portfolio investors in taking advantage of low stock prices. 

The long-term financial tables for both these retailers show how free cash flow per share has tended to be substantially greater than earnings per share (EPS). This is said to relate to their business models, where customers pay for custom designs that are then sourced or manufactured – which I find challenging to square with the fact that both companies offer zero-interest credit.  

Anyway, free cash flow strength is very well established, and evidenced by ScS having accumulated £88 million of cash at end January and DFS £19 million in late December. 

It is also questionable how far interest rates will rise if a recession is on the cards, which tends to be significant for private equity buyers using debt. 

Have stock prices now discounted economic risks? 

ScS has fallen from 320p last August, reaching 157p on 7 March after the Ukraine invasion had triggered a general sell-off. It recovered to 200p by end March, then eased again, and is currently around 190p on a 12-month forward price/earnings (PE) below 8x, with a yield over 7% if expectations for a circa 13.5p dividend are fair. Such a yield suggests the market is questioning this. 

Admittedly, in the long-term context this can be seen as mean-reversion after a very strong run from 150p in March 2020 – when many people sat furloughed at home, flush with cash and keen to make interior improvements. The stock has adjusted back to a median price that persisted from 2015 to 2020. 

Similarly, after hitting 300p last June, DFS declined as low as 179p on 7 March, then recovered to 223p; however, this was not sustained and the price is currently 182p, reflecting a forward PE barely over 6x and a near 6% yield. 

Yes, furniture is one of the easiest items of spending to defer, and we are yet to see how a remarkable conflation of higher national insurance, council tax, energy prices and general inflation pans out. But as I have pointed out regarding pizzerias owned by The Fulham Shore (LSE:FUL), ‘value’ retailers will benefit to some extent from consumers trading down to lower prices.  

Unless ScS and DFS are forced to cut dividends, their stock prices arguably already discount material risk. 

The question for buyers is therefore more a matter of timing based on what amounts largely to guesswork around macro developments. Prices offer long-term value, but buyers have to decide what extent of near-term risk to assume (or avoid should things turn ugly).   

Near-term, much hinges for ScS on its second half 

I feel ScS has made something of a rod for its back, asserting in the 22 March interims that it is able to turn around a £2 million operating loss in the current second half to 31 July.  That seems quite demanding relative to consensus for £11.5 million annual net profit, which would beat 2019 marginally.  

Yet management says its end-January order book of £148 million was up by £57.5 million on January 2021 and twice what it was in January 2020.  Perhaps it can avoid a profit warning, but any such would hit ScS again and most likely DFS too.  

Recently swollen orders are however quite a distortion, resulting partly from supply chain disruption. 

Another risk to profit expectations is cost pressures in product raw materials and shipping. ScS is mitigating theseby working closely with existing suppliers and actively engaging with new suppliers” – but common sense suggests it could be a fine line.  

Until we get a better sense of exactly what UK ‘stagflation’ is to consist of, the market probably is wise to treat brokers2022 numbers for ScS warily.

Yet this is a short-term view, and a case also exists to take a small position – then either cut or continue averaging in, according to developments. 

Revelations at DFS can obviously impact in turn on sentiment towards ScS.  The 15 March interims (to 26 December) similarly cited a whopping order book - £175 million higher than pre-pandemic levels two years ago – giving increased resilience in the current year and through into the June 2023 year. 

There is a similar narrative to ScS: Trading in the second-half-year to date has been strong, again emphasising the increased scale of business and demonstrating the success of our approach to mitigating the impact of inflationary pressures on our profit expectations.” 

Expectations look as ambitious as ScS, if not more so, with nearly £51 million net profit anticipated this financial year, then £76 million to June 2023. As if DFS can truly buck any downturn.   

Given the extent of uncertainties, DFSs circa 6% yield – based on expectations for an 11.5p dividend this financial year, moderating to 10.4p – is justified. 

But it is pointless to quibble over whether ScSs apparent 7% yield offers better value, and also better scope for upwards mean-reversion in the stock. Both are rightly falling ahead of a recession, yet may already be cheap on a long-term view. 

ScS Group - financial summary
Year end 31 July

  2016 2017 2018 2019 2020 2021
Turnover (£ million) 317 333 313 317 255 311
Operating margin (%) 3.5 3.6 4.4 4.4 0.3 8.6
Operating profit (£m) 11.0 12.0 13.7 13.9 0.7 26.8
Net profit (£m) 8.7 9.4 10.7 11.4 -2.2 19.1
Reported earnings/share (p) 21.3 22.9 26.9 27.4 -5.8 50.4
Normalised earnings/share (p) 21.3 22.9 26.9 28.1 -12.2 59.8
Operating cashflow/share (p) 26.7 70.0 43.7 51.2 150 99.8
Capital expenditure/share (p) 8.3 12.7 7.0 13.5 10.0 11.9
Free cashflow/share (p) 18.5 57.4 36.6 37.7 140 87.9
Dividend/share (p) 14.5 14.7 16.2 16.7 0.0 10.0
Covered by earnings (x) 1.5 1.6 1.7 1.6 0.0 5.0
Net Debt (£m) -16.3 -33.6 -41.8 -51.8 54.1 28.4
Net assets per share (p) 74.0 83.2 93.2 107 67.1 117

Source: historic company REFS and company accounts.

DFS Furniture - financial summary
Year end 27 Jun

  2016 2017 2018 2019 2020 2021
Turnover (£ million) 756 763 871 901 725 1,068
Operating margin (%) 10.0 7.9 4.4 3.6 -6.0 12.7
Operating profit (£m) 75.8 60.5 37.9 32.5 -43.7 135
Net profit (£m) 60.3 39.5 18.8 18.1 -69.2 88.7
Reported earnings/share (p) 28.2 18.6 8.8 8.4 -31.4 34.2
Normalised earnings/share (p) 32.5 18.2 13.4 10.5 -25.2 34.5
Operating cashflow/share (p) 44.2 35.2 31.7 19.8 25.3 115
Capital expenditure/share (p) 11.4 13.3 10.3 11.3 10.6 19.0
Free cashflow/share (p) 32.8 21.9 21.4 8.5 14.7 96.0
Dividend/share (p) 11.0 11.2 11.2 3.7 7.5 7.5
Covered by earnings (x) 2.6 1.7 0.8 2.3 -4.2 4.6
Net Debt (£m) 134 145 155 170 669 471
Net assets per share (p) 118 116 119 119 79.1 110

Source: historic company REFS and company accounts.

ScS has the better balance sheet of the two 

ScS recently had a 1.1x ratio of current assets to current liabilities, while DFSs substantial £280 million of trade payables versus only £13 million of trade receivables diluted its liquidity ratio to below 0.3. 

Intangibles as a percentage of net assets were also sub-6% for ScS versus 192% for DFS. 

ScS had no bank debt, although leases constituted £111 million relative to £38 million of net assets. These meant £1.9 million in finance charges, which expanded the interim pre-tax loss to over £3.6 million. 

DFS had £83 million of bank debt, chiefly long-term, and £458 million of lease liabilities relative to (intangibles-dependent) £281 million of net assets. £14 million of finance costs were shaved off £36 million of operating profit. 

Despite the overall better net upshot for DFSs income statement, its balance sheet looks decidedly riskier, exposing its stock to greater downside risk than ScS should a UK downturn crimp spending. 

Favour ScS for now 

Both stocks are liable to respond to shifting expectations for the consumer economy, but if you are able to stomach the risk of a profit warning then I suggest averaging into ScS – hence a ‘buy’ stance – whereas DFS looks an overall hold’.  

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

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