Interactive Investor

Stockwatch: time to back this controversial owner’s £3bn empire

7th June 2022 12:18

Edmond Jackson from interactive investor

It’s previously grabbed headlines for the wrong reasons, but the company’s strong balance sheet can cope with an economic downturn, and its ‘value’ offering is attractive.  

Has the baton for investment value in sports fashion retailing been passed from FTSE 100 listed JD Sports Fashion to mid-cap firm Frasers (LSE:FRAS)? Recent chart comparisons are intriguing although vigorous share buy-backs may have helped Frasers. 

From last November to late May, JD Sports Fashion (LSE:JD.) halved in market value below £6 billion from a peak around 230p a share – amid fears about how inflation will hurt discretionary spending, and also about growth stocks de-rating as expectations shifted to higher interest rates. 

After recovering from a 112p low to 125p, and assuming consensus forecasts, JD currently trades on a 10x normalised earnings per share (EPS) for its year to end-January 2023, albeit a prospective yield of just 0.5%. 

Over a similar timeframe, Frasers has drifted only 12% from a seven-year high of 805p to around 700p where the forward price/earnings (PE) is just over 12x, albeit with no dividend policy. 

This basic comparison shows high ratings as more vulnerable to downside risk, although JD fans can cite this fall as mean-reversion to an upwards trend-line that has existed since 2012. Buying major drops has so far been rewarding. In late 2018 there began a sharp rally from 80p near 170p by February 2020, and from 100p in April 2020 to the 227p all-time high last November.  

Sports Direct could benefit from consumers trading down  

I incline to focus this piece on Frasers out of intrigue about how its “chequered vest” in sports-fashion retailing – chiefly due to its mercurial founder and 61% shareholder, Mike Ashley – makes it a somewhat contrarian play.  

Tweaking an adage: might this stock climb a wall of scepticism if the business continues to deliver? 

While exposed to discretionary spending and having developed fashion interests by acquisition, 58% of Frasers’ revenue derives from sports retail where, similarly to a current trend towards low/no alcoholic drinks, people may be likely to prioritise this spending. 

A major fascia like Frasers’ Sports Direct operates firmly in the value/discounter space which could benefit from people seeking keener prices although, again, JD fans can cite their group owning Blacks, Millets and Go Outdoors which are also cheap, if more outdoorsy than sporting. 

Good margin recovery despite caution about costs   

Yet Frasers does not escape a cautious outlook. At the 9 December 2021 interim results – the last thorough reporting point – the CEO said that despite strong trading “we remain cautious with a number of well-publicised macroeconomic headwinds on the horizon in the form of but not limited to cost increases, supply chain issues and potential squeezes on consumer spending power.” 

This was before cost-of-living concerns have intensified after the Ukraine crisis significantly boosted commodity prices. 

Cost pressures are happening in a context of Frasers’ operating margin declining (see table) from 7.7% back in 2015/16 to mid-single digits, then an April 2021 year loss, although JD has only delivered a circa 10% to 6% range, so a PE nearer 20x was unsustainable. 

Frasers’ margin did however recover to 8.5% in its first half-year, despite £135 million property and other impairments being taken “above the line” (instead of exceptional items) thus reducing operating profit to £200 million. A more normal sense of operating margin would have been over 14%, and impairments were accounted for similarly at the 2021 interims. 

Re-positioning of Sports Direct looks medium-term attractive 

Like-for-like interim group revenue up 24% was significantly boosted by store openings as Covid restrictions eased. 

The main sports retail side rose 27%, reflecting the Sports Direct stores and online sales, also Evans Cycles (acquired in 2018), Game UK consoles and group gyms. Hinting at operational gearing, its adjusted pre-tax profit soared 111% over £117 million. 

Various marketing campaigns for Sports Direct, initiated with its brand partners, look adept. “It’s been a pivotal year…” the CEO said of 2021. 

The premium lifestyle side assembled in recent years contributed 18% of revenue and appears a nod of respect to JD: acquisitions such as Flannels, Cruise, van mildert, House of Fraser, Jack Wills and Sofa.com. Revenue growth of 34% was largely due to new Flannels stores and House of Fraser re-opening, plus online growth. 

Flannels’ compound annual revenue growth in the last four years under Frasers’ ownership has been over 40%. 

Mind, this area of business appears relatively more exposed to weaker consumer spending and “business rates continue to be a significant and disproportionate cost to House of Fraser”. 

Impairments also swung this division into a near £10 million loss, a reminder of the hangover with acquiring troubled companies. 

A latest £20 million acquisition is Missguided, an online women’s fashion retailer in administration. 

European retail constitutes 17% of group revenue, where 14% growth at the interim stage was driven by Ireland. 

Residual activities are rest-of-world retailing and wholesale/licensing. 

Is the new CEO effectively a nepotistic appointment? 

Michael Murray is a 31-year-old engaged to Mike Ashley’s daughter, who joined the group in 2015 to lead its property and retail side.  

Nearly two months ago, he was awarded a near £21 million consultancy fee based on value generated by property deals, which followed £2.5 million in 2021 and £9.7 million for 2019/2020. By comparison, previous Sports Direct senior executives including the CEO had been paid circa £150,000. 

If Murray can get the stock price to 1,500p by 2025 then, under a new deal, he could gain shares worth over £100 million. 

Nearly half of Frasers’ independent shareholders voted against this scheme and over half on whether the CFO should get a pay rise and bonus.  

Anyone owning Frasers equity therefore needs to be confident that the group’s overall positioning can offset what looks like a red flag or two on corporate governance. 

Strong cash flow profile has helped to cut debt 

Modest returns on capital employed (see table) should improve now that debt has been cut from £706 million to £375 million, itself offset by £351 million cash. 

Net cash generated from operations - near £500 million in the first-half-year - was close to the £519 million achieved in the full April 2021 year. It also helps explain a continued vigorous buyback programme where remarkably, around a third of Frasers’ issued share capital is now held in treasury. But you wonder, why not a dividend policy? Would that not suit the tax preferences of Frasers’ 61% shareholder? 

Institutional investors typically want a dividend as proof of wider shareholders’ priority besides underlying cash flow. 

There were also £685 million leases as of October 202, although £16 million total interim finance costs were reduced to just £3.7 million by finance income. 

A total of £930 million debt facilities is refinanced for three to five years, and of £1,367 million net assets last October, £1,066 million represented property and only £114 million, intangibles. 

Frasers’ balance sheet is thus in a strong position to cope with a worse-case economic scenario. 

Frasers Group - financial summary
Year-end 24 April

  2016 2017 2018 2019 2020 2021
Turnover (£ million) 2,904 3,245 3,360 3,702 3,957 3,625
Operating margin (%) 7.7 4.6 6.0 4.3 4.9 -1.7
Operating profit (£m) 223 148 201 161 192 -60.3
Net profit (£m) 277 230 20.1 112 93.8 -83.0
EPS - reported (p) 45.5 38.3 3.8 21.5 18.5 -16.5
EPS - normalised (p) 51.9 31.4 2.4 25.6 27.9 64.4
Operating cashflow/share (p) 10.8 42.9 61.4 52.5 74.3 103
Capital expenditure/share (p) 33.9 68.9 39.2 30.6 63.8 43.9
Free cashflow/share (p) -23.1 -26.0 22.2 21.9 10.5 59.1
Return on total capital (%) 12.3 8.5 9.2 6.3 6.4 -2.1
Cash (£m) 234 205 360 448 534 457
Net debt (£m) 99.7 182 397 379 990 972
Net assets (£m) 1,386 1,223 1,194 1,247 1,267 1,193
Net assets per share (p) 232 218 222 232 224 230

Source: historic company REFS and company accounts. Past performance is not a guide to future performance.

Why I tilt to a buy rating 

Despite real concerns about a 61% shareholder able to influence board composition and policy, the “value” sports equipment space looks attractive on a two-year view. 

A “hold” stance would appear to shy away from Frasers’ marketing agility and pricing.  

Some may prefer to await annual results due in July, plus an updated outlook. Yet broadly, and for a starter position: Buy. 

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

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