Alex Shevelev

The housing market has taken a nosedive this year. And furniture retailer Nick Scali (NCK), our short pick for Livewire last December is feeling the heat. The stock price is down about 20%. But the company is still to see the worst of the housing market pain. So here’s why it’s still a short...

(Keeping in mind Forager doesn’t actually short).

When FOMO runs out

So far this year home prices are down 6%, with Sydney falling 8.2% and Melbourne off 6.6%. Credit access has been cut. A fresh supply of apartments has hit the market. And FOMO (fear of missing out) is quickly turning into FOGI (fear of getting in). So what happens when the buyers of Nick Scali’s $5,000 leather lounges see the value of their homes drop sharply? They will buy fewer leather lounges.

We are already seeing this ‘wealth effect’ elsewhere. New car sales were down 7.4% last month and 6.1% over the last three months. And the share prices of car dealers have been savaged this year. Automotive Holdings (AHG), Autosports (ASG) and AP Eagers (APE) are, on average, down over 40%. Sure, buying a car is a bigger financial commitment than a leather lounge. But consumers will think twice about both as the purse strings tighten.

Same-store sales growth is key

At the recent annual general meeting Nick Scali management were not forecasting a great year. While total sales were up 12% in the first quarter (six new stores were opened last financial year), sales from established stores were up only 2%. Unsurprisingly, management pointed out that “same store sales growth will be challenging in this volatile trading environment”. Read that as established store sales that are flat or falling (gasp!).

And the sugar hit from new stores won’t last forever. Nick Scali has plans for another six new stores in the current year. But if established store sales start falling then the company is going to think twice about opening new stores. And that sales kicker investors expect from new stores will evaporate.

More headwinds

Sales are important, but they are not the only potential source of pain. In retailing rent and staff costs don’t rise much as sales improve. Unfortunately, it’s the same on the way down. In just six years of sales growth Nick Scali improved net profit margins from 8.2% to 16.3%. This stellar increase will be very painful when it reverses.

And profits aren’t going to be helped by a weaker Australian dollar. The company’s lounges are imported into Australia and paid for mostly in US dollars, so now the company will need more Australian dollars to buy the same lounge from overseas suppliers. For Nick Scali to maintain their gross margins this increase will need to be passed onto customers. But as the company pointed out: “market forces generally take time to make the price adjustments in line with a lower dollar”. Those ‘adjustments’ (code for price increases) are easier to make when customers aren’t already feeling poorer.

For those counting, that’s a triple whammy for profits: lower sales, lower gross margins, and higher staff and rent costs (as a percentage of sales).

Does the price compensate for the risks?

What about the valuation? At the moment Nick Scali is trading at a reasonable-looking ten times forecast net profits. Cheap, right?

Not really. Not if the profit triple whammy hits Nick Scali over the next few years. If net profit halves (it was $9m in 2012 and $41m in 2018) ten times earnings would become 20 times earnings pretty quickly. And, as always, it could well be worse.

The housing meltdown is accelerating and Nick Scali is caught in the middle. It’s been a great multi-year run for shareholders. But the party is coming to an end.

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Comments

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Nick Marlin

I would argue that Nick Scali has a few things to suggest it might not be in such bad shape. Crystal ball stuff about what is or could happen however the facts are from last reporting date Nick Scali same store sales and total sales were growing, which is a far cry than the examples of car AHG, ASG, and APE. All these companies carry huge debt loads by comparison to Nick Scali and those companies dont have as healthy margins to play with like Nick Scali has. Finally the Chairman and another director are buying reasonable sums of shares now in Nick Scali compared to directors that are buying AHG after announcing a a lot of bad news and a now roughly 60% share drop. My biggest question would be Anthony Scali selling half his holdings.

eric wells

Well, I have agreed with Alex, selling our holding a few days ago. Whilst Nick has good points, my own views accord more with Alex. Not the least because of the gloom and doom being propounded around by the dismal science. Eric Wells

Wayne Jones

Hi Alex, I don’t think anyone would disagree that retail stocks are under a lot of pressure, especially same store sales growth. But I doubt the Nick Scali store rollout will depend upon same store sales growth. They have one of the smalles footprints in the country with only 51 stores and plenty of Balance Sheet strength to grow from here. Five years ago it was 33 stores. You also have to recognise that rent as a percentage of sales have been falling as they invest in property. They now own $77m of property on equity of $84m versus $15m of property against $36m equity from five years ago. Hence property costs in the P&L have increased less than 40% over 5 years while revenue has doubled. So revenue per store has really improved over past 5 years and they are about to move into bedding in January in 28 of their stores. So I would be looking at other retailers to do it tougher over the medium to long term than these guys. Full Disclosure: we own Nick Scali.

Alex Shevelev

Hi Nick and Wayne - fair points. Just highlighting Wayne's good point on property costs. The $62m of extra land and buildings should (at say a 6% cap rate) be about $3m of pre tax net rent savings ($3.7m less an extra $0.7m of depreciation). After tax that is $2.1m, good for an extra 0.8% of net margin benefit through owning the property. Of course keeping in mind that it ties up capital. I'd still be on the side of the new store rollout being curtailed/cut if same store sales falter.