Interactive Investor

Stockwatch: time to gamble on this small-cap?

Some would argue that the business model has a lot to prove, but director trades are a positive sign. Here's what analyst Edmond Jackson would do.

19th December 2023 10:36

Edmond Jackson from interactive investor

On 14 November, I drew attention to Naked Wines (LSE:WINE) as a speculative “buy” at 30p after three directors bought £75,000 worth of shares at the same price. The chief financial officer deciding on £24,000 worth was particularly interesting given that this is largely a “viability” play.  

It is pertinent to examine the latest interim results, which have aided a 77% rise to 53p, above the stock’s 50-day moving average. Mind how that happened also last April to June, but did not establish a floor until early November at 29p versus 130p a year ago. An aspect of “risk-on” in markets amid optimism over interest rate cuts may also have helped.  

After dealing restrictions were lifted, a non-executive director with his partner bought a total of £66,450 worth around 43p and the executive chair added a further £42,135 worth at prices from 47p to 53p, to own 3% of the company. 

An underlying £2.8 million interim operating profit  

This lies beneath an £11.5 million charge for asset impairment (writing down wine stocks) and a £1.8 million US-deferred tax adjustment that has compromised net profit in the 26 weeks to 2 October. It implies a still-weak but “record” margin of 2.1% in the context of recent years showing it tested only 2% in 2018. 

Naked Wines - financial summary
Year-end 3 Apr

 201820192020202120222023
Turnover (£ million)476178203340350354
Operating margin (%)2.0-5.1-2.4-3.40.5-4.0
Operating profit (£m)9.3-9.1-4.9-11.71.9-14.3
Net profit (£m)7.4-9.48.2-10.02.4-17.4
EPS - reported (p)10.1-13.7-9.3-13.83.2-23.6
EPS - normalised (p)15.8-12.2-9.2-13.73.23.1
Operating cashflow/share (p)36.48.330.146.1-57.5-43.4
Capital expenditure/share (p)5.29.91.63.72.62.0
Free cashflow/share (p)31.2-1.628.542.4-60.1-45.4
Dividends per share (p)7.22.00.00.00.00.0
Covered by earnings (x)1.4-6.80.00.00.00.0
Return on total capital (%)6.6-6.8-4.1-10.91.7-10.8
Cash (£m)15.619.155.385.240.239.5
Net debt (£m)8.518.6-49.8-82.3-36.6-4.5
Net assets (£m)12110911410311098.7
Net assets per share (p)169151156141150133

Source: company accounts.

A dilemma with this “wine club” operation is inherent costs: advertising is nearly 6% of interim revenue, general admin costs are 14%, fulfilment costs 19%, and all this after cost of sales take 60%. What can be cut if revenues are essentially declining, hence a need to spend to get sales? Management cites scope within fulfilment costs, near £26 million in the first half.  

I speculate that one scenario might be the business shrinking, maybe back to a more natural size as a wine club with small-batch rather than mass-market producers. Maybe then it gets acquired, who knows? But is that within management’s agenda? 

Is the marketing pitch effective against wine trade rivals? 

Interim group revenue is down 20% to £132 million, or by 18% at constant currency, with a 16% decline in repeat customer sales. Customer attrition is said to be “at an all-time low” of 33% but still sounds still high: “we are not currently generating enough new customers to replenish those lost to cancellations”.  

Some would say the business model has a lot to prove. Moreover, why should it need investment in new customers of around £25 million a year if its proposition is good enough? 

Yet management contends that if it achieves a stable revenue base and aligns costs with revenue intake, there will be a profitable cash-generative business. It certainly needs to be otherwise current bad financial publicity is liable to scare off new customers taking out subscriptions. 

Unless they are just trying to reassure, what would appear guidance from the CFO to the company broker (by way of consensus forecast) is £2.6 million net profit in the current year to March 2024, rising to £2.9 million, implying a 2025 price-to-earnings (p/e) of 9.3x if it happens. However, mind how notes to the interim accounts speak of various “plausible scenarios”.  

A speculation on inventory value being turned into cash 

Net tangible assets at 2 October end were near £83 million or 112p a share although (quite like financial stocks) it is tricky to know to what extent the £34 million cash (down 14% like-for-like) reflects customer funds. Under balance sheet current liabilities is a 13% increase in “angel funds and other deferred income”, which I assume are customer subscriptions largely spent on wine (how this operation works). This links to note 10 to the cash-flow statement citing a £8.5 million increase in “customer funds in deferred income”.  

It would also explain a 17% rise in wine inventories to £162 million over just six months. Yet management says that it can generate £40-50 million by completing negotiations with winemakers and reducing inventory to £115-130 million by April 2025, linked in future to member base size.  

This implies getting co-operation from the winemakers, but quite whether they are bound to accept Naked’s terms or are free to find other distributors is uncertain. 

At least a £7.9 million write-down a year ago is reversed by £0.8 million, as if valuation estimates are now fair (although interims are not audited).  

While longer-term viability remains a guess, there is scope for further upside assuming the customer base can at least be stabilised and debt covenant issues managed through.  

Cash-flow weakness is behind a material uncertainty as a going concern 

The logic of the results’ statement and notes is rather twisted, although by their share dealings the directors implicitly believe the business can recover. 

The executive chair says that despite a material concern in the going concern assessment – because “trading remains volatile and we still need to conclude some supplier discussions” – he is “confident we have the headroom to weather any plausible future scenario from here”. 

He expects the group to become cash generative in the next 12 months, at least before interest and tax and stripping out any aspect of inventory write-down. 

Yet, and like I noted earlier, “the key dependency is on how well we can perform deploying investment in new customers”.  

The interim cash-flow statement shows cash continuing to be absorbed at the operations’ level – if reduced from near £23 million in the first-half September 2022 year, to £4 million in first-half 2023. After investment and financing, there was a £6 million decrease in cash. Again, I am unsure if customer funds are recognised as part of such (within net operational cash flow?).

Note four to the accounts gets rather convoluted as to scenarios.

Despite weaker US trading in the second quarter and then in October, Naked remained within its “plausible downside scenario” but 7 November guidance has seemingly been revised down as regards the worst-case scenario. 

Management’s “base case scenario” is for liquidity and profitability sufficient to meet covenant commitments for over 12 months. They believe this represents a conservative view of trading prospects. 

They then present a more severe “but plausible” downside scenario where new customers achieved does not meet expectations, revenue from those existing remains flat and cost savings are not realised. This, they contend, would still maintain adequate covenant cover, but “potential recurrence of variance would result in a covenant breach” (with September and December 2024 cited).  

The words get complex, but essentially if Naked’s marketing pitch fails to sustain customers and management does not compensate with cost cuts, it is at the behest of its banks. 

Mind also, the bank facility needs replacing in March 2025 

The US side engaged a three-year facility that stipulates near £16 million equivalent cash be held at all times. The group has £1 million near-term debt and near £30 million longer term, also £5.3 million leases.  

The stock is thus a gamble whether management’s confidence is borne out, or whether Naked is a proverbial “toad” business that continues to croak. 

Much also depends on your risk appetite. My instinct is to give them more time, hence “hold”, or average up into the rise, than take profits. 

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

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