Studio Retail Shares Dive 20% On Worsening Outlook

Studio Retail Profit Warning: Shares in online retailer Studio Retail (LON:STU) went down by a quarter in earlier trade today as the half-year report outlook gave investors the jitters. The Liverpool-based company, whose shares eclipsed 300p earlier in the year has given up all those gains and more:

Notably the shares are not quite back to the pandemic lows of c.150p. However they are not really far off it. As we can also see from the bigger picture, the price has bounced off the 150p region a couple of times. The share has traded in a relatively narrow band as there only has been a very small amount of share dilution.

This warning comes fast on the back of semi-competitor AO World which warned yesterday and similarly cut profit outlooks. The supply chain is something that seems to be affecting all retail companies, particularly those who have a heavy reliance on the Far East. Bullish comments earlier in the year about being able to weather disruption have seem to unwound for a lot of these companies.

Studio are not exactly the same as AO, and probably are more akin to N Brown (who also warned on profits some time ago). They sell a wide range of electronic goods but also clothes and home furnishing products.

What did the Studio Retail profit warning say?

Studio’s warning comes in the half-year report published today. Their half year runs to 24 September 2021 so in the light of AO’s comments these figures are not so meaningful as they had a lot of good news baked in. People had furlough money and reduced expenses due to things such as reduced commuting and holiday costs. Unsurprisingly 2021 (and 2020) were years of exceptional growth.

In fact the first part contains much good news. Debts have been reduced with the sale of their underperforming Findel division for what looks like a really good price of £30m. The bad stuff comes in the outlook:

Studio is not immune to the well-publicised market headwinds and has had to manage challenges in product shipping which has driven up costs in this area. This will lead to selling price inflation going forward, although we have competitive monitoring tools to ensure we retain our value position. In addition, we have faced some product availability issues as deliveries were delayed, but we took a proactive decision to secure stock early aided by our Shanghai based sourcing office, meaning that as we went into peak season, we had higher levels of stock than last year and have good tracking in place on all remaining deliveries due in the next couple of weeks.

This appears the same as the trading update in October, although no mentions of the contracted shipping they had.

Again, as with the wider market, we have seen lower availability of staff to fulfil temporary roles in our operations. However, by putting in place peak season pay enhancements, we are now at a point that we can cater with the demand forecast through December, so customer orders are despatched in readiness for Christmas. As we go into FY23 we are anticipating wage increases due to inflation and increases to national living wage.

Again this seems quite a similar problem which many are facing. At the minimum wage end of the jobs market a lot of companies are competing against each other for jobs. This inflation is a double-edged sword, as it increases wage costs as well as impedes on customers spending ability. This effect is quantified as such:

We will give a further update on this key trading period at the end of January but our current expectation for the full-year outturn of Adjusted PBT is now in a range of £35-40m (previously £42-45m). Despite these short-term headwinds, many of which are impacting the wider market, our strategy for growth remains intact and we maintain our £1bn revenue goal in the medium term.

With the end of their year in March this forecast is interesting: the half-year results show that £23.7m of this profit is already in the bag. So it appears that despite Q3+Q4 being the busy periods in terms of revenue, profitability is not so good.

Studio Retail: The Business

Studio have a long history dating back to the 1960s. Initially they were involved in the greeting card and giftwrap business. Later, they were a very diversified catalogue mail order retail group under the name of Findel. Many small acquisitions and divestments have taken place over the years, the most recent of which was its educational supplies business. With the arrival of the internet, physical catalogues have fallen by the wayside.

The business model here is similar to N Brown. They sell products at cheap prices and seek to make money by providing credit services to customers. Doing this can be fairly lucrative as the interest rates charged can be high. Interest accounts provided almost a quarter of revenues in 2021: £116m. The flipside of doing this is that generally people who need such credit products for items are not the most well-off. Thus the default rate on these loans will be much higher.

Much like AO World, business has been terrific in the past couple of years. There is a good track record. Also like AO the beneficiaries were management, who hit their targets and got their bonuses as a result:

The large loss relates to impairments. Their medium-term goal is for sales to reach £1bn. This looks quite optimistic unless there are acquisitions. Despite the profits there are no dividends being paid.

One unique aspect of these types of companies is that they contain very high receivables and very high debts to provide the financing. So while there is a large debt pile here (in excess of the market cap) this is not as serious as much of that is money owed by customers, most of whom will repay. In fact Studio quote ‘core’ debt. This is debts less things like the loans and leases and this comes out to c.£20m.

The average interest rate Studio pay to borrow money is 2.53%. With close to £300m borrowed,  any variation in this interest rate has an effect on the finance cost. This has dropped in the past year, although further drops look unlikely now. This compares to the interest rate which customers pay.  This is an average of 3.5% per month (and they take an average of 203 days to pay).

It is on this part of the business where the greatest risk arises, as there has to be some provision made for the fact that people won’t pay. In 2021 there was an impairment charge of £55m on gross receivables of £385m. However this charge is very sensitive to inputs. For instance a 1% change in the default rate would add £2.9m to the impairment charge, however a 1% increase in the recovery rate would lead to £1.2m being taken away. These two aspects could potentially move around by quite a lot in these uncertain times.

Is the Studio Retail profit warning a buying opportunity?

Studio is a business that comes with a lot of risks. There is the macroeconomic risk, in which real incomes decline. That produces a reduction of sales but also an increase in defaults – a double whammy. Additionally there is also execution risk; things can ride on the ability of the staff. In good times and to chase revenue targets customers may not be vetted properly at all. This gives the revenues a boost only to be cut down later when their debt turns out to be bad. However, it appears that Studio have invested into this side of the business. This allows a variation of interest rates depending on who the customer is.

Another factor may be regulation. It goes without saying that charging 30%+ interest rates a year to those who can least afford it is not a great look. Those who make only the minimum payment may end up paying a great deal. This sort of thing could easily go the way of payday lenders and be restricted, and have good political support. A cap might make Studio unviable in that it would not necessarily reduce the amount of defaults.

Like AO World, Studio will not be immune from rising wage costs. They are also a large employer (almost 2,000 people). Many of these will be lower-paid warehouse/admin staff. Thus wage rises are likely to be seen on their £70m wage bill.

However unlike AO World, there are quite a few reasons to like Studio. It is profitable, albeit much of its cashflows have disappeared into high capital expenditures and funding pensions (even though there is an accounting surplus). This in part explains why there have been no dividends. Effectively, the company would have to borrow more to fund it. Instead of expanding to other regions where it is unknown whether it will be a success, Studio have stuck to what they know best.

Most of all, the share price has never gotten to the excesses that AO World did. Not much growth was ever priced in, and much of this years earnings has already been earned. Considering that AO’s market cap is over 3 times what Studio’s is, I don’t think this is overvalued. In fact on many metrics it is pretty cheap.

Not cheap enough for me to buy just yet. However I would be interested in the 150p region – which isn’t that far away. 3/5.

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