Is investing in a furniture retailer ahead of a recession a bad idea?
While stocks have climbed the proverbial wall of worry, most investors are anticipating a recession either later this year or in the first half of 2024. Such is the extent of recessionary expectations, derivative investors are predicting at least three rate cuts from the U.S. Federal Reserve or just over 100 basis points of cuts to the Fed Funds rate.
Ahead of such an environment, and while interest rates remain high and consumers tighten their belts, it might seem crazy to be thinking about investing in a furniture retailer like Nick Scali (ASX:NCK).
Before presenting the bullish case for NCK, it’s worth remembering consumers face not only inflation in the cost of essential services, a diminution of savings built during the pandemic and from locking in ultra-low fixed-rate mortgages, and the end of government-funded financial support.
With the COVID pandemic over, investment bank Barrenjoey has drawn similarities between the current withdrawal of government fiscal support for consumers and that in 2011, following the Global Financial Crisis. The difference, however, is the magnitude of the support more recently is larger and is being withdrawn more rapidly. By way of example, in the third quarter of calendar 2022, the Low-and-Middle-Income earner offset (LITMO) boosted household disposable income by approximately $11 billion after tax returns were lodged and refunds received. This cash injection of up to $1,500 per taxpayer has been terminated and will not support spending in the second half of 2023.
Will the end of government support impact retailers?
The potential impact on retailers’ share prices cannot be overstated. During 2011 Nick Scali’s share price fell 14 per cent. Limiting the period over which to measure the sell-off during that time, however, masks the more significant impact to investors in Nick Scali from the decline in consumer spending. Nick Scali’s share price actually peaked in October 2010 at $2.00 and fell 35 per cent to $1.29 in early 2012. The sell-off was a combination of a decline in earnings per share (EPS) and a de-rating of the price to earnings (P/E) ratio.
And it’s worth remembering that if EPS halves and the P/E ratio also halves, the share price declines 75 per cent.
A closer look at Nick Scali
Despite this a market is made of buyers and sellers. The buyers of Nick Scali shares point to the fact it offers a six per cent dividend yield and is trading on a FY24 P/E of less than 11 times EPS, which reflects negative growth of 40 per cent in FY23. Importantly, the current FY24 P/E (1yr forward) is at its lowest level since June 2009. Only during the depths of the GFC, in December 2008, did NCK’s P/E fall towards five times earnings, and nobody is expecting a financial crisis this time around.
Meanwhile, the bulls note industry feedback suggesting the refurbishment of 40 of the Plush-branded stores in the next twelve months is better than expected. They note being vertically integrated helps preserve margins, while the company’s build-to-order (just in time) business model reduces the level of inventory required compared to competitors. It’s worth mentioning here the Scali family invented the build-to-order-and-wait-12-weeks-for-your-sofa in Australia.
More than five per cent of the company’s sales are sourced online, are high margin and growing. Meanwhile, as a measure of quality, NCK enjoys a return on equity (ROE) of more than 35 per cent, suggesting the company is capital-light, which also should help it take share during any downturn.
Meanwhile, 15 per cent of the company’s market cap is backed by property, and the balance sheet has limited debt giving it a debt-to-equity ratio of 54 per cent and a debt-to-asset (equity + debt) ratio of 15 per cent. It’s worth pointing out, however, NCK, like Adairs and Harvey Norman, is not in a net cash position.
The risk of deflation on retail product
Sentiment will always drive share prices in the short term, and investors might consider whether sentiment is bearish enough yet to be taken advantage of. The risk of deflation on retail products is occupying the minds of some analysts. During economic slowdowns, retailers must spend significantly on promotional activity and discounting products to maintain market shares and throughput. Consequently, retailers like NCK have been snubbed by investors rendering the stock ‘under-owned’, meaning investors are underweight.
Meanwhile, some retailers face wage inflation, escalations to rent, as well as material annual increases in the cost of electricity, insurance and domestic freight. The impact of these hikes on a retailer’s cost base may not have been factored into analysts’ estimates of the cost of doing business (CODB). Typically, consensus estimates are produced by multiplying estimated sales by a forecast EBIT margin. But failing to accurately factor in rapid inflation for some inputs results in analysts underestimating the CODB. The consequence is a negative earnings surprise and a harsh share price reaction.
Over the long run, a well-managed (cost-outs?) quality company, one that leads its peers and progresses along its growth runway, will reward investors. Of course, the returns will be inversely related to the price paid. Investors, therefore, should now be calculating a conservative estimate for intrinsic value and assessing whether the share price represents value or waiting until it does.
Assuming a long-term return on equity (ROE) of 30 per cent, a payout ratio of 70 per cent, a required return of nine per cent, a constant 81 million shares on issue and FY24 beginning equity of $207 million, we estimate Nick Scali’s intrinsic value at $9.29. Changing any of the inputs however will increase or decrease this estimate.