Is this the best ‘buy’ on the ASX?

This far into a market cycle, it’s hard to speak to investors without hearing complaints about the lack of cheap, high-quality stocks available.

But what if I told you there was a stock that’s run by the founding family, and consistently produces a return on equity of around 50%? Add to this a record order book, industry tailwinds, and the fact that earnings are up 66% compared to pre-COVID, and you might be asking yourself why it only trades on a PE of ~15?

Well, you wouldn’t be the only one pondering such a question.

As part of Livewire’s reporting season coverage, I spoke with Tim Carleton, Principal and Portfolio Manager at Auscap Asset Management. Read the interview below to find out which stock he described as “one of, if not the best buy in the market.”

What were the key takeaways from the result?

From our perspective, the Nick Scali result was exceptional and we're a little bit surprised by the muted reaction. They delivered underlying profit after tax of $35.6 million.

To put that in some sort of frame of reference for you, in FY20 their full-year profit was $42.1 million, the same as their pre-pandemic record FY19 result. So at $35.6 million they've delivered in a half not far off what they were delivering as record full-year results only a couple years ago.

Have a think about the operating conditions for the half: In Sydney, Melbourne and Adelaide, you had lockdowns for at least the first quarter, in fact stretching into four to five months for Melbourne and Sydney. So at various points, they had up to 55% of their network shut. And the vast majority of sales get done in store, with online a relatively small portion of their business. 

Online delivered about $13.7 million of revenue in the half just gone and that's out of a total of $180 million. So relatively modest. And on top of that, Vietnam, the source of a significant amount of product, was in hard lockdown for 3 months, unable to supply them with meaningful stock. And they only recognise revenue on delivery of the goods so this really impacts the profit generated. 

Then think about the really outstanding feature of their report, and that is January trading. Anyone that has visited a shopping centre in the last month or so has realised that foot traffic is way down. Nick Scali reported that their foot traffic was down 25%. And keep in mind people have been stuck in their homes now for a long time, so it's not like this is the first time that they get out of lockdown and they suddenly want to go and buy a couch.

January '21 was the best January that any of these furniture retailers have ever seen. So they are cycling the biggest January of all time with Omicron active and having a massive impact on foot traffic. And yet they report that sales in the Nick Scali brand were only down 6% and for Plush down only 0.7%. From our perspective that is an incredible result. And they pointed to a real acceleration in sales at the end of January, as people started to get comfortable with the risks Omicron presented for them individually.

How did the market react to the results?

We thought the result was very, very strong and we're quite surprised at the coverage of it. But if we turn to the future and think about what's ahead, in the absence of another exogenous shock or further waves of COVID, we would expect that they have a materially stronger half. So it's our expectation that the second half, or the current half we're in, will be a record half for the business.

Why is that? Well, they have a record order book. The order book just for Nick Scali, at the 31st of December, was up 20% on the year before, which was also a record order book. Add to that the fact that they bought Plush, which they only took ownership of on the 1st of November. So they saw very little sales and profit in that first half from Plush. They're going to get a full six months’ contribution from this acquired business which also has a significant order book, and both Nick Scali and Plush have had a very good January, despite it being down slightly on the year before. And January is the most important month of the year for furniture retailers.

Were there any major surprises in the result that you think investors should be aware of?

Yes. There were two surprises. One is how they have managed that level of disruption in the half. Both on the consumer side, where they had at different points in time 55% of their networks shut, for a business that does most of its sales in person in store. And then on the supplier side, where they had one of the major sources of supply, Vietnam, in hard lockdown for three out of six months.

And yet they have still produced a result in a half that's not far off what was a record full-year result only two years ago.

The second thing was that the orders for January were down only 6% and 0.7% for the Nick Scali and Plush brands respectively. This was reported negatively by the media but to us this is an outstanding result in the face of Omicron and its obvious impact on foot traffic in January. The November and December sales for Plush, for the first two months that they had owned that business, were up 15% on the prior year. So there was some moderation to basically flat in January, but flat in January on what would have been a record January the year before is a really great outcome for a business they have just bought.

What are your expectations and outlook for this company and its industry?

The Australian household sector is in a phenomenal position. The Treasurer recently outlined it, $424 billion saved across the last two years by households and small businesses. That is four to five times the level of savings that would normally be expected.

This is not like past periods of stimulus, where the stimulus goes into the economy and then you've got to cycle it the following year. The stimulus was handed out, but people actually saved it. Not only did they save the stimulus, but they saved a lot more because they were restricted from spending in a whole lot of areas.

Obviously, as borders reopen and tourism becomes easier to pursue, we expect to see some of the consumer discretionary dollars directed towards tourism. But the goods outlook remains very strong in the face of the fact that consumers are in such a good position.

I think people are underestimating the durability of demand in a lot of these categories because households are cashed up. And if that gets unwound over 5 to 10 years, it's pretty long-term support for discretionary expenditure.

In the half coming, we expect a very strong performance. And then in the following year we should see the benefit of the synergies that emerge out of the Plush acquisition because they have fifty to one hundred little things they're working on to increase the EBIT margin in that Plush business, keeping in mind that the Plush margins were less than half of the Nick Scali margins when they bought the business.

And they very quickly identified the ways that they can extract more. At the moment the combined group has 108 stores, they're going to move towards 180 over time so that's a pretty material uplift in the store network. They're growing online very quickly. And unlike a lot of operators, their online business is extremely profitable.

Since Nick Scali listed, it's been net cash at the end of every single year. And at the end of this financial year, given the cash they're going to generate this half, we suspect they might well be close to being in a net cash position again. This is even with the Plush acquisition, which they paid for using cash and debt. If this turns out to be the case it’s a pretty extraordinary situation given they've just made a material acquisition.

If you think about the medium-term picture for this business, this is one of the highest quality retailers in the market. To give you an idea, it has a 10-year average return on equity of a little over 50%. I don't know a single other ASX-listed company that has those metrics.

Is it a buy, hold or sell?

I think Nick Scali is one of the best, if not the best buy in the market. You have one of the best management teams going around doing a lot of exciting things, with a CEO that's extremely invigorated and in the process of making it a much bigger business, trading on a multiple that's way below the broader market. That's a very compelling proposition from our perspective.

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