Matalan - Swinging

All,


Please find our updated model for Matalan here.

2024/25 will be a challenging year. The company is facing a mountain of cost increases it has to overcome. On top of that, management are so bold as to invest further into price and margin in a bet on recently observed elasticity of demand and on holding on to some purchasing economies for a year, before being forced to pass those on again (or perhaps not). But why shouldn’t management swing for the fence? Cash is as tight as the customers themselves and a re-focus of the company on its consumer, its estate and its value proposition is exactly the right thing to do when the consumer is re-allocating his disposable income and reconsidering his habits.


Investment Rationale:

- Since the additional Super Sr. request, we are holding a 4.4% of NAV position of Matalan across Sr. Sec. Notes Tranche II, Priority Notes, 2nd Lien Notes and equity. 2024/25 will be a year of transition for Matalan. The cost headwinds from labour and property are certain, the success of its return to a lower price strategy is likely but altogether less certain. Still, we have been through management's budget back to front and think it perhaps not sustainable (higher than 50% margins have never lasted), but doable for a year while the business needs to adjust. We brace ourselves for 2024/25 EBITDA of £70m on the downside on higher than planned mark-downs with £95 on the upside from better sales performance.

- In light of the uncertainties surrounding the next year, we have taken down our valuation. Even though we remain convinced of Matalan's value in the medium term, it is difficult to model the immediate re-build of its margins without feeling aggressive about any single assumption. But it will happen and so the bonds remain attractive and will be well value covered in the medium term. Meanwhile, however, failure to deliver the budget will quickly require fresh cash, as without RCF liquidity is at a minimum and budget cashflow (after cost investments and some expansionary CapEx) only just earns its interest payments.

2024/25 Revenue and Gross Margin:

- Sales: £1,300m - growth by a net 4% on 4% price increases resulting (hopefully) in 8% volume growth.

  • The FY24/25 plan is looking to increase Gross Margin by roughly £90m (Pink blocks above) and primarily rests on a 2x Elasticity assumption and lower purchase prices. The profit increase can be broken down as follows:

  • - £40m for 4% lower selling prices planned for the year, where a large effect comes from a shift in range mix down into more basic items.

  • + £40m for 8% higher volumes on a 2x elasticity assumption x ~50% Gross Margin (dealing with savings from Freight and FX separately below), (in line with price/volume effects seen in FY23/24, but past performance is no guarantor for ...). We agree that the lower price point should primarily fuel the online business and less so the store business, which the company puts at 1.5x elasticity. 

  • + £70m for 7% lower intake prices for the year (This represents a 20%+ reduction in cost across the range of probably ~£300m COGS down to ~£230m). Again the shift in product/price mix should be important in explaining this large reduction, but it's an extremely aggressive cut. Management say that prices are largely locked in. We tried calling management for clarification, but perhaps it was the wrong week (mid-terms in the UK). Good luck selling those rags!

  • + £10m are to come from renegotiated freight contracts.

  • + £10m supposedly come from lower mark-downs. Mark-downs were bad in Q1 this year, but have since played only a minor role. We are surprised that management budget this much. We understand that purchasing volumes have been prudent, but there will be no flex in that.

- The 2x Elasticity assumption, apart from being on display in H223/24, is underpinned by:

  • "Full chain roll-out of enhanced ladieswear visual merchandising and coordination approach" - whatever that means, but it'll have to do with better presenting the ranges.

  • Restart of the store refit program - effects from this should take time to roll through the P&L, but by year 2 or 3 tend to have a strong (+7% of Sales) impact.

  • Outputs of the "Value Creation Program" that's been running through 2023/24 "more than offsets" the price investment and generates significant Gross Margin improvements. Again, we have no idea what it actually means and management have provided no numerical framework.


2024/25 Expenses:

- People cost:

  • NLW is up another 10% and moving colleagues up from minimum wage. While this increases costs even further, it should lift morale and improve operations.

  • Sales volumes should also add costs of 13m as more personnel is required in the handling of merchandise.

  • Supply Chain automation at Knowsley should offset the increase somewhat. However, further investments into the back-bone are being pared back in favour of focusing available CF on store CapEx.

- Property: 

  • Energy costs increase once more by £4.5m as forward contracts are rolling through. The effect is already net of benefit from a LED roll-out across the estate. 

  • Business Rates grow by £3.3m, partially offset by renegotiated rents. 

  • £5.5m enhancement to cleaning standards and improving store presentation. 

  • FY25 still seeing slight store reduction (open 3, but exit 4 or 5).

- Marketing: Intensified and budget aimed at volume recovery, rebate scheme and loyalty incentives. 

- Other Costs: More investment in supply chain and allowance for IT outsourcing cost. 

- EBITDA: £80-85m


2024/25 Cashflow:

- WC:

  • If EBITDA is £80m, CapEx -£40m and Interest -£35m, but the company wants to generate £15-20m of FCF, then there is no space in the budget for any WC build-up. 

  • WC peaks in March and October, leaving minimum liquidity of merely 30m. 

  • We appreciate that Management consider their purchasing volumes prudent, but underlying the budget is the assumption that volumes grow by 8% (half of the current loss rate). While that is probably a reasonable assumption (same 2x elasticity hopefully working the other way too), there is a risk that the volume growth is not coming and that volumes aren't all that prudent after all. Stock levels are currently very low, prompting management to hold back on sales. We wonder how much lower they can go. The risk of stock overhang will be as palpable as it's always been.

- CapEx: $40m investments focussed again more on the stores than on the logistics and IT backbone. 

- Cash: Planning to generate Cash of 15-20m.  


Q423/24:

  • The familiar scissor effect of average price rises being offset by even larger volume declines continues in Q43/24. 

  • EBITDA of £50m is very difficult to model when taking into account the December sales drop of over 11% and expenses being in line with last year's. We arrive at over 50% Gross Margin, for which there is no historical backing. 

  • We recognise that management tends to be very accurate in forecasting Q4 economics on its Q3 calls - not least because January and February are small months and December is already in the books by the time the call is held. So for Q423/24 only, we discount our model in the short term and confide in management for the next 45 days. EBITDA will be close to £50m.

  • 2023 has a warm winter again. Your’s truly meant to buy a jacket, but that won't happen for another year. Customers need discounts to be encouraged to spend. Matalan however held full price through Christmas. That should make for a strong gross margin, but once again at the loss of market share. For Matalan, Spring/Summer cannot come soon enough.


Update Q323:

  • Matalan achieved Full-Price Sales of 68.8% as it held out with winter discounts until after Christmas. The figure is slightly down QonQ, but up sharply YoY. However, once again this had to be achieved at the cost of volumes - and increasingly so. 

  • Sales missed our Q323/24 expectations by some £-15m, half offset by margins. 

  • At the current price point, Matalan are losing twice as much volume as they gain in price. We note that this relationship (in place for at least 6 months now) underlies the Budget for 2024/25, only in reverse order. It is worth remembering that the quarter included end-of-summer sales that were pushed back from Q2 into September, affecting this elasticity statistic. A fairer basis for elasticity assumptions should rest on Q2 and Q3 together. The budget then appears to have a little sandbag - we are glad to note.

  • Warm winter - Customers are holding back on spending. 

  • Online: Traffic, Conversion and Baskets up (from low) Full price sales up 7.6% percentage points up from last year or growth of 2.7% to 69%. 

  • Online revenue is no longer 35% down YoY, but "only" 22% down. Way to go. The channel is held back disproportionately by the high price point of the 2023 collections. 

  • International activity was challenged as partner had to be refinanced. Operations should resume now.  


FX Hedging and Raw Material Inflation:

  • Currency headwinds for the quarter were approx. £8m, roughly in line with model. 

  • The company is back to hedging some 85% of its requirements a year forward - generally as it orders goods/reserves volumes.

  • Over the last 12 months, Cable has been choppy, but all in all stable. This generally bodes well for planning margins in discount apparel retail.

  • Cotton and other raw material prices remain elevated following the 2022 spike but have been stable since. 

  • New Collections will be far cheaper made - to cater to the lower price point on demand in the UK as well as the higher raw material costs in the Far East (double whammy). 

  • The stability of the cost levels involved gives us confidence that the 2024/25 collections have been well-calibrated.


Here to discuss with you:


Wolfgang

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

Wolfgang FelixMATALAN