Frasers – Top of the class + Another double
December 2023 (£9.20)
We have always felt our job was quite a simple one. We are here to try and make our fund investors and research clients’ money – we were never here to win popularity contests. Our work on Frasers has been a good test case of this distinction. For many years we have highlighted the depressed profits at the company and the potentially huge recovery we thought was coming. Frasers’ move away from discounting and more recent improving relationships with brands signalled future margins would be higher than the past. (#where else are they going to go). Our idea really was that simple, but a lot got in the way of other investors’ understanding of this issue. Now the picture is clear; Frasers £3bn Sports division is the UK’s most profitable retailer.
David Einhorn, a few years back spoke to why there was extreme value in certain parts of the stock market:
“Companies can report stupendous news and have very, very minimal share-price reaction to it. It’s not that the stocks are hated; there’s nobody actually listening. There’s nobody on the call, there’s nobody performing analysis, there’s nobody recommending the stock. There’s nobody there to buy the stock.” David Einhorn, Greenlight Capital, Real Vision Interview Sept 2021
In a few companies we research this is our experience also. The result is some remarkable investment opportunities. The focus we have on our role (i.e. to try and make investors money) seems lost by many others. Shortcomings in ESG policies, lack of Cadbury code adherence, less than perfect share liquidity or more often just a preconceived dislike of the management by institutional investors. All have been reasons why Frasers and a few other companies have never been properly considered by investors. In most of the group meetings we have attended with the company, we are one of a very small number of people actually trying to analyse and better understand the business. Whilst that situation is improving a little now, it is doing so from a very low base.
Travelling and arriving
We have started to pen a separate piece that reflects on the timing of when to buy unloved proven compounders. Our enthusiasm for finding a new one spills over into an immediate thought to purchase the shares, when often a little time could be left to lapse (and watch events unfold) first. That was likely the case with our first piece on Frasers, shown below. Identifying value at a starting price of £4 (in 2016) vs today’s price of £9.20 is no crime. However lower prices and far more angst was to come before a successful turnaround could be claimed as underway. Each bump in the road was seen by others as supporting evidence as to why they were right to despise Mike Ashley and this company so much. For us it was different, each bump offered a chance to invest more ahead of the recovery we felt was sure to come.
“Bad news doesn’t travel well” Anthony Bolton
Fig.1: Our first Sports Direct research piece
Source: Holland Advisors, Sports Direct – Pile ‘em high….with a smile, March 2016
What we have discovered about recoveries in Owner Manager businesses is that they take time to emerge (See Holland Views: Sports Direct – Engine Overhaul, January 2018). This is not by chance. It is because the quick fixes that hired-hand CEO types look for are of no interest to Owner Managers. Indeed, if your holding period is forever what is the point of a quick fix? Sadly, the inverse is true. If incentivised by share options that kick in two years from now you want profits up, no-matter how unsustainable that outcome might be. Real business reinvention takes time. Dear Charlie Munger understood human incentives better than almost anyone else, yet even he admitted he often still underestimated their impact.
Many Sports Direct research pieces of ours followed our ‘Pile ‘em high with a smile’ note. All made the same point; Margins were depressed and would recover when the company came out the other side of its re-invention period (i.e. towards premiumisation and away from discounting).
Fig.2: Frasers/Sport Direct past Margins
Source: Holland Advisors: Frasers: He got you, didn’t he? Aug 2020 (Price: 350p)
We ask readers to look at the chart above which we have now shown numerous times. It shows the EBIT and gross margins Sport Direct achieved in its past. Having made 7-10% EBIT margin for a good period, they shrunk to c.4% for five long years. Now we would like you to compare the bars above to a figure of 16.2%. 16.2% is the EBIT margin level just reported by Frasers in its core UK sports division for the 6 months ending October 2023. (See extract from last week’s results in Appendix). I.e. this is directly comparable with the chart above. For years we have claimed in our research that a higher outcome margin would ultimately be achieved once efficiency returned and there was wider availability of third party branded stock in store… well here it is. Not only has it recovered it is 60% higher than before!
Top of the class
A few points on this margin level we think are worth making:
- Last week we asked if management saw this margin level as the future run rate margin of this division. The answer from both CEO and CFO was an empathic ‘yes’
- This margin was helped by more availability of third party brand inventory for full price sales. This is now the new normal. Indeed, there is more of this tailwind to come with other long-absent brands (e.g. North Face & Columbia) now re-joining the Sports Direct format. They follow the ringing public endorsements that the company has had from both Nike and Adidas.
- This 16.2% makes Sports Direct (SPD) the highest margin UK large scale retailer!
- Next online makes 15% and in store 11% EBIT margins. 60% of Next sales are online/40% in store.
- We don’t know the scale of Sports Direct online sales in its sports division, but it will be much less than Next’s 60%. Aka SPD’s in-store margins are excellent.
The scale of this profit number/% needs to be acknowledged and reflected upon, especially by Frasers/Mike Ashley sceptics. Not only for the extent of its recovery, but also its absolute level vs the company’s long-term past and peers. This 16% EBIT margin is being achieved on a huge business, with c.£3bn of annual turnover. We think this should be headline grabbing stuff. Sadly, this country’s financial journalists who write such headlines were only interested when they could write about a corporate pantomime villain (Mike Ashley). Their interest in the genuine recovery and impressive profit performance of a UK market leading company is sadly far less it seems. We make no complaints about these journalistic shortcomings; their short termism has created our opportunity.
Fig.3: We asked in 2019 if Frasers operational efficiency could be regained?
Source: SPD & JD Sports/Holland Views: Underearning, under values and unloved, Sept 19 (270p)
Travelling and arrived
Another chart we think worth a revisit is that shown above. The UK sports margin recovery has been a function of two drivers. The first is the recovery in gross margins to 44%. Whilst this looks like a recovery to past levels, it is actually better than that. Today there is c.2% of gross margin headwind from the Game business now being consolidated. Thus, the look through gross margin comparable to the past is more like 46%. To us this is unsurprising considering the reduced level of discounting vs SPD’s past. Also for reference JD Sport’s gross margins are c.48%.
However, there is second driver of SPD’s better EBIT margins. Where Sport Direct (SPD) always stood out over JD Sports to us was in its efficiency. This we show in Fig.2 above. What we were observing in the 2019 piece where this chart extract originates (when the stock was mere 270p!) was Frasers then elevated opex. Frasers was carrying a great deal of extra opex in the business during the 2016-2019 years compared to its super-efficient past. This was for a variety of reasons including sizable acquisitions and the equally sizable provisions that often were made whilst such deals were being digested.
Crucially this week’s interim figures showed that opex as a percentage of sales was back to 28% in the Sports division. Thus, the combination of higher achieved gross margin due to better third party brand stock availability and regained efficiency levels has driven the new much higher level of profitability (+ 60% vs past). Interestingly however the opex/sales at the whole group level (i.e. including Premium Lifestyle and overseas was at c.32%). This is an interesting insight we think into the wider group’s future potential profitability. Today these other divisions are only making EBIT margins of 4-5%. What holds them back is higher depreciation charges as investments have been made in them, or depressed level of gross margin (Premium Lifestyle). If more scale can be achieved in the international division and some improvement in Premium Lifestyle gross margins the group’s wider efficiency will result in a good portion of these increased sales/gross profits falling down to the bottom line. This is something Mr Market is definitely not expecting.
Owner Managers and pragmatic investing
We have always been aware of the mission creep that we could be accused of as the Frasers investment story has morphed from ‘Sport Margin recovery’ to ‘Premium Lifestyle growth story’. Indeed, our scepticism on Flannels and Frasers has existed for some time. That there is some logic in the consolidation of this sector (full price third party fashion) we can see. That it is a replay of Mike Ashley’s original playbook in buying up distressed sports brands/retailers is also notable. The economics of shared sites between various Fraser formats, that landlords are now almost giving away and its group wide distribution efficiencies are also pretty clear. So, there is much going in the group’s favour.
We will also be honest that Mike Murray (MM) is not Mike Ashley (MA). He is not the Owner Manager we originally invested in. As our approach is so Owner-Manager obsessed, this creates some complexity/doubt in our level of conviction from this point. We confess that we find ourselves often looking for where MM might be falling short. In almost every exchange we have with him we experience the opposite. Also, we are somewhat fearful of being too wedded to an investment/business that in truth has now fully recovered as we hoped it would.
The complete rebuild of the company’s relationship with Adidas and Nike was surprising, improbable and now complete. Both of these companies have declared Frasers as a global strategic partner. Both too have also publicly and emphatically endorsed what Mike Murray has done at Frasers.
Did this change in strategy need MA to agree to the pivot away from discounting in the first place? Yes (#where else are they going to go). But taking the idea that a discount business can be a trusted brand distributor and executing upon it was a huge challenge. MM and team should be commended for their achievement of this and thus should have earned some investor trust.
Pragmatism we think is the way forward. We think there is great momentum with sports brands now being attracted to Frasers. The potential for the business in a world of better in-store selection and more full price sales is likely only just beginning to be seen. The rollout potential in Europe and further east is also significant when brand partnerships and opex efficiency are considered. If Premium Lifestyle performs strongly alongside that rollout we will be delighted, but such success is not discounted at all in today’s share price. Whilst MM is committed to that vision, we think pragmatism will rule the day. I.e. significant amounts of future capital are unlikely to be committed to Premium Lifestyle from here unless there are more tangible signs of success. That MM is guided daily by MA aides our trust in this capital allocation conclusion. Frasers/MA haters might find that a strange point maybe; after all MA once described to us his asset allocation policy as:
“throw mud at the wall and see what sticks” Mike Ashley
‘Trying stuff and keeping what works’ is an innovation approach we love to see in our owner managers. What we don’t want is a consistency bias tied to some believed but flawed ideology that throws more good money after bad. Pleasingly we see little sign of that in Frasers under MM/MA and Chris Wootton’s watchful eye. Premium Lifestyle is a ‘bet’ yes, but one where the odds of success and decision or not to keep committing capital we think are considered pretty carefully by the team.
The messy business of business
The business of investment like life is sometimes messy. It does not glide its way neatly across a spreadsheet. The business of understanding owner managed companies is even more messy. Cleary it is easier if a proven owner manager stays at the head of a company and stays in their lane of proven past success. Indeed, that exact scenario is why we’ve been so attracted to Ryanair as it approaches its industry endgame. But in truth this is a rarity.
More often we find owner managers that retreat from public/investors view. Their time spent with institutional investors they come to despise. They re-invent their job description to one that allows them to do what they love. I.e. run or heavily influence their business and to do so surrounded by people they respect and trust. With an acceptance of that complexity, we remain reassured by MA’s behind the scenes role at Frasers and impressed by each interaction we have with MM. Whilst the textbooks suggest poor corporate governance or even nepotism, our real life experience with these people suggests something very very different. Their combined experience, energy, and passion for this business we like a great deal. Their ingrained DNA of looking for competitor weaknesses and consolidating fragmented markets we find greatly appealing.
If the boom in UK Sports Direct’s profitability is followed by anything that looks like success in either a European rollout or success of the Premium Lifestyle offering, we think many other investors will line up to sing MM praises. We welcome that prospect, but also enjoy very much the margin of safety the low valuation the share offers us while we wait to see if it unfolds. This is the pragmatism of which we speak.
‘Next’ read across. Cherry on the cake
The other area that we think interesting for Frasers is the new Finance division. Courtesy of the Studio retail purchase Frasers now has a fully operational consumer lending arm (which made £37m in the last 6 months) The speed of take up of this credit product in just a few months since launch is very interesting for us to see.
Fig.4: Percentage of online sales taking up finance offering
Source: Frasers investor presentation slides, December 2023
Whilst this 4-5% take-up across different facias is interesting, this is as a percentage of online transactions rather than all. If we assumed that 20% of group transactions are online for Frasers, this puts credit at 1% of total transactions. We note that Next’s finance arm turnover (a division that has been in place for c.30years) are c.5% of group’s sales. But these 5% of sales at Next drive a 18% profit contribution to the group, i.e. £170m of EBIT on £950m of credit sales. The scale of this division to Frasers is hard to know looking forward, but we sense it could make a strong contribution. An interesting reference point is that Next group has c.£5bn of annual sales, Fraser’s has almost exactly the same group sales at £5bn also (albeit with likely far less online).
Frasers shares have now trebled since their 2020 lows… What now?
As a trusted third party brand distributor, Frasers is now in a very strong position to consolidate the European sports retail market (again!). This is an interesting and arguably easily identifiable growth roadmap. Many a great rollout acquisition plan involved smaller less profitable players that can be consolidated for low prices into a bigger, more powerful parent. Frasers rollout potential in this regard actually looks much easier than many others who’ve been successful in other roll ups. This growth runway we are attracted to.
We must remind ourselves that the last time Frasers set about consolidating the European sports retail market it had the likes of Nike almost as a corporate enemy. Now it has their (and many other brands’) full support.
We are still being offered at great margin of safety in the valuation of the group today. Few investors we think have realised the now strong underlying profitability of the group’s sport retail business that we are discussing. This combined with rollout potential and a good share cancellation mentality has great appeal to us.
Napkin maths
Some simple napkin maths might be:
- £3bn UK Sports retail sales at 16% EBIT margin =£480m
- £1.3bn of International sales at 10% margin =£130m
- £1.1bn of Premium Lifestyle sales at 8% Ebit margin =£90m
- Finance PBT at 50% of Next’s level =£85m (run rate already £74m!)
EBIT/PBT = £785m
This is no forecast looking for future accuracy, it is just a guestimate of underlying earnings power. We have not calculated Debt/Interest etc. The group is very cash generative and also has equity stakes in other businesses roughly equal to its debt.
So, if £785m is what we think you might get, what do you have to pay for that? Today Frasers Market Cap (post buy backs and share cancelations) is £4.1bn. That is 5.2x EV/EBIT on £785m. The above EBIT’s by division assume no growth of sales in any division, nor any property profits. But they do assume that International and Premium Lifestyle EBIT margins double from their current levels. Were that not to occur our look through EBIT would be c.£110m lower. The EV/EBIT would still only be 6x (£4.1bn/£675m). This seems far too cheap for us.
We awarded Frasers, the “Top of the Class” award in our title. We did so for its record Sports Retail EBIT margin just reported, that is now higher than all other scale UK retailers. But how does this profit stream valuation compare to the Manchester City of retail – Next Plc. Helpfully Next also has £5bn of annual group sales (the same as Frasers). Next’s PBT is also comparable to our napkin number for Frasers above, having reported a PBT last year of £870m. Next also likes to buy back shares with excess capital, has a profitable finance division and like Frasers is pretty much unlevered. Arguably the only big difference between Frasers and Next is that of market valuation. For Next’s £5bn of turnover and c.£870m of PBT our friend Mr Market pays £10bn i.e. more than twice the price of Frasers. Um…?
The investment superpowers that control seemingly most of the globes non-index equity investing capital (i.e. franchise styled investors) will easily justify such a valuation difference due to the better “quality” of Next vs Frasers. To a point we agree. Indeed, we have always been happier to buy Next at prices way above those implied by our Frasers purchases. However, beauty is in the eye of the beholder. Frasers fresh revelation as to the whopping levels of profitability now being achieved in its core sports division just made that “quality” perception gap much harder to justify we suggest. Sustaining such profit margins and adding a little growth (International) and margin improvement (Premium Lifestyle) would likely see perceptions change we think.
“A lot of people think that quality has to do with low volatility, like highly predicable, but quality business are companies that are able to earn high returns on capital on a sustained basis. That’s it.” David Einhorn
Allocate + another double (or treble)
We ask the sharp eyed to compare the price and market cap figures at the top of this note with the ones shown in the March 2016 piece extract (Fig.1). Frasers share price is up 128% since that first piece (915p/401p). Frasers market cap by contrast is only up 69% (£4.05bn/£2.385bn). Right there is the difference between smart capital allocation and not. Any investor in Frasers today jumping forward another 5years and assuming an EV/EBIT of say 10-12x might assume to double their investment. Potential growth in the rollout of the business and ongoing astute capital allocation in buy backs will likely result in a far greater investor return than a mere 100% from a re-rating we suggest. Another treble…?
In Closing
Frasers remains to us a fascinating study of both entrepreneurism and re-invention. Its has broken many an established rule along the way. We think it also highlights many of the failings of institutional investing and governance. We are delighted to have seen the potential in this business when others would not. The insights into the business, and more importantly into the people that run it, we have gained along the way have been crucial. Today these insights give us an ongoing advantage over the ever-sceptical outsider investor. That, and an increasing and large margin of safety in its very low valuation give us plenty of reason to stay invested.
One day maybe growth will be more fully realised and the valuation more appropriate for the high ROIC, innovation and great capital allocation this company delivers. If it does, we will consider having a less positive view. We suspect that around that time other investors might consider the company ‘investable’… maybe they will even call it a “franchise”!! Until then we remain fans.
We bought right….we will sit tight.
With kind regards
Andrew Hollingworth
The Directors and employees of Holland Advisors may have a beneficial interest in some of the companies mentioned in this report via holdings in a fund that they also act as managers to.
Appendix
Source: Frasers Group FY24 Interim Results, December 2023
Disclaimer
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