Matalan - Change of view
All,
Please find our updated analysis here.
It’s no longer just about inflation. Even as we had anticipated lower cash levels, reported earnings were disappointing, but on the surface results did not deviate all too much from our model, which had been tracking well and which we had left in place since Q322. We had felt comfortable until a piece caught our attention that, we must concede, is really only news to us, because this has been going on since last quarter already. The result is changing our view a little bit.
FX is the killer:
- Matalan has been running down its USD hedges this year and by our somewhat straight arithmetic, this could cost another £20m+ against EBITDA next year. EBITDA should return within a year or so on better buying - provided Mr. Hunt has a better hand than his predecessor, but in the interim we are now forecasting a materially lower trough EBITDA of £46m.
- The fall-out would mean that the company nearly runs out of cash this time next year when it should struggle to order its AW stock without fresh commitments. Between September and October of each year, Matalan’s cash balance is subject to a £75m draw-down and there has to be £10m of cash in the tillers too.
- The steep fall of Sterling this year, coupled with the 80% share of goods still sourced from the Far East is particularly lethal for Matalan who are now only 50% hedged. Only some £35m of hedges seem to be longer dated than February.
Cotton Spike:
- The all-time-high cotton spike of 2011 left western apparel margins ruined for two years and more. Local suppliers first took it on the chin but passed it on eventually. The same dynamic is likely at play this year and next. To be sure, the Asian cotton is back down below 100, but the new stock for the AW season will have been expensive (and should contain little cotton/viscose/yarn - think short-sleeve jackets?).
- To escape some of these cost drivers, as well as high logistics costs, Management was going to near-shore significant production. Last month’s business update however described Matalan’s sourcing strategy still as 80% Far Eastern.
Inflation and Consumer confidence:
- Inflation is riding at 10%. Consumer Confidence by implication reflects events unfolding in parliament. Matalan have already mothballed SS stock for next year and the same will happen with AW stock. Perhaps by implication, next year’s September cash draw-down will not be as large after all, as some of the stock will already/still be in the warehouse. We expect a giant inventory write-off at year-end to boost margins for the following year.
- We expect inflation to come down next year and around the same time we expect the correspondingly higher earnings in Britain to feed through to sales levels and allow Matalan to draw level with inflation and allow margins to normalise.
Auction:
- It is odd to see John Hargreaves among the bidders for his own company, but with the Distressed Disposal language in place and apparently insufficient cash to buy himself back into the business, he has to.
- We are not sure how real some of the bids from the 2nd lien are and if they really carry over £150m of cash financing or are more tactical in nature.
- This process could yet become complicated and selecting a winner may not just be a purely numerical exercise in the end.
Investment Rationale:
- We remain invested in the SSNs for 4% of NAV, having sold our 2LNs earlier in the year. We see current trading in the 90s as overvalued and will make up our minds if we want to sell our position - liquidity permitting - while we are looking forward to the results of the business auction in December. We would be buying the position back lower once the results come through.
Happy to discuss,
Wolfgang
E: wfelix@sarria.co.uk
T: +44 203 744 7003
www.sarria.co.uk