Matalan - Never Mind the Restructuring
All,cPlease find our unchanged analysis here.
Of the tailwinds management cited for 2022, one related to 6-7 weeks of lock-down in Q122, relative to which the chain should outperform in FY23 (to February 23), even as the online store had compensated for some of the lost sales last year. From there we are netting off and putting into perspective Matalan’s most recent results to try and arrive at an underlying base EBITDA for FY 2023. So looking past the restructuring/extension efforts, how does the normalisation of the fundamentals stack up so far and when taking everything into account, how deep is this valley and how steep is the other side?
£33m headwinds:
- The EBITDA headwinds expected for this year were broadly made up of three components”
1) £-24m of 2021 rates holidays that will not repeat in FY23.
2) £-5m furlough claim in FY22
3) £-3m reopening support.
- Factors including inflation were not part of this calculation; the £33m corresponds precisely to the difference in P&L expenses between FY20 and FY22.
£35m tailwinds:
- Management made two key statements on the Q4 call:
1) It expects “underlying" EBITDA to grow rather than fall.
2) It calculated EBITDA headwinds for this year of £33m.
-> As a result, management must be seeing at least £35m tailwinds for this year - or that would be the math.
Q122 relative to Q121:
- Q1 was the quarter that had seen the lock-down disruption last year.
- Tailwind: Management suggested that Matalan had lost £100m of revenues in sales last year, most of which in that period. To keep things in line, we’ll go with £75m of lost sales in Q122, which would still have narrowly resulted in an all-time-high £277m Q1 revenue. Q123 suggests that is the right assumption as £286m are setting another record. To make no finer calculation, we would expect Matalan to have made approx. £35m of Gross Profit (Sales less COGS) on those lost sales.
- Headwind: Relative to Q120, Q122 expenses had been £-20m light, accounting for the majority of the headwinds calculated above and followed by £-13m, £-8m and £+9m for the remaining quarters - the latter being primarily driven by extra logistics and consulting expenses.
-> So by those metrics alone, we should have expected IAS 17 EBITDA of £30m this quarter, or £5m higher than the usual pre-pandemic Q1. Matalan made £20m.
- Incrementally over Q122, Matalan made £12m more sales this year, which should have resulted in another £6m of Gross Profit, thus raising the shortfall to £16m. All of that was given up this quarter with a distinctly lower Gross Margin of only 44% vs 49% in 2019. Matalan then registered £-5m lower expenses than in Q120, despite renting additional real estate.
-> So there are one conclusion and two questions to ask:
- Conclusion: So far at least Matalan do appear on track to fulfil management’s words, that underlying EBITDA is higher, not lower than the £100m mark.
- Question 1) What about the shocking Gross Margin of a mere 44%?
- Question 2) Matalan has long displayed admirable cost control. But where does it come from and can we count on it going forward?
COGS Explosion - Shipping:
- Management estimate increased shipping expenses will add £40m of headwinds in the next year (not considered above), of which it is mitigating £9m by near-shoring, stretching lead times and other methods.
- These extra expenses have been setting in relatively abruptly in Q123 as older shipping contracts rolled off. So in Q123 shipping expenses as part of COGS should have risen by up to £8m, accounting for half the margin contraction.
- The other half may have been previously incurred COGS inflation that has not yet been passed through. Matalan have begun to raise the average sales price of their garments, but clearly, costs have gone off to a head start.
-> Quarterly Gross Profit (Sales less COGS) should contract by approx. £8m vs. pre-pandemic FY2020.
Expense Control:
- Middle Management: In the age of Zoom, Matalan have taken the axe to their middle management, with now often one manager being responsible for two stores. We did not receive a quantified answer estimate for this action.
- Wages: Nevertheless, wages are set to rise considerably this year with management estimates pointing to at £14m cost rise. This should become particularly important when minimum wages rise 6.5% later this year.
- Distribution (downstream): was up in FY22 by some £13m. Part of that is owing to John Hargreaves's contribution in kind of the logistics facility in the 2020 restructuring. Management however do not consider the same expense necessary this year or going forward. So relative to last year, there should be perhaps some £5m more savings, in particular around Q3/Q423.
-> All in all, expenses look like they may be uniformly up across the year, but not by a tremendous amount.
-> Trends in COGS and Expenses together account for some net £30m headwind this year and should start Matalan out at £75m run-rate EBITDA today before being able to re-capture margin as the market normalises.
-> Assuming costs are what they are and that shipping expenses remain at these levels, Matalan would have to raise sales by 6% or £70m to return to EBITDA of £100m and before further raw material inflation needs to be passed through. Wage inflation in the UK should (well after it adds to costs at Matalan) provide for the relief as would be the tendency of households trading down from high-street brands to good old stuffy Matalan.
Reason to exist:
- Matalan have raised sales considerably through the pandemic. The store chain is “not far off" pre-pandemic levels and online is 60% up (from modest beginnings). Taken together, however, and despite the lower margin, we are not seeing immediate signs that Matalan are buying those additional sales. Rather, it seems Matalan are not yet passing on all cost pressures.
- In the wider UK apparel context, it seems therefore that Matalan are taking legitimate market share. This is not surprising when recalling its performances in the early 2000s and again following the financial crisis.
-> If this format is benefiting (in relative terms) from the situation this country is entering, then this chain has an indisputable reason to exist and perhaps we should not be so stingy and myopic with the multiples we are willing to attach to its earnings these days.
-> Alternatively (not in addition to the point made above, as it’s really only the other side of the same coin), we should feel relatively confident that Matalan can re-build their margins in the foreseeable future.
Other metrics reported today were in line with model. We will be releasing an update in due course.
Positioning:
- We remain long Matalan with a 4% position in the SSNs. These bonds are already trading to a full 5-year extension at 10-12% yield, which appears a reasonably likely scenario.
- Matalan are struggling to refinance their debt as current at the current cost of capital it would be too heavy to carry.
- However, the company does not need fresh cash - even as it is aiming for £40m CapEx this year. Because this means that a SoA is not required to keep the company trading and taking into account management’s bullish stance on the last call (tough to argue now that the value breaks in the SSNs…) an amend and extend seems to us the most mature option - pending creditor composition.
- If we did have to recapitalise the company, momentum could push bonds down into the high 60s even before we would expect a recovery into the 70s not long thereafter. This would hurt, but on the current size of our position, we would not mind owning Matalan. So we are holding our position and although there should be easier names out there, we may even be expanding on bad news as names like these tend to be far less correlated than the average beta-punt out there now.
Happy to discuss,
Wolfgang
E: wfelix@sarria.co.uk
T: +44 203 744 7003