Extraordinary growth continues in peak period

H118 pre-tax profit was slightly higher at £11.6m against £11.4m in H117.

Express Gifts and Findel Education both posted lower first half profit, which was compensated by lower central costs. However, all three were affected by non-comparable elements, and in particular Express Gifts lower result masks significant underlying growth:

The H1 results of Express Gifts were affected as expected by the timing of the pre-Christmas marketing campaign compared with last year. In FY17 the campaign was skewed into September but in FY18 reverted to its normal phasing across the half year point. The FY17 timing, which had been adopted to accommodate the introduction of the Financier financial services platform, had accelerated product revenue growth in H117 to 15.8% (full year 9.6%). In H118 growth was 1.2%, but in the comparable 10 weeks leading up to Black Friday, which includes the start of the marketing campaign in both years, growth was 12%. Year-to-date total revenue growth is now 7.7% and we expect it to accelerate further in H2.

Active customers have increased from 1.8 million at H117 to 1.9 million at H118, and online ordering from 66% to 72% on a rolling 12-month basis showing further progress towards the company’s stated aim of becoming a digital-first retailer.

Product gross margin reduced 50bp as a result of the known termination in August 2017 of a shared services arrangement with Kleeneze, the former Findel subsidiary. Management still expects a margin improvement for the full year. Marketing costs reduced by £3.2m mainly as a result of the campaign timing differences described above.

Financial services revenues grew year-on-year by 8.7%, with an increase in the number of customers rolling forward a balance increasing from 52.5% to 58%, demonstrating the attractiveness of the personal credit facility. Naturally, accounts are closely controlled, with detailed credit management information having improved through the use of Financier. This greater capability, as well as further products under test, should mean the company is prepared for tightening regulation on the management of personal credit business.

Bad debt costs increased by £4.0m, which included the non-recurrence of a £2.5m benefit in FY17 from a change in strategy to sell on non-performing receivables at an earlier point, as well as a £0.8m current-year impact of IFRS 9, the International Financial Reporting Standard on financial instruments effective 1 January 2018.

After adjusting for the non-comparable items within marketing and administrative costs, total underlying cost increases were 1%, modest compared with total revenue up 3.4% and even more so against the underlying growth.

There has been no slackening of the very tight conditions affecting schools’ budgets and in that context the measures adopted in FY17 have proved vital to reversing the previous business decline. In summary these are:

Underlying revenue grew by 0.8% y-o-y, although that was obscured by previously announced cancellation of Sainsbury’s ‘Active Kids’ lines, and was achieved despite significant investment in price reductions to incentivise online customers

The UK customer base grew by 5% in the 12 months to September, with online ordering levels increasing from c 20% at September 2017 to over 55% at September 2018.

Gross margin slipped 250bp in H1 to 33.7%, although we expected this will narrow by the end of the year as a result of supply chain renegotiations and further range rationalisation. Operating cost savings were achieved in all categories and totalled £0.9m.

Management believes its plans for the division are on track. Although the trading effects of the initiatives will be more clearly seen as the school year progresses, these results are very promising, showing a 100% improvement in operating profit, of which only c 30% is the result of overhead cost savings.

Central costs reduced from £3.2m in H117 to £0.5m as a result of the non-recurrence of unrealised foreign exchange losses relating to revaluation of Far East operations.

Core net debt, close to its seasonal peak, was £80.9m at end September, down by £9.1m year-on-year, despite the expansion in Express Gifts’ credit receivables.

Findel’s revolving bank facility and securitisation facility term were both extended during H1 to December 2020. The securitisation facility limit has also been increased by £15m to £185m to support anticipated growth.

The recent High Court decision on Guaranteed Minimum Pension liabilities is likely to mean an additional liability recognised in H219, which management estimates at 2–3% of total scheme liabilities (£104m at March 2018).

Guidance for the full year is unchanged and we make no material change to our forecasts.

The growth in Express Gifts’ customer base, as well as the current double-digit revenue growth supports our 8% product sales target. In addition, with the improvement in its credit information, the company is able to selectively service and incentivise its more sustainable credit customers while reducing the risk of compromising quality. One measure of this is that returns, once around 40%, have progressively fallen to single digits. In terms of margin, management is confident of at least achieving its product gross margin guidance for the year of 125–175bp improvement, helped by US dollar cover rates for its purchases that have improved to close to US$1.25/£1 for early 2019 compared with c US$1.40/£1 in the early months of 2018.

We use a DCF projection to place a value on the longer-term income stream available to investors. We combine this with a peer group comparison of retail companies to take account of market valuations of earnings growth. These metrics identify significant valuation headroom.

DCF valuation of 401p: Quantifying future cash flows

As we make no significant change to our forecast assumptions, our DCF projection does not change. We assume a weighted cost of capital of 6.6% (risk-free rate 3%, risk premium 6%, beta 0.75, cost of debt 3.6% net), resulting in a valuation of 401p/share. We explained our approach in more detail in our June 2018 note Outstanding success with online-led strategy.

Peer comparison valuation of 319p: We reflect sector de-rating

While the recent problems of the retail sector quite largely reflect a residual over-dependence on bricks and mortar, which Findel does not participate in, and while we do not change our forecasts for Findel, we have to reflect the resulting de-rating in terms of a sector comparison.

In this metric we take the common-sense position that higher earnings growth merits a higher P/E ratio than the FY19e 8x on which the shares trade. We compare P/E with two-year compound earnings growth forecasts (CAGR). Based on the chart below, we would expect Findel’s 7% two-year compound EPS growth to command a year 1 P/E of 12x.

We adjust for the sector yield (weighted between the FTSE General Retail and AIM Supersector retail indices) of 3.95%. This produces a P/E of 11.5x and a comparative share valuation of 319p:

As a result our valuation is a blend of DCF 401p and peer comparison 319p, an average of 360p (previously 428p). This is still, however, a 62% premium to the current share price.