(Debtwire) Matalan expects full-year earnings slide as margins erode and leverage creeps higher
20 January 2020 | 17:19 GMT
Matalan is still lowly levered, has reasonable liquidity, and it continues to increase sales from online and mobile initiatives. But the UK-headquartered discount retailer this morning (20 January) noted that it expects FY19/20 earnings of just GBP 80m–GBP 82m. While partly due to calendar effects, there was still margin erosion in December, leaving little room for any further earnings slippage, according to four buysiders and an analyst.
The company today reported 3Q19/20 results with IAS 17 EBITDA falling 15.8% to GBP 33.7m, which left 3Q19/20 LTM EBITDA down to GBP 89.8m for quarter-end 30 November. The trading period was to quarter-end 30 November versus the prior year period that was to quarter-end 24 November 2018. Management noted that 3Q19/20 trading benefitted from a GBP 4.1m boost for calendar effects as the period included a larger near-December week and, leaving behind a quieter August week, which shows how underlying operations excluding calendar effects were even weaker.
Matalan had a tough start to the quarter as the September trading suffered from adverse weather, leading to like-for-like sales down 5.3% YoY for the month before being flat YoY in October and then up 1.6% YoY in November. Gross margins were also down 280bps YoY to 46.8% for 3Q19/20 versus 49.6% in the third quarter a year back. Categories such as Baby, Autumn Mens and Schoolwear delivered decent growth, management told investors.
The executives also highlighted the upcoming 4Q19/20 period will gain an extra week of relatively quiet February trading but lose a week of busy November trading. Therefore 4Q19/20 trading will have a GBP 5m negative EBITDA impact from these timing effects, reducing FY19/20 EBITDA guidance to GBP 80m–GBP 82m [versus GBP 89.8m 3Q19/20 LTM EBITDA and GBP 102.4m at FY18/19]. 4Q18/19 EBITDA was GBP 14.8m, suggesting that 4Q19/20 EBITDA will be down at just GBP 5m–GBP 7m, or GBP 11m–GBP 13m ahead of negative calendar effects.
“I’m surprised the bonds have not moved lower – they had a profit warning and it is a 53-week year so GBP 80m–GBP 82m EBITDA guidance includes around GBP 2m EBITDA that came from an extra week [in 2Q19/20]. On EBITDA you are now back to where you were a few years back and they were trying to not mislead on calendar effects, but results were worse than expected,” one buysider said. “After the Knowsley warehouse debacle now they are towards the recovery levels. [But] Brexit is happening, it is not good for the economy and the reality is these bonds are not trading at a level with the risk. Net leverage could climb towards 6x and that is not refinanceable. This business does not fall off a cliff, but liquidity is becoming tighter than it was.”
“They had flagged in 2Q19/20 that results had softened and that 3Q19/20 would be down was well telegraphed. They gave more disclosure on timing effects and [how] this contributes to [reduced] FY19/20 guidance, while when companies benefit from timing effects [as Matalan did in 3Q] it is not often they are upfront and honest about it,” the second buysider added. “The net effect from timing is negative for FY but the gross margin erosion also concerns me and there is more pressure to come through with them coming off the back of a couple of strong years behind them and management believing their own hype. If they get more collections wrong, then there could be something structural in their ordering processes and design team leadership.”
Deeply discounted
Earnings are heading downwards. Matalan’s 2Q19/20 LTM EBITDA of GBP 89.8m remains down versus the FY17/18 EBITDA of GBP 104.5m and GBP 102.4m at FY18/19 as well as the lofty GBP 153.6m at FY10/11. EBITDA was last around the GBP 80m–GBP 82m mark years back, when the Knowsley distribution centre issues brought to FY16/17 EBITDA as low as GBP 77m.
Net leverage has also crept up given the falling earnings. It has climbed to 3.1x through the first lien and 4.5x total net leverage versus 2.8x and 4.2x, respectively, in the last sequential quarter. A GBP 81m implied median FY19/20 LTM EBITDA would mean net leverage could climb to 3.4x first lien and 5.0x total net leverage assuming stable net debt.
The group will unlikely deleverage further given the muted cash generation off its current earnings. With expected FY19/20 EBITDA of GBP 80m–GBP 82m, the group has guided for GBP 35m capex and could face a similar annual GBP 37.2m interest and GBP 5.4m cash taxes leaving just GBP 2m–GBP 4m of annual free cashflow ahead of working capital movements.
Liquidity is reasonable for now. Matalan had GBP 73.1m of cash at 3Q19/20 with GBP 39.6m of its GBP 50m revolving credit facility available. Additionally, members of the Matalan shareholder family disclosed during the refinancing that they held GBP 65m of the previous second lien notes and could have rolled a significant proportion.
The UK retail environment remains tough, buysiders noted. BRC data in early January noted retail sales fell for the first time in2 5 years last year. Conditions have been extremely challenging with UK-headquartered clothing company Superdry issuing a profit warning after sales dropped 16 in the 10 weeks to 4 January, according to a press report. UK luxury clothing retail company Ted Baker also warned last month of a possible 90% fall in profits for full-year pretax profits as it announced the departure of both its CEO and executive chairman. The group issued four profit warnings in the space of a year, according to another press report.
“They’ve had some poor collections and I’d not be keen to take a strong position on how they fare next year. Momentum is key and in the next year they face pressure from the National Living Wage coming through with question marks on Brexit as well as the underlying issues on the business, so you have to be overly optimistic despite the yield on offer. This is an industry that is challenging given how the likes of Superdry and Ted Baker have had issues, with bricks and mortar retailers struggling. There is not much of an equity cushion despite the net leverage,” the second buysider commented.
“If they get things wrong, then they can lose customers and this feeds into a negative perception. One year of poor collections could be a drag and they are having a tough time in Ladieswear, which is key to the business,” the same buysider continued. “Given the recovery values and structural headwinds, you are not overly compensated, and this has a chequered history so it is about picking the right entry point and next quarter will be negative, so where is the positive catalyst for the bonds to reprice? You need to position with conviction and this name is cheap, true – but it could always go cheaper.”
“There was evidence on the 2Q19/20 call to suggest that back-to-school had gone alright and we therefore felt in October that they wouldn’t be that far off the YoY comparable for the 3Q period, especially given the one-week shift,” independent deep-dive research provider, Sarria Research noted. “They’ve managed inventory rather than margin so as to start December with stock on target, rather than managing margin and not selling anything.”
Matalannouncements
The group is taking steps to turn earnings around and has announced a number of managerial changes. It is forming a new Chief Commercial Officer role that will report to the Board. Meanwhile Adrian Mountford is set to re-join as Interim Trading Director. He left UK discount retailer Pep&Co last year, having previously served as a commercial director at Matalan.
On the upside, expansion abroad is continuing. The group had 232 stores at the end of the quarter and plans to open 20 stores in Egypt in the coming years as well as franchise stores in Georgia and the Balkans. New city centre stores are also set to open in Leicester and Preston.
Online initiatives are proceeding with 25% online business growth in the quarter. Management noted its Mobile App has been a real success with customers being able to order more and shop more frequently than online. Meanwhile, planned upgrades at its Corby and Knowsley distribution centres will also speed-up order flow with Radio-frequency identification (RFID) technology used now in all stores to count stock.
Matalan’s B2/B- rated GBP 350m 6.75% first lien 2023s fell a half-point this morning to 94-mid yielding 9.0% while the Caa2/CCC rated GBP 130m 9.5% second lien 2024 notes were steady at 92.5-mid yielding 11.9%. The z-spread differential between the two bonds is around 268bps versus around a 200bps differential in mid-October and 400bps back in April.
“94-mid on the first liens is no-man’s land. The bonds had dropped previously after the BRC data in early January so there was already a big move heading into results. It was the worst year for retail on record and a tough year with a later Black Friday occurring late boosting December figures but it gives good insight into the UK retail market and at this level you don’t really want to enter,” the third buysider said. “If positive on sterling credit you go for the carry but otherwise UK retail has constant negative headline risk with negative read-across.”
“The bonds have fallen since the start of the year due to weak 3Q19/20 earnings being priced in. The 4Q19/20 period will also be down YoY given the weak EBITDA guidance, but management are doing whatever they can given the weak UK retail market going forward. However, even if they are taking the right steps on shortening lead-times for example and going into Spring-Summer season with tighter inventory, the market will remain volatile,” the fourth buysider pointed out. “There is no issue on leverage and liquidity, and this is one of the less levered names in the retail sector, but it is hard to see where the bond prices end up on this name. If there is a weak 4Q19/20 market and their actions cannot compensate for this, and bear in mind they have had a few quarters of weak EBITDA now, then these first lien bonds could go to the mid-to-high 80s. But these prices could then be a good entry point and the relative value would then become more interesting.”
Matalan declined to comment.
by Adam Samoon