Findel — Update 21 June 2016

The process of simplifying and refocusing the group is almost complete. Following the sales of Kleeneze and Kitbag during the past two years, Findel now comprises only two businesses: the home shopping retailer Express Gifts and education supplies business Findel Education. The former is, by far, the largest business in the group, accounting for >92% of operating profit. It is predominantly and increasingly an online business as it moves from its catalogue heritage, while benefiting from the physical infrastructure that its home shopping history provides. The Education business faces a challenging market, but also has work to do to make up ground it has lost to rivals in the years leading up to FY16.

We have reduced our sum-of-the-parts valuation, partly in response to lower earnings estimates for FY17 and FY18, but also to acknowledge that valuation benchmarks have reduced. Our new valuation of 238p (previously 300p) remains far in excess of the prevailing share price. Based on today’s price and our new FY17 estimates, Findel trades on a P/E of 5.8x, PEG ratio of 0.45x and price-to-book ratio of 1.3x.

We have reduced our estimates for FY17 and FY18, mainly to reflect the difficult conditions in the educational supplies market. Exhibit 1 summarises the changes. Despite the reductions, we still expect Findel to post c 9% normalised PBT growth in FY17 followed by c 20% in FY18.

Although we expect total net debt to increase modestly in each of the next two years, this reflects expansion of the consumer credit book within Express Gifts. We expect core net debt to reduce further.

In the very short term the major risk to our estimates is a sharp reaction by UK consumer spending to the EU referendum result. Express is, by far, Findel’s largest business and the one with the better short-term prospects. It has protected itself against a severe impact on either currency or interest rates in the near term, but remains sensitive to significant swings in consumer spending. Any financial services business is always vulnerable to greater regulatory intervention and tighter limits on operating freedom, albeit we are not aware of any specific proposals of this nature. The shares could also be vulnerable to the activities of 29.8% shareholder, Sports Direct, although there has been no visible activity other than CFD purchases since the failed attempt to appoint a board director last December. The risk of dilution from the 8.34m convertible shares appears to have diminished with the fall in the share price. We believe the structure of the group is such that the planned change of executive chairman should not prove destabilising.

As foreshadowed in Findel’s pre-close statement, FY16 normalised PBT of £24.8m was very close to our estimate of £25.0m and broadly in line with consensus. The group booked a series of exceptional charges, which we will discuss in due course. Management further strengthened the balance sheet: the small reduction in core net debt would have been greater but for the timing of working capital investments in Kitbag before its disposal. That disposal of Kitbag in February 2016 generated cash, eliminated a source of trading losses and allows management to focus on only two businesses. The encouraging outlook statement accompanying the results suggests that the actions taken in both businesses to prepare them for challenging conditions in FY17 are bearing fruit.

Express Gifts is a credit-based home shopping business offering its customers – online and via catalogue – a broad range of home and leisure items, clothing, toys and gifts. It has c 1.4 million active home shopping customers, predominantly women aged 30 years of age or more, whom it targets through the annual production and distribution of over 150 publications ranging from six to over 1,000 pages made available in both paper and electronic versions, together with press inserts, media advertising and television, to support the recruitment of new customers. Express is, by far, the largest business in the group. It accounted for 76% of revenues and 92% of EBIT in FY16. By its own admission, Express had a mixed year. Product sales increased by only 2.3%. Express believes that this was the result of self-inflicted supply constraints rather than weakness in demand.

A cautious approach to buying, particularly for newer ranges, led to stock shortages in the run-up to Christmas. This followed an autumn trading period that had been affected by four times as many tests of catalogue promotions as in the comparable period. Express has been investigating ways to utilise its expanded clothing offer to recruit customers throughout the year. In addition, in an effort to ensure the affordability of its credit offer to customers, Express tightened credit controls, which had the effect of reducing some customers’ spending potential which, in turn, adversely affected product sales.

Moves to address these issues paid off as early as Q416. The improvement in trading performance has continued into Q117. Clearly, Express has accumulated more trading history for its newer ranges, which can inform future buying decisions. The tests on customer recruitment yielded valuable insights, as evidenced by the 36k new customers recruited already in FY17, en route to a target of 100k recruits across the full year. Express has refined its credit controls and will continue to do so as it continues to upgrade its financial services capability. These measures have led to strong year-on-year product sales growth so far in FY17. We expect a further positive update at the time of the AGM at the end of July.

The over-tightening of credit controls was not all bad news: Express achieved a further reduction in bad debt levels to only 5.2% (FY15: 8.1%) of revenue in FY16. We would regard a bad-debt level of 6-8% sales as more ‘normal’, better balancing sales revenue and loss control. Default fees were lower and interest income was higher. Overall, financial services revenue increased by 7.6% to £88.1m. Express reached an important landmark when it submitted its application to the FCA for full authorisation of its consumer credit business in October 2015.

Express’s gross margin slipped from 51.6% in FY15 to 51.0% in FY16. The proportion of goods imported from the Far East via the group’s in-house sourcing office (FASL) increased. However, sourcing gains were offset by sterling weakness, which reduced operating profits by c £2m. Despite continued investment in infrastructure and systems, normalised operating profit declined by only £1.8m from £33.5m in FY15 to £31.7m. FASL recorded a loss of £284k.

The Educational business is one of the largest suppliers of school and early years resources (excluding IT, utilities and publishing) to primary, secondary and nursery educational establishments in the UK, with c 7% market share (Source: BESA 2012) of the UK’s educational supplies market. The division’s international unit exports to English-speaking schools in over 120 countries.

Findel Education offers three distinct brand propositions: School, Classroom and Specialist. The main route to market is via printed catalogues and web-based solutions, including multiple websites and e-procurement solutions. The School brands (GLS, A-Z and WNW), accounting for over half of the division’s revenues, focus primarily on servicing the basic commodity needs of educational establishments with products such as stationery, janitorial supplies, furniture and arts & crafts materials. The Classroom brands (Hope Education) supply specialist curriculum and early years teaching aids to primary schools and nurseries. The Specialist brands (Davies Sports, Philip Harris Scientific, and Learning Development Aids – focused on special needs) specialise in their respective fields and sell to both primary and secondary schools. The Commercial business unit focuses on multiple academy groups – a growing opportunity – LEA tenders, trade customers and key account customers.

Education endured a tough FY16 and difficult market conditions seem likely to persist for the foreseeable future. Although per-pupil spending is being maintained, a greater proportion of this is being diverted into areas such as payroll, leaving educators with less to spend on products such as those provided by Findel Education. While this background is unhelpful, the division has been the author of its own decline, having lost customers and market share in recent years. That led to a change of senior management within the division last year and new plans to arrest its decline.

FY16 revenues declined by £8.4m, or 8.1%, to £94.4m. Despite a 1.4pp increase in gross margin to 36.3%, gross profit reduced from £35.9m in FY15 to £34.3m. Management reduced operating expenses from £31.7m to £31.1m despite investing c £1m in restructuring marketing, buying and sales functions into integrated brand business units. Nevertheless, FY16 operating profit of £3.2m was £1m lower than in FY15.

Importantly, there were signs by the year end that some of the new team’s action plans were bearing fruit. School brands, as noted above the largest part of the division, has seen the rate of decline in customer numbers slow in every quarter since Q415. Within Classroom brands, the launch of a mini-catalogue in January 2017 appears to have contributed to a slowing of the decline in its customer numbers. Following this result, the division is considering whether to pull forward next year’s April catalogue launch to January. When it wins business, Education clearly does a good job: its net promoter score in FY16 was 92%, its highest in five years. If the new structure generates additional sales, the business appears capable of retaining them.

Total FY16 pre-tax exceptional charges were £32.0m. This included £5.5m (£5.3m after tax) related to discontinued operations resulting from the sale of Kitbag. The remaining £26.5m divides as shown in Exhibit 2.

The largest item covers product protection plans ‘mischarged’ for anything up to 11 years ago. There is therefore a material interest cost element in the overall charge. Express has now reviewed all of its historic financial services products, so we do not expect to see additional redress for other products. That said, it remains possible that the final tally for redress on product protection could differ from the current best estimate shown above.

Changes introduced to Express’s receivables collection processes over the last two years, including the sale of significantly overdue receivables to third parties, have enabled and required management to refine the models used to estimate receivables provisioning. In some areas, in particular in relation to customers with whom forbearance arrangements have been entered into, better information is now available to allow a more accurate assessment of the provision required. Based on this improved information, Express recognised an additional provision of £4.3m at March 2016, of which c £3m is required to correct previous non-compliance with IAS 39 (Financial Instruments). Management has concluded that the changes made would not, if they had been made during the previous year, have had a material impact on the FY15 income statement, as the level of provision at the beginning of 2014 would also have been similarly affected. As a result, management deems it appropriate to recognise the additional £4.3m provision in FY16 although, since the increase in the provision does not relate to current year performance, it has been classified as exceptional.

The onerous lease provision covers the discounted value of the expected shortfall on rents on Education’s Enfield warehouse, which will be vacated later this year and has 12 years remaining on its lease. The refinancing of Findel’s bank and securitisation facilities in November 2015 for a four-year period to December 2019 resulted in the unamortised fees of c £1m that were paid in respect of previous refinancings in May 2014 and January 2015 being combined in an exceptional finance charge.

Although the pre-tax charge totals £26.5m, the cash impact in the near term will be muted. More than £9m of the charge is either non-cash or has already been incurred in FY16. £4.8m will dribble out slowly over the 12 remaining years of the Enfield lease. The phasing of the remaining £12.6m redress costs will depend on the balance of cash and credit settlements and how customers respond to the latter, but is likely to be spread over the next two years.

Finance charges of £9.9m in the FY16 income statement were barely changed from the £10.1m charged in FY15. This reflected the initial benefits of the better terms in the new borrowing facilities, which were applied to a larger total net debt figure of £216.7m (FY15: £206.6m). This includes the securitisation facility that funds much of Express’s receivables book. Core bank debt edged lower from £86.9m to £85.6m, as expected. This was despite a sharp increase in capex from £10.3m to £15.9m. It also reflected additional inventory investment of c £2.3m in Kitbag before its sale, which was not recovered until after the year end. In addition to the core bank debt, Findel also utilised £2.2m of finance leases.

Excluding finance leases, and not adjusting for the timing of the Kitbag inventory investment, core net debt improved further in FY16 in a year of abnormally high capex. The long-term underlying trend in core net debt remains downwards. As debt has reduced and EBITDA has increased, the affordability of the group’s facilities has improved.

Findel provides additional analysis of the financial situation that shows it to be even stronger than the headline data shown above. It excludes from core bank net debt the portion of the revolving credit facility funding the part of Express’s receivables book that is not covered by the securitisation facility. On that basis, net core bank debt (excluding finance leases) to EBITDA has reduced from 2.6x in FY11 to 0.8x in FY16.

Findel made additional voluntary contributions to its defined benefit pension schemes of £2.5m in FY16 (FY15: £4.1m) to improve the deficits in those closed schemes. As agreed with the trustees in early 2014, £2.5m of contributions will be made in FY17, rising to £5.0m from FY18. The IAS19 net deficit at the end of FY16 reduced to £2.3m (FY15: £11.5m), mainly reflecting an increase to the discount rate and a change to the mortality tables used to value the scheme’s liabilities. This year will see the triennial revaluation of the pension funds..

After almost seven years on Findel’s board, executive chairman David Sugden has announced that he intends to stand down at the forthcoming AGM. Findel states that the search for a replacement is well advanced. Sugden’s move to executive chairman in March 2015 followed the resignation of the group’s previous CEO, Roger Siddle, at the end of FY15. It created a non-standard board structure but not one that concerns us. The simplification and refocusing of the group in recent years has reduced the role of the centre to one of resource allocation, strategic and financial control. In that regard, the continuity provided by finance director Tim Kowalski, who has served in that role since August 2010, is reassuring. Moreover, there is continuity at the top of the group’s largest business, Express, which is the key to the group’s financial performance in the near term: MD Phil Maudsley has run the business since 1994.

The incoming chairman faces one obvious group-level strategic question: how and when to separate the group into its two component parts, Express and Education? In the short term, the focus will be on operational performance. Express needs to sustain the improvement in performance seen since Q416 and capitalise on the investments it has been making in systems, ranges, financial services and people. The more challenging division is Education. Management reports that other sector operators are now also showing signs of the weak UK educational supplies market. Nothing in the political landscape suggests that this situation will improve in the foreseeable future. That suggests to us the likelihood that the industry will consolidate. One of the new chairman’s key strategic decisions will concern how Education should participate in that process to generate the best return for Findel shareholders. There is a range of options from a simple sale to a buy, consolidate then de-merge approach, with a host of contingent alternatives in between. Given the need to rebuild profitability within Education, we suspect that this is a medium-term rather than short-term issue. Once it has been dealt with, we would expect the board structure of the remaining business to be more in tune with accepted norms.

Findel’s outlook statement notes, “Express Gifts has had a particularly encouraging start with the underlying rate of product sales well ahead of last year and comfortably in line with our expectations”. Categories such as clothing, furniture and electricals have all seen strong double-digit percentage gains in the early part of FY17. We have therefore modelled product sales growth of 8% for the year, allowing for the impact of any knock to consumer confidence from the referendum result (should there be one), but also recognising that the comps for Q2 and Q3 are far from challenging. There will be a further headwind from currency movements this year. Findel has c 60% covered the US dollar for 12 months on a rolling basis, not least to cover against any post-referendum collapse of sterling, at a rate of c $1.43. On the other hand, as clothing continues to grow its share of sales, we would expect to see a mix benefit to gross margins. Assuming continuing strength in financial services income, we model a 70bp increase in Express’s gross margin to 51.7%. We expect the bad debt ratio to increase to c 7% as Express seeks to restore a more profitable balance between revenue growth and bad debt levels. After a period of substantial investment in expenses, we expect further cost growth of c 5% in FY17. The result is a divisional operating profit of £35.2m, representing growth of 10.9% on FY16 and an operating margin of 10.3% (FY16 10.1%). We assume that FASL will again post a loss of c £0.3m.

The challenging market conditions for Findel Education that we described earlier have led to a disappointing start to the year within its Schools brands, which has been partially offset by an encouraging performance from Classroom brands and international sales. The group’s aim for this year is to stabilise sales in Education. This will require H2 sales growth to recover from a decline in H1. We model broadly flat revenue. We expect the division to invest margin to win back customers and market share and therefore model a decline in gross margins of 90bp. On the assumption that operating costs can be held close to last year’s level, we estimate that operating profit will decline again, from £3.2m to £2.3m.

We expect net interest in FY17 to be slightly above last year’s level. Although the new facilities have lowered the interest rate, we model higher average debt as Express increases its receivables and incurs the cash costs of part of last year’s exceptional charges. We expect capex to return to more normal levels of c £8m. Our model suggests that year-end net debt of £219.4m will be an immaterial £2.7m higher than the end-FY16 level. Since we expect trade receivables to increase by c £18m, core net debt should reduce further in FY17.

In FY18, we expect Express to be able to sustain sales growth of c 7.5% as it adds customers and further broadens ranges. We model slightly lower growth in financial services revenues. This leads to a small adverse mix change in the gross margin, which slips to 51.2%. We assume cost growth is 6% as variable costs increase with revenues, and that there is a further drift in the bad debt ratio. On these assumptions, the operating margin holds at 10.3% and operating profit increases by c 7% to £37.6m. We assume that Education carries positive sales momentum from Q417 into FY18 and manages 2% revenue growth. We assume flat gross margins in an environment that will remain challenging at that stage. However, since management reports that its warehouse and logistics programme is on track, we incorporate the targeted £3m of cost savings from that project into our expense estimates. The result is a sharp increase in operating profit, from £2.3m to £5.3m and a healthier operating margin of 5.5%. We model a tiny increase in the net finance charge as the Express receivables book continues to build.

We assume a tax rate of 21% in both years. The following table summarises the changes to our profit estimates.

In the very short term the major risk to our estimates is a sharp reaction by UK consumers to the EU referendum result. Express is, by far, Findel’s largest business and the one with the better short-term prospects. We are not persuaded that the average consumer attaches as much importance to the referendum result as economic forecasters and commentators do and are therefore suspicious of spending forecasts on both sides of the debate. Findel has addressed the short-term risks to sterling by locking in c 60% of its US dollars requirement for the next 12 months on a rolling basis and has also capped its interest rates, again to avoid the worst excesses of volatility that could, in theory, materialise.

The Chancellor of the Exchequer has threatened further austerity measures should he not get his way in the referendum. That could 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 severely hamper the division’s recovery plans, although the warehouse savings expected in FY18 should be relatively unaffected. Whether Mr Osborne could remain Chancellor after a referendum vote went against him or could carry such a measure through the House given the government’s tiny majority is beyond the scope of this note. In any event, a tougher industry background might merely hasten consolidation, bringing forward synergy benefits.

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. However, the levels of current 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 work forces is likely to be small, perhaps as little as £0.25m. However, its customer base is likely to be beneficially affected, which creates a sales opportunity for Express.

In November 2015, Sports Direct, which owns 29.8% of Findel, requisitioned a general meeting to appoint a director to Findel’s board. This amounted to planting a spy in the camp and would have provided Sports Direct with valuable information on Findel without any value passing to Findel’s shareholders. Predictably, the general meeting overwhelmingly rejected the appointment. Since then, there has been no development in the relationship beyond purchases of Findel contracts for difference by Sports Direct. Instead, Sports Direct has been linked to a series of deals and potential deals, the most recent of which were Austin Reed and BHS. We regard Sports Direct as too unpredictable to make judging its next move a worthwhile exercise. However, one cannot ignore its potential to serve as a distraction for the senior team at some point. Equally, it could simply sell its stake, leaving the market to absorb a substantial overhang.

Findel has 8.34m convertible shares in issue. The annual report states that these shares may be converted into 8,34m ordinary shares at the option of the convertible shareholders in the event that: (i) the company’s volume weighted average ordinary share price rises above 479.4p for a period of one month during the period commencing on 22 March 2013 and ending on 22 March 2021; or (ii) an offer is made for the company (regardless of the company’s share performance). If the shares have not been converted by 22 March 2021 they will automatically convert into non-voting deferred shares. Findel will have the right to buy back such deferred shares for a nominal value at that time. With the current share price languishing so far below the conversion price, the risk of dilution appears much reduced. By the same token, the likelihood of dilution from the performance share plans is also low.

Sitting on an FY17e P/E of 5.8x, which falls to 4.9x in FY18e, Findel is not expensively rated. These ratings apply to a company that we expect to generate earnings growth of c 9% in FY17 and c 20% in FY18. The resulting PEG ratios are 0.45x in FY17 and 0.26x in FY18. For reference, N Brown Group, arguably the best reference point for Express, trades on c 9x FY17e earnings (source: Bloomberg) in a year during which the consensus expects little if any growth. We are mindful that Findel lacks a dividend yield, which we expect to remain the case for the next couple of years, while N Brown yields over 6%. It is also possible that the market has not appreciated the extent to which management has simplified the group and continues to apply a ‘conglomerate discount’ to Findel. However, it seems more likely that it is focusing on the scale of its headline net debt.

Findel’s FY17e and FY18e EV/EBITDA ratios are 7.7x and 7.0x respectively. These are closer to the levels that one would expect to see for a retailer, albeit still on the low side. That said, N Brown, which has a lower proportion of debt within its EV, trades on 7.2x and 6.6x for roughly comparable periods. It is important to stress that much of Findel’s debt funds the current and up-to-date debtor book within Express and is thus matched against interest-earning assets. The level of core debt that we have discussed elsewhere in this note is much lower. In this sense, Findel has some of the characteristics of a bank. It is therefore worth considering the price-to-book ratio. In FY17e we calculate that to be 1.3x and in FY18e 1.1x. The implication that the group cannot generate organic growth beyond FY18 seems harsh.

We have again employed a sum-of-the-parts methodology to generate a valuation for the shares. We have applied a post-tax multiple of 9.5x to Express’s and FASL’s FY17 NOPAT. This is slightly higher than the N Brown rating given the superior growth prospects (eg we expect Express to generate c 10% NOPAT growth in FY17). We acknowledge and have taken into account the absence of a dividend yield at group level in our selection of multiples. Because of the timing and significance of the warehouse consolidation plan in Education, we have used its FY18 NOPAT and applied a multiple of only 8x. We have then deducted core net debt and the pension deficit to generate our valuation. We have divided that by the undiluted share capital to generate a valuation of 238p a share. This is a reduction from our previous valuation of c £3 that reflects both lower earnings estimates and reduced valuation benchmarks.