McColl’s Retail (LON:MCLS) Warns on FY Profit: Share Price Falls 25%

By | 3rd December 2018

Convenience store operator McColl’s (LON:MCLS) today pushed out a profit warning in it’s Q4 trading update. Whilst net debts are lower, adjusted EBITDA is too for this year. The share price lost an almost immediate 25% this morning, but arguably, the markets have seen this one coming a mile off. Taking a look at the bigger picture, the share price has lost half its value in less than half a year; an incredibly fast decline:

It is fair to say that McColl’s are well-established, operating convenience stores under a variety of different brand names. These stores fit inside quite a niche market, serving areas where more than a newsagent is demanded, but also is too small to fit a supermarket. ‘The neighbourhoods favourite shop’, as it likes to promote itself. Things have been changing in this sphere in the past few years, with the bigger supermarkets opening their own McColl-sized shops.

However, McColl’s have hit back. In 2017 they acquired 298 former Co-Op sites, which is a significant purchase considering their store estate is around 1,600 stores, and increases their average size. Geographically the company operates UK-wide, with a presence in every area. With the convenience sector of the grocery market outgrowing all others, this should be a great place to be.

The Warning

These can be seen in the highlights of the trading statement, which presents a real mixed bag:

Financial and operational highlights:

Total revenue down (0.5)% in Q4; up 8.3% for the full-year reflecting the annualisation of the 2017 acquisition
Total like-for-like (LFL)1 sales flat at 0.0% in Q4, an improvement on Q3 supported by a strong performance in tobacco; with full-year LFL sales down (1.4)%
59 convenience store refreshes completed in the year, delivering average sales uplifts above 5%
11 new convenience stores acquired in 2018
Continuation of estate optimisation programme with 66 under-performing newsagents and smaller convenience stores removed in the year
Further sale and leaseback transactions completed in Q4 generating full-year cash proceeds of £25m and significant profits on disposal
Year-end net debt materially lower than expected at around £100m
In light of transitional challenges and continued difficult trading conditions, adjusted EBITDA for FY18 now expected to be around £35m

The last line perhaps was of biggest concern. Adjusted EBITDA in FY2017 was £44m, so factoring in a full year increase of revenues there must be other adverse impacts which have affected profit.

Later in the statement, a single sentence also indicates this might be a far-reaching profit warning:

As a result we now expect adjusted EBITDA for FY19 to be no more than a modest improvement on FY18.

The Business

Judging by the share price, McColl’s is a business on the slide, and it is not difficult to see why: alongside the competitive pressures from the big retailers downsizing, operations-wise they have had plenty of problems this year with one of their main wholesalers going bust. Whilst they have now acquired new ones, it remains to be seen if the new terms are better than the old ones.

On top of this, other macro factors such as Brexit and increased wage costs are likely to provide further headwinds. In this context, flat like-for-like sales means the company is actually moving backwards. Perhaps this is understandable as the core range of brands are very small shops, typically selling a small range of goods. Acquiring the Co-op stores unlocks potential for increased average basket sizes and hence profits.

One of the issues was that acquisition of the Co-op was funded by debt. The final payout of £117m might end up being quite a good deal, but this adds risk to investment in the company. Debt levels are higher than the market cap at the moment, and decreased profits lead to a smaller safety margin. An excerpt from the 2017 accounts reads: 

Finance costs total £6,721m. This seems a tad high, and as we can see from the update, something was done about it:

Further sale and leaseback transactions completed in Q4 generating full-year cash proceeds of £25m and significant profits on disposal
Year-end net debt materially lower than expected at around £100m

This is payback at quite some rate, as earlier this year the figure was £142m. A sale and leaseback obviously increases expenses in some way (as rent has to be paid where it previously wasn’t), but it is also likely that McColls were sitting on some very old sites which had enjoyed massive unrealised capital gains.

The balance sheet is very weak, with a large amount of intangibles relative to tangible assets, and negative tangible asset value. However, for a supermarket, this is par for the course. Typically not paying for their goods until after they have been sold, they can afford to sail a little closer to the wind. With its borrowings having an accordion to £150m, it does not seem likely that there will be any threats in the short-term.

Comment

What was an already cheap share has just got even cheaper: the market cap of McColl’s is now under £100m which gives quite a low forward valuation multiple of between 5 and 6. That being said, it is perhaps deserving of such a multiple, as companies like these have little pricing power with the supermarkets making bigger and bigger inroads. Margins are about the lowest you can get – for it’s £1bn+ turnover, profits before tax are around £18m – a lot of work for not much money.

One of the main attractions to the share is the dividend: McColl’s have paid this every year since IPO and it now stands at 10.3p. If this were to be maintained, the yield would be in the double digits. But this dividend was only barely covered by profits the last time out, and with the business still in transformation, the market seems to be doubting whether this would be sustainable.

I don’t like the sector particularly but I do feel that McColl’s can turn it around, although it may be a long time in coming. Suspending the dividend and increasing the sale and leaseback programme would be two obvious actions to reduce debts significantly, but the bigger issue will be the integration of the Co-Op stores and pruning of the existing store estate. The price certainly is cheap, but with the trading statement promising challenging conditions I can’t be sure if worse is still to follow. 3/5.

Leave a Reply

Your email address will not be published. Required fields are marked *