Studio Retail Group — Revenue aspiration with a wow factor

SRG represents a focused play on the online value retail market, which is expected to continue taking share from physical retail, following the recent disposal of its Education division. The group’s overall growth profile has been diluted historically by the lower growth rates and profitability of divisions subsequently sold as part of the multi-year transition. Therefore, SRG should demonstrate higher medium-term growth rates than previously. Management is now committed to accelerating the already-strong growth rate of Studio through more of what has come before: growing the number of customers and taking share of wallet by increasing the number of available products and improving the structure of the product range. Key to this will be enhanced digital marketing capabilities and ongoing investment in infrastructure to make the business more agile.

At the capital markets day (CMD) presentation in June 2021, management presented its aspiration to generate revenue of £1bn, with no margin guidance, within four to six years. From the FY21 base of £579m, it implies a revenue CAGR of 10–15%, which compares with SRG’s long-term historical revenue growth rate (since FY12) of c 11% (customers +8%, spend per customer +3%). Following a very strong performance in FY21 (revenue growth +33%), management points to lower FY22 adjusted PBT of £35–40m (FY21: £48.8m), implying an acceleration in growth from FY23 as SRG’s levers to growth gain traction. Having been restricted on publishing forecasts due to Takeover Panel rules, we introduce forecasts for FY22 and FY23. Our FY22 adjusted PBT forecast (SRG’s definition £35.4m) is at the low end of management’s revised guidance (£35–40m). In FY23 we forecast c 6% revenue growth (£582m) and 23% adjusted PBT growth (£43.6m). As revenue grows, medium-term profitability should improve given gross margin improvements (greater contribution from Financial Services) and leveraging opex. This will help SRG to continue strengthening its financial position. We forecast a core net cash position, excluding IFRS 16 liabilities, in FY22.

A DCF-based valuation, which assumes management achieves its revenue target by FY27 (ie within six years), with an EBITDA margin of 16% (12.8% in FY21), a WACC of 8.8% and a terminal growth rate of 2%, indicates a valuation of 420p/share. SRG’s FY22 EV/sales multiple of 0.3x and P/E multiple of 5.0x are below their long-term averages since FY12 of 0.55x and 9.4x, respectively. Its multiples also compare very favourably to its online and offline peers, despite higher/in line profit margins, albeit the wide range of margins for the peers reflects the different maturities of those companies and their revenue growth profiles. We believe SRG’s more focused portfolio, improved medium-term growth outlook versus historically and attractive margins justify a higher multiple.

The mains sensitivities we see are:

Studio Retail Group (SRG, formerly Findel) is now focused on one business following the recent (April 2021) disposal of its Education business (see our flash note published on 20 April). Studio is a home shopping retailer, which is predominantly transacted online (over 90% of revenue in FY21) with a broad and increasing product range and integrated credit offer.

Nine years ago, SRG was an over indebted, diversified group with five main operating businesses in two core sectors: retailing and education supplies, plus an overseas sourcing subsidiary. Retail included Studio and three businesses that were subsequently disposed: Healthcare (outsourced healthcare equipment services), Kleeneze (a marketing company that supplied household and health and beauty products through a network of independent distributors) and Kitbag (a retailer of sports leisurewear and official football kits). They were sold in April 2013, March 2015 and February 2016 respectively as management’s strategy evolved to focus on the higher-growth core home shopping business.

In Exhibits 1 and 2 we show how SRG’s revenue and profit profiles have changed since FY12. Exhibit 1 includes revenue for continuing operations, ie as disclosed by SRG, and total revenue, ie including the results from all divisions including discontinued activities until their ownership ended.

SRG’s total revenue (including revenue from the smaller and lower-growth discontinued activities through ownership) has grown from £538m in FY12 to £650m in FY21, a CAGR of 2%. Revenue from continuing operations grew at a slightly higher CAGR of 3% over the same timeframe from c £461m to £579m. The underlying strength of the core Studio, whose revenue CAGR was c 11%, increasing from £232m in FY12 to £579m in FY21, is masked as its growth rate was diluted by the lower growth rates and subsequent disposals of the other businesses. Therefore, SRG’s growth outlook as a focused business should be better than reported previously. As highlighted later, Studio was a notable beneficiary of the COVID-19 related lockdowns and restrictions in FY21, but even when FY21 is excluded, the revenue CAGR was a still impressive c 8% to FY20.

As for revenue, the long-term improvement in Studio’s operating profit (from £19m in FY12 to £62m in FY21, a CAGR of 14%) was also diluted by the reshaping of the group, a CAGR for total operating profit of 12%, from c £21m in FY12 to c £58m in FY21. Divisional disclosure was changed in FY17 to reflect the fact that overseas sourcing became almost exclusively focused on procurement for the group rather than on behalf of third parties, and has since been included within Studio.

Note that SRG’s year end is normally the last Friday of March, therefore accounting periods are typically 52 weeks in length. However, occasionally the accounting period is for 53 weeks, as was the case in FY17, which slightly distorts comparisons of year-on-year growth rates in that year and the following year. On a 52-week basis, revenue growth in FY17 for continuing activities was 10.2% versus the 11.3% reported for the 53-week period. Similarly, in FY18 revenue growth based on the 52 weeks of FY17 was 5.9% versus the reported 4.8%.

Studio, previously known as Express Gifts, was formed in 1962 as a catalogue-based mail order retailer with a key product offering of paper products and gifts with a main focus on Christmas. Studio has evolved from its origins in catalogue-based mail order with a limited and highly seasonal product offer. Over time the product ranges moved away from the core offer in order to grow the business by increasing the number of customer visits and spend per customer while reducing seasonality. In parallel, the focus of the company moved towards increased online distribution. Studio is supported by an FCA-approved credit business, which is an important part of the offer to customers. which helps with the economics of value retail, while offering more potential touchpoints with the customer, and enhancing customer loyalty.

There are two main brands. Studio (www.studio.co.uk) is the largest (well over 90%) of Product sales in FY21, and has a wide-ranging offer including clothing, home, garden, electricals, toys, gifts and jewellery, health and beauty, and sports and leisure. The clothing offer includes Studio’s own range of branded clothing, which is very competitively priced versus the high street, as well as discounted clothing footwear from brands such as Adidas, Diesel, DKNY, Nike, Superdry and Timberland among many others. Many of the products can be personalised at no extra charge in the company’s in-house facilities. The smaller second brand, Ace, is a legacy but identical brand with an identical product offer albeit with a slightly older demographic and the company does not recruit new customers to the brand. Importantly, it does not have an app, an important contributor to new customer recruitment and retention for Studio. At some stage it would be reasonable to expect the Ace customers to be ‘ported’ across to the main Studio brand.

Studio’s main infrastructure is a warehouse in Accrington, c 20 miles north of Manchester, which consolidated the prior operations from seven different warehouses. It predominantly handles the fast-selling items that require packing, as well as performing the personalisation of products. A second warehouse in Chadderton, c 7 miles north-east of Manchester, mainly handles the despatch of larger items and some clothing, and a further warehouse manages returns, and handles overflow and slower moving products.

Studio has delivered impressive long-term growth in revenue and profitability with CAGRs for FY12–21 in revenue of c 11%, gross profit of c 8% and operating profit of c 14%. The main driver of growth has been Product, c 77% of FY21 revenue, and to a lesser extent Financial Services (see below). Product’s revenue CAGR of c 12% has been driven by growth in the number of customers (CAGR of c 9%) and average spend per customer (c 3%). The number of customers has increased year-on-year in all years apart from FY16 due to capacity and promotion issues, and FY20 due to a challenging retail market. Similarly, average spend per customer has increased in all years except FY17 due to higher promotions and FY18 due to 53rd week.

Important influences on Product’s gross margin have been the depreciation of sterling following the Brexit referendum, gains to gross profit from improved sourcing and high street competition. FY21’s strong gross margin improvement was due to its impressive sales performance and a relative lack of promotional discounting on the high street.

Below we highlight the positive tailwind enjoyed by the company from the increasing proportion of retail conducted online, and the boost provided by the COVID-19 pandemic from March 2020.

Exhibit 4 shows the monthly progression of internet sales as a proportion of total retail sales. It clearly demonstrates the long-term increase in the online proportion of retail sales and the short-term boost as a result of the COVID-19 pandemic. In October 2021, online retail sales represented 26.3% of the total, a significant increase from July 2019’s 18.7%, but well below the peak of 37.6% in January 2021, during a national lockdown. While the near-term online proportion of sales is likely to normalise as physical retailers resume trading post lockdowns, management believes the long-term trend of increasing online sales has accelerated and continues to represent a favourable tailwind for Studio.

Management’s stated aim at the time of its strategy update in 2017 was to make Studio a leading online value retailer, continuing the transition from a traditional catalogue business to a digitally driven online value retailer. Studio continues to make good progress as its results show: online orders had increased from 63% of the total in FY17 to over 90% in FY21.

Management has traditionally seen Studio as a disruptor at the value end of the retail market and has long held the aspiration to reach revenue of £1bn. With the FY21 results and capital markets day, a timeline for this aspiration was set at within four to six years from the end of FY21, implying a revenue CAGR from FY21’s £579m of 10–15%. These compare with Studio’s long-term revenue growth from FY12–21 of 11%, or c 8% from FY12–20 excluding the significant positive benefits of the pandemic. It therefore requires an acceleration in the annual growth profile from pre-COVID-19 levels, especially so from FY23 given management’s initial guidance for limited revenue growth in FY22, made at the time of FY21 results, and subsequent reduced profit expectations on the publication of H122 results.

The three key levers of the strategy, which will gradually begin to drive growth over the next few years, are as follows:

Note there is no indication of the relative contributions to the revenue target from Product (c 77% of Studio’s revenue in FY21) or Financial Services, or the expected group profitability on achieving £1bn of revenue. The guidance for an increasing proportion of customers to use credit (see below), and a higher gross margin for Financial Services (65.7% in FY21) versus Product (35.9%), suggests a greater revenue and profit contribution from Financial Services, and therefore a high group gross margin, in the medium term.

Management indicated the £1bn revenue target will require 3.5 million active Product customers, a CAGR of 6–9% from FY21’s c 2.5 million active customer base over four to six years. It also expects credit customers will represent c 72% of the customer mix (ie c 2.5 million of the 3.5 million Product customers) versus FY21’s 1.53m, a CAGR of 9–13% over the four to six years. Following the decline in customer numbers reported in H122 and subsequent lower expectations for FY22, growth in outer years will have to increase versus the initial expectations.

The implied average customer spend in the £1bn revenue target across the whole of Studio (Product and Financial Services) is £286 pa. An average credit customer currently spends c £1,000 with Studio over five years versus the average cash customer spend of £300. The implied average spend of £286 in the £1bn target compares with FY21’s £234 (£578.6m revenue from 2.48m customers), and would represent a four- to six-year CAGR of 3–5%.

The new strategy is a progression from the previous CEO’s strategy (introduced in 2017), which had three key pillars: improving retail profitability by growing the customer base, developing the range and focusing on costs; maximising the financial services opportunity; and building strong foundations by investing in technology and business infrastructure to support the growth. The strategy had the same medium-term revenue target of £1bn, albeit with no stated timescale, and was expected to be achieved by growing the active customer base to three million from about two million at the time. Therefore, the revenue target under the new strategy requires more active customers (3.5 million) than the old strategy (3 million), as cash customers are typically less loyal than credit customers.

Studio’s target customer base is lower income families who want flexible payment options. Experian profile analysis has shown approximately half of customers are from households with an annual income below £30k. The customer is predominantly female (over 80% of the 2.5 million active Product customers), with the core age range being 25–55 years’ old and therefore of family age. Over five years, in response to previous activities to develop the brand, there has been more significant growth in customers in the 35–45 years age range, such that Studio’s average customer age has reduced to 45 years from 52.

The target demographic is estimated to be 11 million adults in 5.9 million households, suggesting the FY21 active customer base (2.5 million Product and 1.5 million Financial Services) has plenty of opportunity to grow. Key to growing the customer base are improving Studio’s brand awareness and the use of data analytics to target new customers and drive marketing efficiency:

Management believes increasing the spend per credit customer (gaining share of wallet) will be the most significant contributor to achieving its revenue target.

As already indicated, Studio’s Product revenue grew at a CAGR of 12% between FY12 and FY21, within which spend per customer increased at a CAGR of 3% as the product offer evolved and with better promotion of that offer. In addition, management estimates Studio’s share of its customers’ non-food wallet has grown from 12%. Therefore, it has credibility with its ambitions to increase spend per customer.

Over the long term, management has been successful at developing and expanding new categories. For example, clothing and footwear revenue has increased from c £30m in FY11 to £110m in FY21, but still represents c 25% of Product revenue. In FY20, clothing and footwear represented c 29% of Product revenue. Its share of the total declined (but still grew by c 23% in absolute terms) due to stronger demand from other categories from natural demand changes during COVID-19 lockdowns and restrictions (ie less need for new clothing at the expense of household items).

In order to grow spend per customer, a combination of increasing purchase frequency and average order values is required, with three key building blocks:

The third lever to management’s strategy is to broaden the appeal to customers who are seeking great value and flexible payment options.

Management views the credit proposition as an important means of enhancing customer loyalty and maximising their lifetime value by having more frequent touch points (eg statement receipt, prompting customers to regularly visit the site and app to manage their accounts), and providing the data to underpin Studio’s customer relationship management. In addition, it represents an important source of income, which helps to improve Studio’s economics on products with low price points relative to its competitors.

At the end of FY21, 1.53 million customers (c 62% of Product’s active customers) had a credit account that allows them to pay off their balance within 28 days of receiving their statement or spread the payments over a longer period. The option of paying with a debit/credit card (ie cash customer) at the point of sale was introduced in FY20.

Maximising the opportunity and profitability of financial services has been a consistent core feature of the strategies of the current CEO and prior CEO. The aim has been to make the credit option more appealing to customers by having more appropriate credit limits while improving the operational efficiency of the business. Through a process of continual investment, Studio has completed the transformation of all core systems (via partnerships with leading third parties) and upgraded its datasets (partners include Experian and TransUnion) and analytical tools, including the use of artificial intelligence. The aim of the investment and transformation has been to further improve Studio’s responsible lending credentials while streamlining and personalising the credit decision making process (now processed in real time with decisions typically returned in less than five seconds), and providing the ability to tailor the most appropriate and attractive credit options to its customers.

Core to the growth strategy is increasing the number of customers with a credit account as well as increasing the ‘quality’ (ie creditworthiness) of its customers (ie more customers with higher credit limits and an implied lower average interest rate than at present). Management believes it now has the infrastructure and capabilities to grow the total customer base in time by c 600k pa versus the recent gains of 100k pa. With a current concentration of customers in the near-prime (annual percentage rate, APR, 24.9–44.9%) and sub-prime (APR 44.9–99%) categories, management expects the customer profile will gradually shift to more (absolute and proportionate) near-prime and prime (APR 9.9–24.9%) customers. Studio’s relatively high dependence on near-prime customers is reflected in its market share of retail finance customers of 8.4%, but just c 2% of retail lending value.

In Exhibit 6 we show the strong growth profile of Financial Services as well as some key indicators of how the quality of the business has improved, as management sought to improve its responsible lending credentials.

In FY21 Financial Services revenue of c £133m represented c 23% of Studio’s revenue, and its gross profit of £87.5m (gross margin c 66%) was c 35% of the total. Its revenue CAGR of 6% has lagged the 12% growth from Product sales, due in part to a lower proportion of customers taking credit, and lower fees being charged.

Credit account interest’s CAGR of c 11 % is due to growing customer numbers, APR changes (down in more recent years) and a decline in the average credit period (from 300+ days to 203 days in FY21). Other revenue (late-payment fees and penalties) has declined by an average of c 6% over the same period, highlighting Studio’s success in better identifying the creditworthiness of customers and more proactively managing the account balances. Despite the strong growth in the number of customers, the allowance for expected credit loss as a percentage of gross receivables at year-end has reduced from low-mid 30s in the earlier years to the high 20s in recent years, and the number of accounts on repayment plans at year-end has reduced from 27–40k during FY12–17 to 12–17k from FY19–21.

Comparing the profitability of Financial Services across time is complicated by changes in accounting standards. More notably, the adoption of IFRS 9 in FY19, which required earlier recognition of potential default and therefore a potentially higher bad debt charge than previously.

The FY21 impairment charge of £45.7m (to give a gross profit of £87.5m) was lower than FY20’s charge of £53.9m, which included an incremental £20m provision to allow for potential bad debt losses that may arise due to the deterioration in the macroeconomic outlook caused by COVID-19. The FY21 provision reflected management’s view that some customers had benefited from temporary financial support provided by the government to protect jobs and therefore the charge remains higher than might otherwise have been the case.

In February 2021, the Financial Conduct Authority published the Woolard Review, a report by its former interim chief executive, with recommendations on how regulation could improve the market for unsecured lending given the changing business models and potential effects of the COVID-19 pandemic. There were 26 recommendations including a more prescriptive approach to affordability assessment and levelling the playing field for different financial products (ie bringing new credit products that are currently unregulated, eg buy-now-pay-later (BNPL) products such as Klarna, within the regulatory framework as a matter of urgency). The report stipulates customers should have access to credit and credit lenders should lend responsibly so that customers can afford their credit. The FCA has agreed the recommendations should be brought into law and in October 2021, HM Treasury published its consultation on the options for how widely to regulate the new BNPL products.

As we have shown above, SRG has invested heavily in improving outcomes for its financial service customers and enhancing its systems, leading to an improvement in the KPIs and financials of SRG’s Financial Services. Management believes the SRG customer base has a typically older age profile than those of companies like Klarna.

Ian Burke, non-executive chairman, joined the board in January 2017. He is also currently the chairman of Pets at Home Group and a member of the board of governors of Birmingham City University. Ian spent the majority of his career in the leisure industry, having been CEO and chairman of Rank Group, and CEO of Holmes Place Health Clubs and Thistle Hotels. He commenced his career at Lever Bros.

Paul Kendrick, CEO, joined in May 2016 as commercial and deputy manager of Studio Retail before being promoted to managing director in April 2017, and appointed to the board in December 2019. Prior to joining Studio, Paul was marketing and ecommerce director at Bonmarche, and held various roles at N Brown Group. Much of his early career was spent within the travel industry at both Thomson (now Tui) Travel and The Co-operative Group. He succeeded Phil Maudsley as CEO in March 2021.

Stuart Caldwell, CFO, joined the group finance team in October 2010 and held the post of acting CFO from April 2017 before his appointment to the board in July 2017. He is a qualified chartered accountant and a fellow of the Association of Corporate Treasurers. After qualifying as an accountant, he held a number of roles at Provident Financial before moving to Studio Retail Group.

We believe the main sensitivities are:

We introduce our forecasts for FY22 and FY23, having been restricted on providing forecasts due to Takeover Panel rules surrounding the Education disposal.

In FY21 SRG enjoyed underlying momentum in the core business, which was boosted by the effects of COVID-19 related lockdowns on its offline competitors. At the FY21 results and CMD, management guided to a year of consolidation in FY22 with an estimated adjusted PBT (ie before exceptionals and mark-to-market on derivatives) of £42–45m. On the publication of H122 results, the guidance for adjusted PBT for the year was reduced to £35–40m, a reduction of c 14% at the middle of the ranges.

The initial FY22 guidance (ie at FY21 results and CMD) included management estimates of flat revenue for Product, broadly flat revenue for Financial Services, and the lower (£40m) bad debt charge for Financial Services. It recognised an expected more competitive operating environment on the re-opening of the high street following initial COVID-19 related lockdowns and restrictions and the tough comparative of FY21.

Against the initial guidance for FY22, trading through Q122 was encouraging but the background became more challenging than initially expected through Q222, while SRG still reported encouraging H122 results. For H122, total revenue grew by c 3% to £239.6m, gross profit by c 7% to £114.5m (gross margin of 47.8% versus H121’s 46.1%), and adjusted PBT by 36% to £23.7m.

With respect to Product sales, management initially expected revenue growth from an enlarged credit customer base offset by lower absolute spend from cash customers who will have more options of where to spend their money post lockdowns. In FY21, cash customers grew by 36% yoy to 944 thousand, while credit customers increased by 14% to 1.532 million. In Q122, SRG reported Product sales in line with Q121, which increased by 51% versus Q120, and for H122 revenue was broadly flat at £170m, in line with expectations for the full-year guidance. However, SRG experienced a decline in the number of active customers to 2.35 million at the end of September 2021, from 2.48 million at the end of March. The lower customer base reflects the recruitment of fewer new customers due to media inflation, ie less ‘bang for the buck’ on advertising (now normalising) and more strict screening of potential new customers, the expected decline in cash customers and lower availability affecting the conversion of customer interest to sales. On the plus side, annual spend per customer increased by c 10% to £189, encouraging confirmation that management’s strategy is working. Management believes SRG has been relatively unaffected by the more widespread product availability issues elsewhere given its early commitment to securing stock. However, there have been selective product shortages, mainly due to the offloading of products on arrival in the UK from overseas. In addition, there is more volatility around individual categories and total, which management believes is due to customers shopping more selectively given wider inflationary pressures and recovery from the pandemic. To conclude, external factors (media inflation and availability issues) have outweighed the positive results (increasing spend per customer) of the strategy. Therefore, as these normalise, growth rates should improve.

For Financial Services, management initially guided to broadly flat revenue in FY22. In Q121, revenue increased by 15% and there was a clear message that growth would moderate through the year as the changes to improve outcomes for customers feed through. In H122, Financial Services revenue grew by c 11% to £69.6m, within which credit account interest grew by c 14% y-o-y to £62.7m and other revenue declined by c 8% to £6.9m. The number of customers with a credit account fell to 1.46 million at the end of September 2021 from 1.53 million at the end of March 2021 for the reasons highlighted above. Despite lower customer numbers, the growth in credit account interest reflects growth in the debtor book through FY21 and the start of H122, helped by emerging product inflation. Lower other revenue suggests a further improvement in the quality of the customer base.

For FY22, we forecast c 1% y-o-y revenue growth for Financial Services revenue and a decline of c 7% for Product, to give total group revenue of £548.9m, a y-o-y decline of c 5%. The key drivers for Product are an assumption that SRG loses 10% of its active customers (2.2 million by year-end) which is partially offset by a c 3% increase in spend per customer. For Financial Services, we assume c 7% fewer credit customers, ie a relative increase in the number of customers in the base that take credit. We forecast c 6% revenue growth for FY23 to £581.9m, slightly above FY21’s continuing revenue of £578.6m. The key assumptions are a return to y-o-y growth in the number of Product customers and spend per customer, and further gains in the percentage of Product customers that take credit. In the medium term, we assume an increasing proportion of credit customers will be positive for interest income, albeit with lower APRs, but the initiatives to improve the quality of the debtor book will lead to lower financial penalties, etc (ie other revenue).

In order to achieve management’s revenue target of £1bn by FY27, SRG would have to deliver a revenue CAGR of 14% post FY23. This is consistent with management’s indications of the timing of increased revenue momentum from the introduction of new product categories, the ability to market more products to more credit customers, and the still-ongoing investment in systems.

For FY22, management initially expected Product’s FY22 gross margin to reduce by 50–75bp from FY21’s 35.9% due to well-publicised inflationary shipping costs and the expectation of more competitive discounting from the high street. In H122, Product gross profit fell by c 3% to £59.3m with a deterioration in the gross margin to 34.9% from H121’s 36.1%. Within the period there was a high level of volatility to the gross margin. It increased by 340bp y-o-y in Q122 due to less discounting of clothing and the benefits of lockdown, but fell by 610bp in Q222 due to a mix change towards lower-margin branded products, more promotions on higher-margin clothing and the early impact of higher freight costs late in the season, which were unable to offset price increases. Following the H122 results, there is no specific guidance for Product’s gross margin in FY22, but management flagged that the supply chain challenges have added extra costs versus initial guidance. We assume a c 300bp y-o-y reduction in the Product gross margin to c 33% in FY22, as higher freights costs will continue to affect the period, before assuming a modest 150bp rebound to 34.4% in FY23 on the expectation that incremental cost pressures ease later in the year and can be passed through to customers without compromising value. Over the longer term, there are a number of potential positive (greater expected proportion of higher-margin clothing and own-branded products, increasing scale and sourcing efficiencies) and negative (branded products in new categories, competitor activity and foreign currency moves) drivers in the direction of Product’s gross margin.

Significantly, the bad debt charge for Financial Services declined by c 32% y-o-y to £11.4m in H122, increasing the Financial Services gross margin to 83.7% (73.3% in H121). Although management has not specifically provided new guidance for FY22 beyond for group adjusted PBT, we believe the H122 performance warrants the assumption of an improved, ie lower, bad debt charge for Financial Services in FY22 than management’s prior guidance of £40m. The key driver to the gross margin is the bad debt charge, so it is dependent on the quality of its debtor book. In the medium term, we assume the bad debt charge increases in line with Product sales, which may be too cautious given that management is seeking to improve the quality of its debtor book.

As previously indicated, a greater contribution from higher-margin Financial Services would be positive for total group gross margin.

Management initially guided to a 10% increase in marketing costs in FY22 due to catch-up from lower relative costs in FY21, and an increase in other operating costs of 2–3%. In the H122 results, marketing costs grew by c 6% and administration costs grew by 6%, but distribution costs declined by c 3%. At the H122 results, management pointed to increased cost pressures from media inflation, staff costs and the supply chain, which will have more of a negative effect through H222, and hence the reduction in FY22 guidance when coupled with the recent trend in customer numbers. With the significant increase in scale expected over the medium term, there are likely to be efficiencies from marketing given the indicated better data analytics and distribution costs, as the company has demonstrated historically, so we would expect some operational leverage relative to sales beyond our explicit forecast period.

Historically, exceptional costs (‘Individually significant items’) have been a persistent feature of the income statement and relatively high versus operating profit as the portfolio of businesses were rationalised, albeit they have been at much lower levels in more recent years. The exceptional items typically consisted of restructuring costs, impairments and redress for historical financial services mis-selling, which has now ended. With a more-focused portfolio and an improved growth outlook, it is reasonable to expect a lower incidence of exceptional costs on an absolute and relative basis. Discontinued activities, further down the income statement, also include exceptional costs relating to those business.

SRG does not intend to pay a dividend in the near term despite the return to positive distributable reserves of £9.9m at the end of FY21 from a deficit of £76.3m at end FY20. The priorities for cash flow are investing in the digital transformation, working with the trustees of the legacy defined benefit scheme to explore ways of removing any potential residual pension scheme liabilities (surplus of £20.8m at end FY21 and expected cash contributions of £14m in FY22, of which £9m is one off and £5m is recurring).

Over the long term, SRG has made good progress in reducing its core net debt, falling from £131.8m in FY12 to £27.6m in FY21. SRG’s trading cash flow generation has improved, more notably since FY17, on an absolute basis and relative to revenue due to the increasing importance of the higher-margin Studio business as the portfolio was rationalised.

Using statutory reported operating cash flow understates SRG’s real free cash flow generation as the change in working capital, primarily investment in customer debtor book, excludes the financing from the securitisation facility, reported in financing activities. Studio’s customer credit is substantially funded by the securitisation facility, currently available to fund £275m of eligible receivables, increased by £25m from £225m in April 2021, and a further £25m approved at the time of the H122 results. For every £100 of credit granted to customers, typically £75 is drawn down from the facility and matched against consumer receivables. The remaining balance (ie increase in trade debtors) is funded by the company from a revolving credit facility with available funding of £50m to December 2024, extended in June 2021. The structure is typical of the home shopping industry. In Exhibit 9 above SRG’s free cash flow post interest is typically negative before the securitisation drawdown is included, but is typically positive when the drawdown is included. Using our estimates above and extending towards management’s long-term revenue target, we estimate that the securitisation facility peaks during FY25, and thereafter the investment in working capital will be wholly funded by SRG in the absence of any further increases in the facility.

At the end of H122, SRG’s cash position was £18.2m versus £37.4m at the end of FY21. Trading cash flow of £25.6m funded the peak investment in working capital ahead of the key trading period, Q3, which typically represents c 40% of total annual sales. The core net debt position was £20.8m versus £27.6m at the end of FY21.

The group is not highly capital intensive, with the net investment in tangible and intangible assets representing c 2–4% of revenue since FY14. For FY22, management has guided to total investment in tangibles and intangibles of £18–20m.

We forecast SRG will move to a ‘core’ net cash position (ie excluding securitisation debt and IFRS 16 liabilities) by the end of FY22.

SRG is relatively capital light from a tangible and intangible perspective. The main feature of its balance sheet is the trade debtor book and associated funding (ie securitisation). We highlighted the long-term relative improvement in receivables and allowance for bad debt in Exhibit 6.

At the end of FY20, SRG had moved to a net positive position on retained earnings, having operated with accumulated losses for the majority of the last decade.

We value SRG using primarily a discounted cash flow (DCF)-based valuation, but also consider its valuation relative to peer groups of predominantly online consumer-facing companies as well as more traditional general retail competitors.

Our DCF-based valuation extends our published forecasts beyond FY23 to FY31, reaching management’s revenue aspiration of £1bn by FY27 and quickly fading revenue growth down to 2% pa thereafter. A stable Product gross margin, increasing contribution from the higher Financial Services gross margin, and leverage of operating costs leads to an estimated EBITDA margin of c 16% in FY27, which we keep stable thereafter. Recognising the partial funding of consumer credit activity, we model the working capital component of free cash flow in our detailed model as the company does, offsetting increases in receivables to the extent they are funded by the securitisation facility. Our forecasts estimate the securitisation facility caps out during FY25, and thereafter the full working capital investment (c 6% of revenue) is funded by SRG’s balance sheet. Consistent with this, we take as current net debt the bank borrowings excluding the securitisation borrowings.

We assume a weighted cost of capital of 8.8% (risk-free rate 3%, risk premium 5%, beta 1.34 (source: Refinitiv), pre-tax cost of debt of 3.3%), giving a valuation of c 420p/share. This would represent an FY23 sales multiple of 0.75x and P/E of 10.6x. Changing the assumptions for the cost of capital and the terminal growth rate would change the DCF valuation as follows:

To test the sensitivity further, if we assume lower revenue growth from FY23, 10% pa, lower than achieved growth rates, this would lead to SRG reaching the £1bn revenue target in FY29, two years later than management’s aspiration. Combined with a quick slowdown in the revenue growth thereafter to 2% pa, and EBITDA margin of 14.5% by FY29, this would lead to a reduced DCF valuation of c 270p per share. Therefore, the current share price is discounting lower revenue growth than the company has historically provided with limited margin growth.

In Exhibits 11 and 12 we show SRG’s prospective EV/sales (current EV) and P/E multiples for FY22 and FY23 versus historical multiples (using historical EV and market values). We exclude IFRS 16 debt, so the EV is comparable across time. SRG’s FY22 EV/sales multiple of 0.30x and P/E multiple of 5.0x are below their long-term averages since FY12 of 0.55x and 9.4x, respectively. We believe these do not reflect SRG’s more focused structure and improved medium-term growth outlook than previously.

Below, we show SRG’s growth, profitability and valuation relative to peers including online consumer-facing companies and more traditional general retail companies with varying degrees of online exposure. Following a very successful FY21 in which SRG’s revenue grew by 33%, which compares favourably with most peers, SRG’s estimated FY1 revenue decline of 5% is lower than for the majority of the online peers. SRG’s forecast EBIT margin of 8.4% for FY1 compares favourably to the majority of the online peers. Its EV/sales multiple for FY1 of 0.3x is significantly below all peers, as is the P/E of 5.0x despite its attractive medium-term revenue growth potential and margin profile.