Douglas - Modelling for elasticity

All,

Please find our updated analysis here.

Much around Douglas has changed since last year. The highly indebted refinancing last year had come at the height of the market and was predicated on an online-infused IPO story that’s since returned to the Hut it came from. What’s more, inflation is now squeezing consumer wallets, it’s German home market has posted poor numbers and the online division has had to take a step back YoY. But not all is bad. The SOP program has been a success and the affordable luxury market is once again showing signs of holding up better than other retail sectors. We also think it’s key to understand the company’s supply side. So having expanded our model to reflect these new realities, how does the company behave over the next 12 months and what will be thereafter?


Online Story:

- It’s gone. As is the IPO.

- Multiples back to the ordinary.

- Online is not all gone. It used to be a drag on the company’s valuation. But representing a profitable 1/3 of the company now, it has turned to being an asset and should be seen as supporting valuations.


SOP:

- The first salvo of 500 stores has been a success. The program that was designed to save €100m at EBITDA level is over 90% complete. The reason that is not visible is mostly attributable to the poor performance of store chains since the pandemic.

- This and the now unsustainably small Spanish store business are the reason Douglas are looking to extend the program by another 100 stores. We have not been given the details, but by extension we expect the program to have similar metrics to the first one: i.e. be largely self-financing and save another €20m at EBITDA level.


Inflation: Revenue and Expenses:

- Consumer disposable income will be seeing a squeeze, particular when the summer party is over, we expect a sobering mood to take hold in the subsequent 12 months.

- We do not see inflation per se as a constant drag on performance. Rather it is the rise of inflation that we consider relevant here. Once inflation has found a level, purchasing power should adapt.

- We are not macro experts, but the current meteoric rise of inflation and the unprecedented rate hikes on the back of it suggest to us that YoY inflation next year should not be running as high anymore and we don’t know if it will increase again thereafter. So we have been modelling a normalisation from FY2024.

- Importantly, inflation will also drive sales prices - initially at the expense of volume, then volume should come back. Exactly what the elasticity of demand will be is anyone’s guess. Assuming 66% ability to pass prices on, we model sales prices offsetting COGS rises, but not expense inflation and having additionally a negative effect on volumes of up to 5% YoY. Please play with our model (Inflation settings are in top section of Driver page).

- German minimum wage is set to rise by over 12% in September and elsewhere similar movements are visible. The feed through to the wider labour market may lag somewhat, but we expect material labour cost, distribution and other expense inflation to materialise within the next 12 months.

- Interestingly, there should be little inflation on rent expenses in the near term. So in relative terms that will favour the store chain over the online division.


Inflation: COGS:

- Douglas negotiate their annual supply contracts during Q1 (calendar Q4) for the vast majority of their supply. This means that during the crucial next season and even for most of Q2, COGS will still be based on pre-inflation cost negotiated between September and December 2021.

- Meanwhile, Douglas will be competing for the consumer wallet in an environment that is fully exposed to inflation, either making the offering more attractive in relative terms or allowing for a better margin. We, therefore, remain relatively positive on Douglas’ FY23 as its Gross Margin will be 3/4 determined on pre-inflation COGS. We expect this effect to be true for most fragrance and cosmetics suppliers, so this may not be an opportunity to gain market share within the sector. Rather the sector gaining wallet share within the economy.

- Q223 is in theory covered with pre-inflation stock at the end of December typically accounting for over 3 months. But not all stock is created equal, so we expect some of the higher volume items to require replenishing at inflated COGS already during Q2.

- Q3 should be poor. This is where almost all stock will be subject to inflated COGS (and expenses) whereas the labour market is still unlikely to have fully adjusted to re-fill consumer wallets.

- Q423 and Q124 as well as half of Q224 should then see a normalisation of Gross Margins, again because the product costs negotiated this autumn will not change while inflation continues to raise average sales prices.

- There are two mitigants to the above view of Douglas’ next 12 months: 1) Consumer wallets still appear to be flush from high savings during the pandemic. Much of that will be spent on travel over the summer, but it should cushion (away from energy and commodities is in party the reason for) the immediate impact of the current inflationary spike in CPI. 2) The affordable luxury segment tends to perform better than most retail sectors during times of uncertainty. For instance, Douglas performed well during and in the aftermath of the financial crisis.


Cashflows:

- We see Douglas returning to above €300m EBITDA - despite inflation. While creditors should feel comfortable only from €350m and upwards, our modelling suggests that under most scenarios the company will find those levels again and their post-inflation equivalents as trading normalises.

- With only basic normalisation we see Douglas also return to above 2x cash interest coverage.

- The migration from 20 warehouses to five automated distribution centres should also set free some 20% of inventory, which should account for a deleveraging by approx. 0.5x EBITDA, mostly over calendar 2023.

- Over the next 12 months we therefore still anticipate a deleveraging of the company to something with a 7-handle through the PIKs.


Positioning:

- We are long and wrong the PIK notes, which have taken a beating every time we concluded we’d rather continue to hold them. This time is no different, however. Not wishing to take a die-hard attitude (rarely a good idea) we realise that these bonds trade as proxy for inflation and that the market is concerned about the large PIK that is eating into equity valuations.

- Whether or not the market is in a better place next year, we struggle to see both the PIK and the SSNs trade as wide as they do if our projections are correct.

- Levels of confidence are running low across the market and Douglas certainly provide sufficient moving parts to make the a more speculative bet than we had in mind. But the company remains the biggest fragrance and cosmetics retailer in Europe and is very much on the front foot in that space (this was not always so). It has a reason to exist, has liquidity, has no triggers and promises a comparatively resilient next 12 months.

- In this market environment PIKs are clearly out of favour. So we may look at spreading a position across the two bonds if we feel that has better upside from any of the positive surprises that we are anticipating.


Happy to discuss,


Wolfgang

E: wfelix@sarria.co.uk
T: +44 203 744 7003

www.sarria.co.uk

Wolfgang FelixDOUGLAS