Matalan - Will they make it? - Positioning
All,
Please find our updated model here.
Operating momentum has returned to Matalan with a strong performance in September (back-to-school) and October. Despite H1 weakness of £20m in EBITDA, management is sticking to EBITDA guidance of £57-62m for the full year ending in February. This implies generating c. £40m in EBITDA in H2 which appears aggressive but in our analysis, it is entirely doable with c. £35m coming from the typically strong Q3. Furthermore, as the cost-of-living crisis continues to subside and core customers return, we provide a path for the company to reach at least £83m of EBITDA in the following year putting it on course to refi the capital structure. However, the road must be free of supply disruptions, inflation pressures and FX headwinds - the last being a concern.
Investment Rationale:
- We are taking a 1% position in the 10% SSNs with the view that the capital structure will be refinanced in at least one year's time resulting in a 20-point gain plus cash interest. Since we already have a 0.7% NAV position in the equity, we are limiting our downside risk with the 1% SSN position. If Matalan fails to refinance, we calculate 30 points of downside in the SSNs and a write-off of our equity position, resulting in a 1% NAV loss.
- Our previous long positions in the SSNs, Priority Notes and Super Sr. Notes in late were sold in July at slightly higher prices than currently. Back then, our view turned negative following a revision in guidance and concerns over Q2 reflecting the poor weather in June. We felt the risks outweighed missing a few points on a pull-to-par trade. Given current prices are now lower, our decision was the correct one.
- We view our new positioning as purely tactical, reflecting the positive momentum in the sector and improvements in margins which should push Matalan's Q3 EBITDA to £35m, enabling it to meet FY24/25 guidance (£57-62m). This should result in at least 5 points of upside, and we will review our positioning thereafter.
Fundamental View:
- Matalan continue to occupy an undiminished position in the UK apparel retail landscape where it has neither grown nor shrunk in the last 20 years (but in real terms it has shrunk c. 60%). During the pandemic and following the exit of some retailers from the market, the company took market share, but has lost 40 bps of share in Q2 24/25 to 2.2% per Kantar. From an average £90m EBITDA since the cotton spike, the primary headwinds have been inflation, the cost-of-living crisis and supply disruptions despite £18m of freight surcharges due to the crisis in the Suez.
- Thus, its difficulties are more cyclical than secular, and margins, footfall and revenues are all showing signs of coming back in July through October.
- Although online pressures partially limit growth, UK value retail remains relatively insulated from its volatility.
- Our valuation analysis (DCF) below suggests that Matalan is worth c. £361m implying a 5x multiple, which is low for a traditional value retailer (NXT LN = 10x FY1), but it incorporates the distress and limited growth. The SSNs and Priority Notes are fully covered in this scenario.
Value Drivers:
- In theory, consistent underspending by customers could lead them to catch up once the cost-of-living crisis subsides and real disposable incomes lift. However, this is debatable as we have not observed many situations (past and present) of this occurring; usually lost revenue remains lost.
- Improved weather patterns and a successful sports season. For example, the weather in Q1 was very cold and wet and contributed to underperformance of its budget. Better weather in August and September has had the opposite effect.
- Labour's growth initiatives could spur growth and increase the incomes of Matalan's core customers while taming the cost-of-living crisis.
- Maintaining good buy-in prices in SS collection (as was done in AW) should preserve margins as footfall returns.
- With the sales levels Matalan have indicated, stock should not feature in any risks. If anything, a low stock overhang in Q4 is an opportunity (included in the positive Q4 guidance).
- Raising an RCF or other kind of WC financing would alleviate liquidity concerns, but only possible in our opinion when results improve measurably.
Risks:
- Key Risk: Consumer confidence and disposable income of the lowest earnings bracket, which can be disproportionately affected by economic gyrations (e.g. Brexit, inflation, higher interest rates, wage pressure, cost-of-living crisis).
- FX: While the US are implementing policies that should drive a strong dollar, the UK budget is leaning on Sterling. Despite typically hedging 70% of USD-tied COGS, Matalan should suffer FX headwinds in 2025.
- A return of supply disruptions could again cause spontaneous freight surcharges.
- A failure to properly manage inventory levels (especially into the critical Q3) could result in markdowns and reduced product margins.
- Liquidity: if business conditions do not continue to improve as we forecasted, Matalan may require fresh cash in the Spring.
Happy to discuss.
Glenn
T: +44 203 103 7965
www.sarria.co.uk