Why are investors buying Nick Scali?

When Citi's sell-side team shared its most recent views on the UK expansion of Australian furniture retailer Nick Scali (ASX: NCK) two weeks ago, they sounded nervous but hopeful:

Their concerns are warranted given most major central banks have seen their interest rate cutting plans scuppered by higher-for-longer inflation and phenomenally resilient labour markets. Furthermore, higher-for-longer interest rates have been leaving a significant impact on Australian consumers. Even if the RBA is likely to cut in February, we won't see that corporate impact for quite some time. 

So, it should be little surprise that Nick Scali has reported the following:

• A 2% fall in H1 ANZ revenues, with written sales orders down 8.5% in January
• UK revenues at $28.6 million, but still making a loss
• Gross margins down 120bps to 64.4%
• Group NPAT down 30.2% to $30 million - Note: This figure was above its own guidance
• Interim dividend down by five cents to 30 cents/share

With numbers like these, is it time to sell the stock? Or, like Citi, do you hold on and hope the UK expansion and the consumer rebound both exceed expectations? Shareholders, so far, have voted for the latter. But to get the fund manager's take, we spoke to Will Mumford of Auscap Asset Management.

Nick Scali's 1-year share price performance

What was the key takeaway from this result?

The financial result itself was fairly noisy, but the key thing that matters for the stock is whether the team can capture the UK opportunity as it replaces the Fabb Furniture inventory in the UK with Nick Scali product and begins its branding campaign - It’s early days here but so far, the signs are encouraging.

Were there any surprises in this result that you think investors need to be aware of?

January sales were down 8.5%, which was weaker than the market expected. But we think there is a lot of volatility in foot traffic and retail sales numbers at the moment on a week by week basis, so after a strong November and December we wouldn’t read too much into it.

On the positive side, CEO Anthony Scali provided the market with a number of very promising data points about the UK, and historically his commentary has been very conservative. Fabb’s old 41% gross margin products are being replaced with Nick Scali sourced products which are already on track to achieve a 57-59% gross margin within twelve months, which we think has the potential to improve further longer term. The Nick Scali product appears to already be resonating with the UK market. Nick Scali’s top ANZ product is now the top selling Nick Scali UK product and despite management only completing the rebranding of 4 stores to Nick Scali by Boxing Day, 3 of these 4 stores were already the top 3 performing UK stores within the network for January.

Management have also reduced the UK cost base by $2 million per annum, with more cost and scale benefits to come. Anthony suggested that he is already looking at opportunities to grow his UK store network, suggesting that his confidence in the market is growing.

Would you buy, hold or sell Nick Scali off the back of this result?

Buy. Nick Scali is one of the highest quality businesses on the ASX with outstanding financial metrics, excellent store economics, opportunities for ongoing domestic growth, a strong balance sheet and a high performing founding family-led management team. It currently trades at a similar P/E multiple to other similarly high quality domestic retailers like JB Hi-Fi.

But this doesn’t fully capture Nick Scali’s UK opportunity, which has the potential to be transformational and is currently losing money and therefore detracting from short-term consensus earnings expectations. High quality ASX businesses with proven international success generally trade on higher multiples than Nick Scali’s current multiple.

There are also signs of improving macroeconomic conditions, with the Bank of England and the Reserve Bank of New Zealand having recently cut rates multiple times, the Reserve Bank of Australia expected to cut rates soon and REA Group yesterday pointing to signs that the headwinds to housing turnover are abating, with REA now expecting ongoing upside from here.

Are there any risks investors need to be aware of?

The key risk remains the UK expansion, and we’d emphasise that its not yet a forgone conclusion that this will be a success. Losses in the UK will likely accelerate in the second half. It could take multiple years before it’s possible to tell whether the UK operation is going to be a success. Further investment will be required, the Nick Scali brand needs to gain acceptance by the domestic population and the UK is currently experiencing a recession, so we still see risks of ongoing short-term volatility.

From 1 to 5, where 1 is cheap and 5 is expensive, how much value do you see in the ASX today?

Rating: 3.5

There are pockets of the market that appear extremely expensive. The domestic retail banks are in this category especially given their benign earnings outlook. The highly favoured growth stocks are also generally trading on elevated multiples. On the flipside there are clearly pockets of value, especially if we see interest rates decline over time. For example, some of the property assets, particularly in the retail space, look compelling value. Many blue chip healthcare companies are trading on their lowest price to earnings ratios in many years. There are also a number of high quality cyclical businesses trading on reasonable valuations despite earnings that could have upside in a lower interest rate environment.

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Auscap Ex-20 Australian Equities Fund

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Managed Fund

Auscap High Conviction Australian Equities Fund

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