(9fin) Douglas delivers no surprises but questions mount on future profitability - Q2 22 earnings review

By Emmet McNally | Distressed Credit Analyst | emmet@9fin.com; Lara Gibson | lara@9fin.com; and Michal Skýpala | michal@9fin.com

Douglas’ Q3 22 (April to June) earnings print this morning served up few surprises with a muted market response thus far across the cap stack. This may prove something of a relief given the earnings-driven volatility seen in the bond prices for other consumer credits last week (see PDA; Upfield).

Management was bullish on the outlook for consumer spending in Q4 22 (i.e. July to September), suggesting there was no evidence of down-trading thus far. Other positives were that margins improved sequentially and this boosted credit metrics for the German beauty retailer.

Negatively, management conceded that margins of its growing in influence e-commerce segment are having a dilutive impact on profitability. Compounding this is intense competition from online-only players and a structural trend towards digitisation. The outlook for margins is unclear, though management reiterated a sentiment outlined during the Q2 22 earnings call - that current margins cannot be compared to those of the business pre-pandemic.

Wolfgang Felix from Sarria told 9fin: “Management is currently prioritising getting customers into stores and driving up overall market share rather than increasing margins. This year’s objective is definitely to maximise revenue in preference to margins.”

Separately, management suggested there were no current plans to use a healthy cash balance to buy back bonds despite the €475m 9% 2026 PIK notes trading in the low 60s. A source close to the company told 9fin: “Bond buybacks are not something being actively considered at present as management would rather focus on retaining liquidity in a difficult macroeconomic environment.”

Growth in topline, EBITDA and margins

Q3 22 group revenue increased by 35.2% year-on-year (YoY) on a like-for-like (LfL) basis to €830m. This excludes the contribution of stores in Spain that are in the process of being closed. The DACHNL (Germany, Switzerland, Austria, Netherlands) and CEE regions saw the biggest LfL growth at 39.5% and 42.6% respectively. Lockdowns in various regions in Q3 22 and Q3 21 are distorting the year-on-year (YoY) comparison, but the company helpfully outlines revenue growth against pre-COVID levels also. Across the group, Q3 22 sales exceeded pre-COVID levels (i.e. Q3 19) by 8.9% with DACHNL (18.5%) and CEE (56.1%) again the strongest performers.

A 2.4 point YoY improvement in the gross margin to 44.3% translated into EBITDA margins also, with better opex/revenue meaning the adjusted EBITDA margin rose to 7.5% from 3.5% in Q2 22 and 3.7% in Q3 21. Management outlined a €20m contribution from the store optimisation program (SOP) in Q3 22 EBITDA. Sales mix also helped margins as the company launched two exclusive fragrances during the quarter and these are at a “much higher margin” according to management. There was also some help from a greater contribution of own-brand products which too are higher-margin.

A buysider told 9fin that he was cautious about the margin rise in Q3 as the business is highly seasonal and margins can fluctuate significantly between quarters, as seen in the jump from a 3.5% margin in Q2 22 to 7.5% in Q3 22.

Good liquidity but no plans to buy back bonds

Total liquidity of €430m is strong with €271m of cash and €159m of availability on the €170m RCF. Management suggested the business was “comfortably funded with cash for the next twelve months”. On the flip side, there is a remaining consideration to pay on the acquisition of Disapo which closed in April and for which the company raised a €75m TLB add-on in February. Management were not overtly clear on the quantum of the remaining consideration during the call and the Q3 21 financial report doesn’t offer more insight.

Management were asked during the earnings call about whether they would consider using their healthy cash balance to buy back some bonds. CFO, Mark Langer, responded to say: “the short answer is no, we’re not currently considering it”. Management made it clear that de-leveraging is a key focus currently and buying back debt at a discount to face value should help the cause.

There is at least €90m of capacity to repay subordinated debt under RP provisions in the bond docs, per 9fin’s Legal QuickTake. That being said, we estimate that using €90m of cash to buy back some of the PIK notes at a 30%-35% discount would only move Q3 22 net leverage down by 0.1x to 7.1x from 7.2x reported.

That might explain why it’s not something the company is actively considering at present. It does, however, raise the question as to just how the company intends to de-lever and the extent to which it is possible.

A second buysider commented: “On a LTM basis the company has de-leveraged significantly, however I feel slightly concerned management did not address de-leveraging efforts in the call as they made it clear business transformation was their primary priority.”

De-leveraging trajectory is not clear

The company is not yet seeing a down-trading effect in consumer spending in bricks & mortar (B&M) or online, management said during the Q3 22 earnings call. This should bode well for Q4 22 results which run to end-September. The Q3 22 adjusted EBITDA margin of 7.5% is a good proxy for Q4 22, the CFO suggested, adding that they see no major disruption to sales or margin in Q4.

Quantifying this, we would expect Q4 22 sales to grow YoY on the back of higher pricing, a continued positive mix effect and limited disruption from Covid. Were sales to grow 10% YoY and the adjusted EBITDA margin to stay flat at 7.5%, FY 22 adjusted EBITDA could reach ~€342m. This would de-leverage the group to ~6.5x from 7.2x as of Q3 22, assuming net debt stays reasonably flat. The de-leveraging effect could be greater were the company to generate positive FCF after cash interest and working capital movements.

The first buysider remarked: “Cash is getting better and EBITDA is improving although not yet back to pre-pandemic levels. It remains to be seen if they deleverage, and despite the decent quarter they will not be able to do this through pure cash generation.” Adding to this he said he believed that “ultimately the demand will hold up. L’Oréal and other peers are also showing stable demand in the current environment. Douglas’ operations have been improving, they are managing the cost increase and have fairly robust demand.”

In terms of risks in the outlook, management outlined that possible supply chain disruption from global producers is not something that could be ruled out. Providing more colour, European suppliers producing only in Europe have greater security of supply, whereas global producers are more susceptible. Douglas is ordering a little earlier for this Christmas period this year in an attempt to mitigate this risk and be well prepared for Christmas. Certainty of supply varies by brand and product, with the CEO suggesting glass sourcing is the biggest problem for producers currently.

Management not drawn on FY 23 and further de-leveraging

Management would not be drawn on the outlook for FY 23 earnings or the longer-term EBITDA margin or leverage target aspirations of the business, despite several questions. FY 22e net leverage of ~6.5x (as above) is still clearly too high and creditors will no doubt be looking further out at the earnings trajectory and comparing it to the pre-pandemic levels.

According to the source close to the company: ”Douglas’ leverage has been too high since it ran into operational issues in 2019 and then was hit by the Covid-19 crisis. Management’s main aim is to reduce leverage with the ultimate goal being an IPO in a few years time.”

As during the Q2 22 earnings call in June, the CFO rebuffed considerations around the comparability of current or future margins to those generated by the business pre-Covid. The business is structurally different now, he argues, as e-commerce has a greater share of revenue (33.4% in Q3 22) and footfall still remains below levels seen before the pandemic. Management is confident that the e-commerce share of earnings will grow as Millennial and Gen-Z customers are seen as more digitised. There are also structural shifts in consumer habits in certain regions, per management.

We don’t see margins broken down between B&M and e-commerce though management have previously suggested and reiterated during the Q3 22 earnings call that the gap is limited. That said, the CFO conceded that the higher share of e-commerce sales has a dilutive impact on profitability. With the share only expected to grow in future, this begs the question as to how group margins evolve.

The other factor impacting the comparability of margins to pre-pandemic levels is the level of footfall in B&M. It is still overall ~18% below the pre-Covid level as of Q3 22, and this impacts cost absorption, despite the company’s efforts to optimise its store portfolio.

Wolfgang Felix commented: “Store footfall has increased year over year but in Germany stays far below pre-pandemic levels. In line with that the conversion rate has increased and remains high. As such the online shift in Douglas Germany is a good case study for future revenues and margins in the remaining business.”

As a final point, management noted that they had seen enormous spending on promotion post-Covid from purely online beauty players. This is impacting the margin in the e-commerce segment as the company has thus far opted to not give up market share to “aggressive online-only players”, thus having to price appropriately. The marketplace is expected to remain highly competitive in years to come.