Plenty left to do
On Monday I wrote a short introduction to Mothercare and the last few weeks of trading for them and tossed up a few ideas surrounding the structure of their business and its valuation. This time, then, I'll take a more detailed look at the figures they've been reporting and the potential - if there's any left - for the next few years. To summarise the last post, Mothercare is currently a business with a very divided set of fortunes - a strong and profitable franchised international division, and a domestic division widely believed to have been left by the wayside somewhat in the past few years, and derailed completely by the recession and the drop-off in consumer spending it brought with it.
Unfortunately, with the domestic division accounting for around 75% of revenues, it's that story that the graph tells; falling margins reflected by the still growing revenue and significant drop off in operating profit. The news doesn't get any better going forward, either; analysts predict a result this year much worse than last with profits nearly halving as the continued consumer woes in the UK take their toll. As much as the last 10 years have been a transformative period for the group, then, their tribulations don't seem to have ended - and luckily for investors, that's a fact that management seem to have recognised. While in the last post I highlighted the restrictive effect operating leases have on the flexibility of the business and how it could adapt, Mothercare seem to have had their eye on the ball in the last few years with regard to this; their portfolio is rather fortunately weighted towards short-term expiries, giving them a real opportunity to rationalise their UK store network.
That's the train of thought I'll be looking at in this post, as I believe it presents the greatest opportunity for real value - a Mothercare which, going forward, exploits its strong brand name around the world and shifts itself away from a high street marketplace which is increasingly competing against internet operations, and all the advantages they have. That, I think, is a key point; Mothercare (and indeed many western brands) are fortunate in having hundreds of millions of emerging middle classes around the world who evidently attach some value to their developed world roots; there seems to be some element of aspirational spending from which many western brands benefit.
The graph below left, then, shows the revenue split between international and domestic over the last 6 years; note the incredibly sluggish growth in domestic revenue, with only the acquisition of Early Learning Centre providing any real push to the figures. International revenues, on the other hand, have grown at a CAGR of 25%, with underlying profits growing with scale at an even more impressive 39% CAGR. It doesn't stop there, though; in Mothercare's 2011 annual report, management states a desire to "grow... International sales by 15-20 per cent per annum, opening at least 150 new stores each year". It appears there's plenty more room for the wheels to keep on turning on this front, with their franchise model making the business easily scalable; certainly a plus given the current situation.
What are normally considered the 'highest growth' regions also seem to be underrepresented in Mothercare's store coverage; their heavy investment in mainland Europe (389 stores) was probably a safer move historically, but leaves the larger Asia-Pacific region (242 stores) looking to an outsider as if there's significant room for expansion. All things considered, I like the international potential of the business and the direction they're going with it; though I am slightly concerned about the company's intention to diverge slightly from the franchise model and open some joint ventures, if the business is as profitable around the world as it appears, it should simply result in Mothercare taking an even bigger slice of the pie. It's that franchise model which also gives me another slight pause for concern, as it makes it far more difficult to see the actual results of the businesses selling the products. Are they struggling? Are they incredibly profitable? Which one of these is the case can make the business look like a huge growth story or a house of cards waiting to collapse. As is, all I have to go on is the constantly growing revenues and profits. While it's a little more uncertain, it does suggest that the businesses on the ground are doing just fine.
That's the nice bit out of the way, then, but I'd be a fool if I didn't consider exactly what Mothercare plan to do with their UK retail estate. Firstly then, and somewhat counterintuitively, it's definitely upscaling store-wise. The company plans to shift its positioning from smaller high street stores to big out-of-town 'hubs'; offering more for parents in one place. I'm not particularly swung either direction on this; while I'm not sure if it's the best thing to do, I would agree it's better than doing nothing and keeping their unprofitable and expensive to maintain high street stores. Fortunately, the aforementioned structure of their lease agreements makes this easier than it otherwise might be - they state that 90 leases expire this year, with 30 next; that's compared to a total number of 373 currently.
They envisage, by March 2013, a total estate of 266, with 102 being these larger out-of-town 'Parenting Centres', and the rest comprising of their (presumably more profitable) standard in-town variety. The company also states it expects occupancy costs to drop by around £18m due to this restructuring; a number which is difficult to really analyse, but sounds reasonable - I can, for instance, compare it to the total net rent of properties - £68.2m last year. Perhaps the biggest takeaway from the cost breakdown is that the structure of business costs mean that the opportunity to close stores is really a boon, not for the direct impact, but because it gives an opportunity to sharply improve margins and reduce cashflow risks.
Either way, it looks like a step in the right direction to me. In a sense, they've been hit doubly hard but having high street stores in the recession, as the fixing of rents over many years means that they're costs aren't quite as variable as they might be; they are likely still paying 2007 whack on high street stores whose market rents are now lower. Still, all this talk of restructuring and operating leases does mean one thing; for me, Mothercare certainly aren't as risky as market opinion seems to believe. While profit warnings make things look uncertain, I'm not sure there's anything intrinsically unstable underneath it all; it doesn't take long to find an opposite example, of a business currently performing strongly but saddled with debt, long operating leases and cashflow issues. The second type topples far faster, I suspect.
Total future minimum lease payments amount to under £500m, and the group is quite firmly in positive tangible equity - with a tangible book value figure of around £85m, mostly comprised of inventory, trade and other receivables, and property plant and equipment. Long-term debt is completely nonexistent, with the company financed solely by trade and payables - something which saves them on the interest payments, though probably annoys their suppliers somewhat! Cash flow is, as with any business in a transitory period, difficult to untangle. Depreciation brings the operating cash flow figure up significantly, but the business has also continuously invested in property, plant and equipment; meaning little net short term gain from the timing differences arising there.
My gut feeling, in the end, is one of annoyed uncertainty; not from a business point of view, but a management one. The management shakeup the market was so fond of pushed up the price and saw a transformational leader disappear. I'm not entirely sure what he had done wrong; it seems to me he took what he was given and ran with it. The international growth, in particular, was clearly a good move. Market opinion seemed to believe his 'time was up' as he left the UK to drift - but in reality, I'm unsure the UK operations are really where the money is. The risk now, for me, is that the next chief executive plays to the market and throws good money after bad trying to revive the UK business. In this sense, I'm now well out of my comfort zone. With such a short history of stock picking and analysis to go on, and no specific focus on retail, I couldn't even begin to take a guess at where the next Chief Executive will take the business; as with my view on takeovers, I hate buying businesses with an obvious near-term catalyst I'm unable to form a reasonable opinion on. As usual, then, straight on my watchlist!
Finally, a note on the DCF table at the top I spent so much time wrangling with. The management uncertainty, as I say, makes it particularly difficult for me to put my thoughts into numbers, but I tried to come up with 3 reasonable scenarios:
Worst sees a depressed next 3 years, with FCF low as the UK business remains difficult and management reinvests cash earned on the international side in the domestic front. Thereafter, it assumes a 4% growth rate as the international boom story slows down.
Base sees cash flow low this year, though picking up next and the year after. All figures are below 2009 levels, though, as management continues to invest in realigning the domestic business. Thereafter, it assumes a 5% growth rate on a relatively low cash base; my proxy for a much smaller UK operation which never returns to its pre-crisis profitability.
Best sees cash flow low this year, with international growth driving it back up in year 2 and 3. Cash flow rises above pre-crisis levels in 3 years time as the international growth and franchised model requires less investment than the old, more UK driven concept.
As ever, I'm including them merely for your interest. I use them myself to compare the spread between 'best' and 'worst', and to compare my own evaluations of different investments; the worst case is, as always, a complete and total business failure - but that doesn't really tell us anything.