Nick Scali FY23 Results: Onwards and upwards despite consumer volatility

There are a handful of retailers in Australia that we can class in terms of quality as superior, if not unsurpassable. Those retailers include JB Hi-Fi, ARB and Reece Plumbing. Another is Furniture giant Nick Scali (ASX: NCK). The company unveiled its financial results for FY23, Friday, demonstrating praiseworthy resilience and adaptability despite the uncertain market conditions.

It's worth noting the company is temporarily benefitting from a sharp drop in freight on items it has already pre-sold, allowing it to bank solid margins, while the economic slowdown in China is prompting suppliers to offer discounts.

NCK reported a sales revenue of $508 million in FY23, reflecting a 57 per cent increase, with a gross profit margin of 63.5 per cent. The earnings before interest and tax (EBIT) and net profit after tax (NPAT) were $154 million and $101 million, respectively, surpassing consensus estimates.

NCK's recent results reflect the company’s quality and its market position. At the same time, Friday’s share price surge indicates both a flight to quality and an underestimation of the benefits of the company’s strength in a slowing consumer environment.

While fluctuations in monthly trading are evident, June and July proved particularly promising, with increased foot traffic suggesting either consumer confidence or a company winning market share. As mentioned a moment ago, it’s worth noting that gross margins are expected to remain elevated into FY24, benefiting from reduced shipping costs and Chinese supplier promotional activity.

Although May presented challenges due to rising interest rates, both June and July witnessed significant improvements, possibly driven by reduced marketing from competitors. Notably, despite both Nick Scali and Plush reporting negative order momentum in July, the Nick Scali brand is rebounding strongly when viewed against pre-COVID levels of activity.

2H23 showcased a substantial improvement in group gross margins, rising from 62.0 per cent in 1H23 to an impressive 65.4 per cent. and the aforementioned decline in shipping costs.

It is worth noting shipping expenses have declined since March, but Nick Scali has not reported discounting in July, setting up a promising start for margins in the first half of FY24. If the margin improvement – the result of stronger buying conditions or buying power – is taken by analysts as structural, it is likely analysts will upgrade their earnings estimates for FY24, FY25 and even FY26.

Remember, when it comes to truly high-quality companies, the market tends to overestimate the short term but underestimate the long term, which frequently provides opportunities for patient investors. Investors should not forget this company’s balance sheet strength reflected in its property portfolio – it owns about $105 million of land and buildings at cost (less depreciation) – nor its zero net debt.

Analysts will continue to quibble over the company’s trajectory but its robust business model and reputation for quality will win it market share, leveraged by further store openings. Meanwhile, the strategic acquisition of plush provides exposure to the other end of a bifurcated furniture market, while also providing buying power, operational synergies, and another store rollout story.

Despite the inherent challenges and volatilities of the retail market, which will inevitably pressure the share price from time to time, Nick Scali has again proven it deserves its high-quality status. A retailing legend backs its management team and is undertaking a measured and disciplined approach to its operations and strategy.

Back in May with the share price at $8.80, I wrote about Nick Scali; "Over the long run, a well-managed (cost-outs?) quality company, one that leads its peers and progresses along its growth runway, will reward investors. Of course, the returns will be inversely related to the price paid. Investors, therefore, should now be calculating a conservative estimate for intrinsic value and assessing whether the share price represents value or waiting until it does.

Assuming a long-term return on equity (ROE) of 30 per cent, a payout ratio of 70 per cent, a required return of nine per cent, a constant 81 million shares on issue and FY24 beginning equity of $207 million, we estimate Nick Scali’s intrinsic value at $9.29."

And remember the share price at the time was $8.80.

The share price has since rallied 40 per cent against a market that is up just 1.8 per cent. While future share price performance cannot be guaranteed, the future appears bright for the brand and the business.

Valuation:

Assuming a discount rate of 9.0 per cent, a sustainable return on equity of 30 per cent (it was materially higher last year) and an ongoing payout ratio of 70 per cent, the estimated intrinsic value of Nick Scali is close to $11, about eight per cent below the current share price of $11.98. We cannot guarantee what happens to the share price in the short term, and there are sufficient uncertainties about the state of the economy to warrant caution, however, the quality of the company remains high and the current estimate of intrinsic value is not far away.