After making a big profit on this share tip in just a matter of weeks, companies analyst Edmond Jackson reveals what he’d do now.
Occasionally, a simple macro call applied to an out-of-favour stock is all you need to exploit mis-valuation.
On 7 June I made a “buy” case for mid-cap retailer Frasers Group (LSE:FRAS) based chiefly on its main Sports Direct subsidiary operating in the value/discounter space. Historically, during challenged times people have often prioritised fitness and looking better, and Sports Direct is well-placed to benefit as shoppers trade down from expensive items, and newcomers seek cheap kit.
Together with businesses such as gyms and Evans Cycles, UK sports retail accounts for just over half of group revenue.
Yes, there is competition from Decathlon, 40% owned by a French billionaire, but Frasers’ interim results already appeared to show signs of a behavioural shift given a 27% rise for sports retail.
Benefiting from a period of investment
CEO Michael Murray had proclaimed “a pivotal year” for Frasers after various marketing campaigns initiated with brand partners. Other operations such as Flannels high-end fashion stores were doing well, and luxury marketing can prove rather resilient.
Despite the lack of a dividend policy, Frasers’ balance sheet was in a strong position to cope with a worst-case economic scenario, and consensus forecasts implied a modest 12x price/earnings (PE) multiple.
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There was enough there to justify a “buy” rating at around 700p, even though the stock was down only 12% from a seven-year high of 805p.
After soaring 36% to 950p in response to a full financial year update, the stock is currently around 900p.
(Mind, that this update does not strictly constitute annual results but notwithstanding errors and an audit, they are as good as.)
A stock spike or portent of a company well suited to the times?
This re-rating is on the back of guiding profits up 45% for the current year to 24 April 2023, which is outstanding for a retailer. Murray even describes Frasers’ projections as “conservative” versus challenges such as inflation, supply chain disruption, business rates and cost-of-living pressures on consumers.
The market’s reaction is not necessarily a spike, for it maintains an approximate 12x forward PE assuming the guidance is fair. Some extent of profit-taking is going to happen, given economic uncertainty.
Group revenue is up 31%, if benefiting from a re-opening of stores from March 2021 and prior results affected by lockdowns.
Murray extols: “building incredible momentum with new store openings, digital capabilities and deeper brand partnerships – such as Nike, Hugo Boss and Stone Island – across all of our divisions”.
Quite whether his messianic sense of being is a function of 31 years of age, or something unique about Frasers’ operations. But they are quite well diversified, and I would prefer to hear a more measured approach as pressures mount on consumers.
We are yet to see the effects of another energy price cap being removed this October. Managers may be excited when soaked in their current operations, but might be less attuned to what lurks on the horizon.
Yes, the value/discount end of retailing can benefit in some ways from tough times, but remember Poundland cautioned earlier in June about how UK shoppers were cutting back even on essentials.
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Possible beneficiary of a ‘barbell’ marketing strategy
Benefiting from a “barbell” marketing strategy is not a term Frasers employs, but is instead my own sense of interpreting the group.
The update actually cites revenue from the “premium lifestyle” side – 22% of total revenue – up 44%, relative to UK sports retail up 31% and European retail by 28%.
Flannels is the driver on this side, which otherwise includes the House of Fraser stores – historically problematic and whose purchase from administration for £90 million in 2018 was something the then boss Mike Ashley came to regret.
When his son-in-law CEO complains about business rates, I suspect this significantly remains an overhang from House of Fraser.
“Barbell” because Frasers is essentially driven by the success of Flannels and Sports Direct; where yes, I would respect both luxury and value merchandise can outperform mid-range clothing typified by Marks & Spencer (LSE:MKS), for example.
It could therefore be an intelligent combination for a challenged consumer environment ahead, so long as for example gyms and the House of Fraser stores do not become a drag.
Going back to 2010, the stock – in a slimmer form, more focused on Sports Direct – had a big run from around 100p over 800p by early 2014, despite the eurozone financial crisis affecting commercial sentiment. While Decathlon has since expanded its reach, this did affirm the Sports Direct concept.
The stock then slumped below 300p on corporate governance concerns and the House of Fraser saga, whereupon it traded volatile-sideways until re-gaining its mojo from early 2021.
I still regard it as “a Mike Ashley play” whereupon he has learned lessons and has genuine retail flair. I cannot imagine his son-in-law has joined the group in early 2019 – suddenly to become Head of Elevation, and CEO from May 2022 – without 61% shareholder Ashley having some influence on him.
Frasers Group - financial summary
Year end 24 Apr
|Turnover (£ million)
|Operating margin (%)
|Operating profit (£m)
|Net profit (£m)
|EPS - reported (p)
|EPS - normalised (p)
|Operating cashflow/share (p)
|Capital expenditure/share (p)
|Free cashflow/share (p)
|Return on total capital (%)
|Net debt (£m)
|Net assets (£m)
|Net assets per share (p)
Source: historic company REFS and company accounts.
Can investment alone sustain revenue and margin?
This is how Murray justifies the extent of raised guidance, and you can see from the financial summary table how capital expenditure once again over £60 million has checked free cash flow to £11 million.
The operating margin has risen to 7% which is only just behind the 8.4% JD Sports Fashion (LSE:JD.) achieved in its last financial year, although Frasers’ margin trails JD’s historically.
Return on total capital is at a six-year high at over 11%. That’s nothing special, although return on equity has jumped to 23%. That will reflect Frasers’ operational gearing which has kicked in – for £297 million annual net profit versus a £78 million net loss in 2020/21.
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Murray reportedly characterises recent years as “crawl-walk-run” where the group is now more firmly running if not sprinting.
He hopes to open around 100 more of the high-end Flannels fashion stores, versus 53 currently, which assumes quite a lot about discretionary spending.
International development is also being pursued, with a new 2.4 million square feet warehouse and distribution site in Germany, supporting growth across continental Europe. Assuming demand holds up.
I therefore see some risk that Frasers has a young CEO – unseasoned over business cycles – who is buoyed by recent momentum but whose expansion aims could be optimistic.
Would you not be optimistic and pursuing expansion when incentivised to receive equity worth £100 million if the stock reaches 1,500p by October 2025?
Respect is an unknown aspect of consumer demand
This to me is the crux. I respect how Sports Direct and Flannels may continue to thrive even as demand tempers, given their focused marketing. I am less sure about House of Fraser or Studio Retail – the old listed Findel plc – both of which were problem businesses. A harsher consumer environment may reopen cracks.
Mind how operational gearing works both ways. Frasers also has exactly £1 billion of net debt including leases, and last year’s interest charge rose 34% to £48 million. Investment income offset this 1.4x but was derivatives-related. I would not rely on that to offset any risk of interest rates rising more materially.
The stock’s easing reflects some investors locking in gains according to their risk appetite, I suggest you consider too. Broadly, I adjust my stance to: Hold.
Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.
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