An online retailer in waiting

After some years of rationalisation Findel has emerged with one significant profit contributor, Express Gifts, the home shopping retailer trading under its brand Studio, which is increasingly moving online. Express also operates a related credit business. A smaller operation, Findel Education, serves the school supplies market, and a small Far Eastern sourcing business is in decline as an external player as a result of Express’s changing approach to the Far East.

Findel’s FY17 results demonstrate significant sales growth of 10% on a 52-week basis at Express. Customer numbers were up 17% on a successful recruitment drive, although at a short-term margin cost, and margins were also affected by foreign exchange. The operating results of Findel Education and Overseas Sourcing were down on the year but are relatively immaterial. Mainly as a result of the lower margins in Express, pre-tax profit declined by 10% to £22.2m.

We are downgrading FY18e pre-tax profit by 7%, carrying forward the undershoot of our FY18 forecast, but projecting 17% year-on-year growth driven by revenue gains as well as margin improvement at Express:

We are materially increasing our sum-of-the parts valuation from 236p to 324p. With these results Findel has clarified its strategic goal to move inexorably to become a pure-play online retailer. Its existing cost structure is already in line with such companies and we believe from observing its business that it needs to make few fundamental changes to enjoy the greater revenue growth potential online, although it is focusing on appropriate measures such as digital marketing and improved online software. It has effectively bottomed out legacy issues, making full provision for past financial service product liabilities, recognising onerous leases on simplifying its locations, and modernising bad debt provisioning procedures, and these are reflected in our valuation.

The main sensitivities we see are:

Following some years of rationalisation, Findel now comprises two businesses, heavily weighted to the home shopping retailer Express Gifts, which accounted for 98% of FY17 operating profit. The education supplies business, Findel Education, made a small profit and an independent Far East supply chain business, Overseas Sourcing, a small loss. Express is now predominantly, and increasingly, an online business which benefits from the physical infrastructure that its catalogue retailing history provides. The Education business faces a challenging market with a mission to reverse a recent history of market share losses.

Based in Accrington, Lancashire, Express evolved from origins in general merchandise mail order based on a printed catalogue. It trades mainly through its Studio brand www.studio.co.uk (a second brand, Ace is effectively identical). The key proposition elements are low-cost value and personalisation. It has recently stepped up its apparel business based on Far East supply although, with a product mix of 30%, this has some way to go. It incorporates an integrated FCA approved credit business.

With its FY17 results Express Gifts unveils a new strategy of migrating the business to a ‘digital first’ approach. The move to online pure-play is customer driven: 63% of Express Gifts’ customers ordered online in FY17, from 56% in FY16 and a previous plateau close to 50%. However, in FY17 71% of newly recruited customers placed their first orders online. This increases to over 90% for younger customers aged under 35. Management, already committed to providing what its customers require, now sees “this figure inevitably approaching 100%”. The company is therefore planning for the investment and transformation required to keep pace with this digital evolution.

Customer numbers, spend per customer and online ordering all moved ahead in FY17, reinforcing a previous trend.

Customer numbers, up 17% (19% on a rolling 12-month basis to date), benefited from the innovation of investment in recruitment in Q4 of the financial year, driven by Far East value products (although due to exchange rates these came at a lower margin). The increase in new customers also has a dampening effect on margins because of their acquisition and higher maintenance costs:

The bad debt percentage rose from what had proved to be an unsustainably low level in FY16 (which had unnecessarily curbed sales) as a result of a review of the balance between credit standards and sales.

Of Express’s 1.6 million active customers, 86% are female with the core market 25-55 years old, of whom 37% have children. Experian profile analysis shows that just over half of customers are from households with annual income below £30k. Coincidentally, an almost identical proportion of customers take credit averaging £350, which they pay off in an average of nine months (although customers have flexibility to match payments to their budgets and could take longer than this).

Traditional written and phone orders will continue to be catered for by the company, and it will continue to print its catalogue, but the strategy is now clear in terms of a specific objective to move towards a high mix of online sales. In line with this strategy, the company has increased marketing activity, particularly around TV and social media advertising, and has led the effort with ‘showcase’ promotional products such as the computer tablet at £19.99, which sold c 60,000 units, and ladies’ wraps at £2.99. It has also opened a Philippines call centre, which is already achieving UK customer service standards at lower cost.

The online channel continues to gain share within the UK retail market and represents a favourable tailwind for Express. We therefore regard both the fact that 63% of orders are now online, and the accelerated rate of growth of the online share, as significant. The average online order value is 10% higher than the offline equivalent, at £52. The cost to administer an online order is clearly lower than that of a telephone or written order, which requires manual intervention. 40% of customers buy personalised products; the personalisation process is more cost-effective online. Around half of customers pay their bills online.

The online channel also provides marketing opportunities. Express can track customer visits providing valuable information on dwell times, conversion rates, failed searches, complementarities and other customer statistics available for data analytics. That should result in better product selection, range structures, assortment mix, marketing approaches and therefore sales.

Around 30% of Express’s revenue is from financial services to its customers, and over the past two years management has been successful in rebalancing product sales against financial services income, with an aim of stimulating product growth without customer detriment. In FY17 financial services income grew 12.6% on a like-for-like (52-week) basis against 15.6% for product sales, with credit account holders up by 9.1%. Towards the end of FY16 the company introduced ‘risk-based pricing’ where the rate of interest charged to customers is tailored to their credit risk. Currently, Express is well advanced in introducing its new credit account management system, “Financier”, which will offer significantly greater flexibility in the management of consumer credit and the range of credit products that can be offered to customers.

Express’s main distribution facility is housed in a modern warehouse at Accrington, near Manchester. We recently visited the facility, which consolidates an operation once spread between seven warehouses, manages around 3,000 SKUs and employs c 200 people. Different areas are connected by 3.5km of conveyor belts. The order processing system currently picks c 200,000 items per day with capacity to increase this to c 300,000. The Klug software relies on barcode identification and is capable of bringing together a typical basket of five to six items within a session. This may include goods such as clothing, cutlery or pencils, which go through a personalisation process to inscribe or embroider a name on the product, this being a popular and differentiating feature of Express’s offer. Personalisation operations take up c 75sq ft of the site. The system incorporates a double-check on order fulfilment, as a result of which the unit has a record of over 99% accuracy.

In short, from its origins in home delivery, the fulfilment structure is ideally established for a transition to high levels of online orders. Express is now focusing on adapting its front-end offer more specifically to the online marketplace. As part of its platform development, it has moved its websites to IBM’s Commerce platform, which includes new account management features and cyber security compliant with the EU's General Data Protection Regulation (GDPR), effective May 2018.

Findel Education is a leading independent educational resources supplier, serving educational establishments in all parts of the UK. Consolidating a number of smaller businesses, its main areas of operation are Stationery Essentials, Science, Art and Craft and Early Years. Its well-known brands include Hope, GLS, Philip Harris, Davies Sports and LDA.

As is well known, school funding is currently under pressure. Of the three main areas of expenditure, teaching, buildings and resources, the first two have inflexible features and therefore the latter is where the most pressure exists in practice. As a result, school resources spending across the five major educational resources suppliers reduced by 6.3% in FY17 (source: BESA market data). However, long-term fundamentals remain positive with pupil numbers expected to increase by 0.55 million between 2017 and 2022.

Within this difficult market, Findel Education’s strategy is centred on:

During November 2016, a major business IT systems and warehouse integration programme was completed, with an investment of c £7m to produce a modernised distribution facility in Nottingham and a single core ERP IT system for the business. Further business simplification actions have also been identified to reduce costs and improve return on sales. Management expects this to deliver £3-4m of annual cost benefits over the next two years, while improving operational service levels.

Online retailing remains the top determinant of success in retail and is changing the face of the retail industry. In the ONS retail sales numbers for Q117, UK online sales grew year-on-year by 19.5%, against 4.8% for all retail, and represented c 15.5% of all retail spending. Traditional retailers continue to face challenges, with input cost pressures now adding to structural changes in demand to make investment returns increasingly difficult to achieve from terrestrial retailing. In the January 2017 edition of Edison Insight we wrote: “Relentless share gains in online will likely continue, riding long-term social trends. We expect further consolidation of physical store numbers as productivity pressures drive more retailers towards the ‘fewer, larger’ paradigm. And it is likely that the list of retail failures will lengthen.” Jaeger, Jones the Bootmaker and Agent Provocateur are among recent failures, while Woolworths and BHS remain monuments to the terrestrial general products retail segment of the past. Physical store numbers are set to decline 22% in the five years to 2018, according to forecasts by the Centre for Retail Research. However, online retail is forecast to grow 14% by value, according to the IMRG Capgemini eRetail Sales Index.

An e-tailer is defined as an online retailer without physical stores. Of the top 50 online retailers listed by IMRG for 2016, only 19 were e-tailers, and of those only 10 (Amazon, Apple, ASOS, EE, Telefonica O2, Three, Very, DIY, Littlewoods, Vodafone) sell physical products, four of which are phone companies (the rest are mainly travel companies like easyJet). Nonetheless, as Amazon, ASOS and Boohoo demonstrate, e-tailers selling physical product are positioned to take share and are actively doing so.

There have been significant management changes in the current year. In January 2017 David Sugden, who had been chairman for seven years, stood down as previously announced in February 2016. He was succeeded by Ian Burke, who was appointed executive chairman. Ian Burke has had a number of high-profile roles in consumer companies with a notable record in change management. He is currently chairman of The Rank Group, having previously overseen Rank as chief executive. In the past, Ian has served as chief executive of Thistle Hotels and has also held the position of managing director at both Holiday Inn Worldwide and Gala Clubs.

In April 2017, Phil Maudsley, previously managing director of Express Gifts, was appointed as chief executive. Phil has led the development of Express Gifts for over 20 years, and has been responsible for its transformation to a leading online retailer. At the same time, Ian Burke stepped back to become non-executive chairman, and Tim Kowalski, who had been FD since 2010, stepped down. Stuart Caldwell, previously group financial controller, became acting CFO and has now been appointed permanent CFO.

These management changes, reflecting the simplification of the group over the last five years from the five divisions to two, and equally the appointment as CEO of Phil Maudsley, with his extensive background in Express, indicates where the group’s strategic emphasis now lies.

As a value retail operation across a horizontal range of product types, Express has broad exposure to UK retail demand, an area of likely challenge in the near future. Retail sales volumes (excluding fuel) rose by only 0.3% for the first quarter of 2017 (quarter-on-quarter), although this was an improvement on the final quarter of 2016 when they declined by 0.1%. However, this is a more ambiguous picture than, say, a year before when retail sales volumes increased 0.7%. Following the Brexit vote of June 2016, consumer demand has remained more resilient than many observers expected. However, average earnings increasing by 2.4% for the year to March 2017, less than inflation of 2.7% in the same period, may presage a period of perceived hardship among consumers. Although a shortage of disposable income may relatively favour value retailers, a significant cutback by customers would not be good for any retailer.

The return of an economically relatively hardline Conservative government in the UK may result in an even tougher market for Education, making it much more difficult to stabilise revenues even if it increased its market share. This would hamper the division’s recovery, although the warehouse savings expected in FY18 should be relatively unaffected. Following the June election result, however, it seems likely that some of the May government’s hardline policies could be modified.

Any financial services business is always vulnerable to greater regulatory intervention and tighter limits on operating freedom. Express has reviewed all of its products and satisfied itself that it has identified all those where redress would be required under current rules. Particularly, it has now completed a detailed account-by-account review of its liabilities to customers for the past sale of financial products that were not fit for purpose. However, the levels of redress could still change. Moreover, there remains a risk that limits could be imposed on the profitability of future products, albeit we are not aware of any specific proposals.

On a more positive note, Findel is one of the few retailers that might see a benefit from the introduction of the National Living Wage. The cost impact on its warehouse and call centre workforces is likely to be small, perhaps as little as £0.25m, while its customer cohort is likely to be beneficially affected.

Like any business, but particularly as an increasingly online one, the company could be exposed to cyberattacks. Management is well aware of this, and for example the move to IBM’s Commerce platform includes cyber security compliant with forthcoming EU regulatory standards.

Findel’s results demonstrated significant sales growth in its main operation, Express, although at a short-term margin cost. The operating results of its smaller businesses, Findel Education and Overseas Sourcing, were down on the year but are relatively immaterial:

Express’s revenue growth was 15.6% on a 52-week basis. However, this came at a margin cost of 0.4% on total Express revenue, resulting from the cost of recruitment, the higher maintenance cost of new customers, and heavier debt provisioning that the policy requires. All these disbenefits are expected to reverse over the first 18 months, and in fact the new customers should be higher margin as more of them are online. In addition, adverse foreign exchange affected margin for products sourced in the Far East. As a result, Express’s operating profit declined by £1.3m. Education suffered a larger decline of £1.8m as a direct result of more difficult trading and competition, with consolidation and synergy benefits not having yet come through.

Our FY18 forecast is driven by an assumed 10% revenue growth at Express, continuing to benefit from customers acquired in the second half of FY18, while we reflect some operating margin improvement from those customers (net of further customer acquisitions), driving 12.4% operating profit growth. At Education we forecast £3.5m benefit of warehouse rationalisations, together with variable cost savings, increasing operating profit to £2.5m despite continuing demand weakness. As a whole, we forecast a 16% improvement in operating profit and 17% growth in PBT to £26m.

Findel produces cash flow that is more than adequate for its needs. Although £8m of the £40.8m EBITDA in FY17 was absorbed by exceptionals, capital expenditure mainly to develop the financial services and customer service aspects of Express Gifts, was substantial at £11.7m, and the increase in customer business (increase in receivables net of securitisation inflows) appropriated £7.1m, with other working capital accounting for a £1.7m credit. With pensions and other items taking £2.6m, free cash flow was £13.3m, a yield of 8.5%.

Allowing for the fact that the debt structure includes Findel’s substantial consumer credit business, the balance sheet is increasingly strong.

The lending business is funded by a £155m securitisation facility (increased during the year by £10m and maturing in 2019). For every £100 of credit extended to customers, £71 is drawn down from this facility, and therefore matched against customer receivables, which are appropriately provisioned on a formula basis consistent with IAS39. The other £29 is funded from bank facilities. This structure is typical of the home shopping market. Of total net debt of £225.0m at March 2017, securitised debt was £144.2m and net bank debt, shown below, was £80.8m.

The core element of net bank debt continued its reducing path, down by £10.3m to £22.6m. Effectively, therefore, c 90% of net debt (£144.2m+£58.2m) now supports good credit receivables, with the £22.6m representing less than 0.5x EBITDA.

We forecast total net debt (including securitisation) to increase from £225.0m at March 2017 to £237.6m at March 2018, mainly on financial redress payments, and remaining flat in FY19. This is adequately covered by total facilities which are currently £265m (securitisation facility of £155m plus RCF £110m), although management believes the securitisation facility will be increased to fund growth.

Findel has significantly added to its provisions and impairments in FY17. The main reasons were:

Express Gifts’ evolution from a mail order background to its current, predominantly online status suggests that it already has the fulfilment capability to take it the rest of the way. An analysis of other retailers’ selling, distribution and admin costs is revealing. Clearly pure-play e-tailers show superior revenue growth, driven by the buoyancy of the online channel. This is a state that Express should be able to aspire to as it increases its online presence closer to 100%. We do not compare gross margin, since this is product-specific. However, the structure of selling and distribution costs reflects generally higher costs for more fully online businesses. We rank them by online sales percentage.

Shown graphically (below), this indicates that pure-play e-tailers such as Amazon and Boohoo have costs of roughly 20% of sales, while those of largely terrestrial retailers such as M&S (17% online) and Debenhams (15% online) are closer to 10%.

Taking total SG&A costs (Exhibit 8), despite having 42% online sales (we assume equal to Directory sales), Next has an exemplary low cost base of 14% of sales. Sports Direct (c 14% online) has notably high total costs of 35% (we note that it does not separately disclose selling and distribution costs. Sports Direct has accumulated a 29% holding in Findel). The same trends are apparent for those retailers that separate out selling and distribution expenses in their reporting (Exhibit 9).

What is apparent at Findel is that both its total SG&A costs and its specific selling and distribution costs are already comparable with the cohort of pure-play e-tailers. This finding is important, as it suggests that (as Findel is structured for home delivery) the cost structure is unlikely to alter fundamentally as the proportion of online sales accelerates, as it is now doing.

We are raising our sum-of-the parts valuation from 236p to 324p, as a result of a several factors:

We do not reflect the onerous leases provision in our valuation as our forecasts already reflect actual rents payable.

Our valuation of 324p would equate to a P/E ratio of 13.0x for FY18e, falling to 11.9x for FY19e, which is close to the current rating of N Brown. However, as we show above (see ‘Structured for an online future’), Findel has a cost structure that is already more closely aligned with pure-play online retailers such as ASOS, Boohoo and Gear4music, which enjoy Year 1 P/E ratings of between 74x and 76x earnings. Even if a material discount were taken for the smaller size of Findel, the steps it still needs to take to develop as a pure-play retailer and allowance for past issues, this reference would suggest much higher headroom for the share price.