When will sales growth follow through into profit and cash - and is this the right economic backdrop for such a business, asks our companies analyst.
Continuing my examination of mean reversion and net asset value, it is logical to consider the slump in THG (LSE:THG) – generally known as The Hut Group.
This e-commerce group floated at 500p in September 2020, achieving a market valuation near £10 billion last January when its stock tested 800p. The price then slipped below 580p in August, rallying to 670p in early September. But recently the fall has sustained down to a 170p range, which capitalises THG at £2.2 billion.
It represents a 64% drop on the September 2020 offer price of 500p, when £1.9 billion was raised; half of that was to sustain capital expenditure until THG became cash flow positive, but also private equity was cashing in.
Macro risks besides those company-specific
There has recently been some innuendo in the media directed at the founder-CEO, which has made it hard for the stock to find support.
Call me a relic, but discussion of fast-paced, acquisition-hungry CEOs brings to mind other such listed companies that came off the rails in the 1980s. Operational risk is high. But in fairness, the history of Amazon (NASDAQ:AMZN) is busily acquisitive too.
THG is interesting to consider: on the short side in the near term because it lacks proven earning power, and potentially a long recovery play if its numbers can stack up.
But various online retail companies are now warning. The fancy exercise bike company Peloton (NASDAQ:PTON) warned on sales on 4 November; its highly rated stock is now being shorted.
E-commerce giant Alibaba (NYSE:BABA) has just missed revenue and profit expectations, cutting expectations for 2022.
Near term, it looks as if a bubble in online spending, blown by the pandemic and government handouts, is bursting.
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Market valuation now equates to expected 2021 sales
Looking further ahead, the challenge is guessing when THG’s sales growth can pivot into profit and cash, and to what extent. Consensus targets £2.2 billion revenue, which according to interim and third-quarter numbers may be the best outcome.
Revenue rose in the first half by 45% to £959 million (at constant currencies), then by 38% to £508 million in the third quarter. Implicitly, THG needs to make £733 million in the fourth, and a comparison with 2020 does suggest this may be achievable: £378 million revenue achieved in the third quarter of 2020 was followed by £559 million in the fourth.
A net annual loss of £33 million for 2021 is expected to become a £22 million net profit on £2.9 billion revenue in 2022, albeit implying EPS only of 1.1p.
Net asset value involves substantial capitalised costs
The table shows net asset value (NAV) more than doubled over 2020 to 92p a share, and the 2021 interims cited £1.8 billion or 144p a share at end-June.
However, the balance sheet shows 68% of net assets comprised of intangibles, which rose 80% to £1.2 billion in the first six months. Note 6 cites £551 million of “business combinations” added by way of capitalising platform development costs.
Yes, there is intangible value to recognise, but the question is whether it limits downside risk to the stock if earnings fail to kick in sufficiently.
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Excluding lease liabilities, THG did have net cash of £385 million, claiming overall liquidity (including bank facilities) over £1 billion. This followed a £740 million equivalent capital-raising last May when SoftBank and Sofina, two high-profile technology investors, took stakes.
Not dissimilar to faith in Ocado’s valuation
I would not dismiss THG’s £2.2 billion valuation outright, given Ocado (LSE:OCDO) is valued at £13.5 billion. There is a parallel with Ocado as a logistics operation and especially a technology platform with scope to license the technology globally. THG Ingenuity and On Demand offer similar potential.
But critics who see Ocado as part of a wider stock bubble blown by monetary stimulus since the 2008 crisis, can point to its stock losing 37% from £28 last January to £17.75 now. The story may be great, but over the long run market valuations respect earnings power and are mean-reverting.
Most likely, THG managed to sustain a £6 billion plus market value until October last year because investors thought they had found the next Amazon. But Amazon diversified extensively into everyday essentials, not just discretionary spending items, so it is buttressed against a consumer slowdown. It also enjoys a very strong position from first-mover advantage in online retail and distribution.
THG proclaims itself as a brand-builder “taking some of the world’s most distinguished names in beauty and nutrition to the next level…direct to consumers across the globe”.
THG - financial summary
|Year end 31 Dec||2015||2016||2017||2018||2019||2020|
|Turnover (£ million)||334||501||736||916||1,140||1,614|
|Operating margin (%)||5.3||3.3||-0.5||1.8||-1.7||-30.0|
|Operating profit (£m)||17.8||16.6||-4.0||16.6||-19.7||-482|
|Net profit (£m)||13.5||10.8||-10.1||0.8||-44.2||-533|
|Reported EPS (p)||1.2||1.0||-0.9||0.1||-4.1||-66.2|
|Normalised EPS (p)||1.2||1.0||-0.9||0.1||-1.2||-42.4|
|Return on capital (%)||7.4||3.7||-0.6||1.8||-1.8||-25.6|
|Operating cashflow/share (p)||3.8||6.9||1.5||4.2||5.0||9.4|
|Free cashflow/share (p)||0.4||-7.0||-5.1||-3.2||-11.6||-20.4|
|Net debt (£m)||40.7||134||220||294||476||-11.2|
|Net assets (£m)||63.3||144||319||385||468||1,145|
|Net assets/share (p)||5.8||13.2||29.4||35.5||43.1||91.9|
Source: historic company REFS and company accounts
Reliance on beauty and nutrition products
Beauty products constitute 48% of group revenue, nutrition 34%, ‘ingenuity’ (technology services to global brands) 9%, ‘on demand’ (product launches) 5%, with the remainder listed as ‘other’. It is currently intended to spin off THG Beauty as a separate listed company in 2022.
You have to take a view as to whether demand for such products is soundly based or susceptible to changes in disposable income.
In the US, THG has enjoyed strong organic growth across beauty and nutrition, and the acquisition of a prestige online skincare products business been fully integrated.
Luxury consumer goods may be somewhat more resilient now that global income inequalities have grown. But in the UK at least, they rely on the very top segment of society.
British consumers now face high fuel and energy costs, plus rises in council tax and National Insurance in 2022, with inflation around 7% by next spring according to some economists.
In the first half of 2021, the UK represented 41% of THG’s sales, continental Europe 22%, the US 18% and rest-of-world 19%. However, management’s recent narrative has cited 50 websites launched across 22 territories, so the group is vigorously diversifying from a UK base.
Director and institutional buying
On 5 November, a non-executive director bought £64,582 worth of shares at 200p, and a closely associated person £50,600 worth at 196p. That reflects confidence, albeit in greater success for THG’s business plan over the longer term than can be derived from current figures.
Simultaneously, Goldman Sachs announced that it had cut its stake from 4.15% to 3.38%, although I would not assume this represents Goldman’s view: more likely, it is acting as prime broker for funds.
Holders can take some encouragement that T Rowe Price International has declared a maiden 5% stake. It has historically pursued a ‘growth’ style of equity investing, although with some £1.2 trillion equivalent of funds under management, it arguably needs to take some risks and can spread its bets widely.
THG has today opened around 177p and I suspect traders are awaiting a more clearly defined support level, rather than risk catching the proverbial ‘falling knife’. One difficulty is that this company is immature as yet to publish a blockbuster earnings update that blows sceptics away.
Given a worsening macro context into which THG is vigorously expanding, you need a very strong risk tolerance. I cannot conclude with a ‘hold’ stance, and with fresh money would steer clear for now. Thus: Sell.
Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.
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