Stockwatch: a bet on recovery as crisis could transform sales

Should you follow the chairman and buy this increasingly popular retailer as a hedge for troubled times?

Should you follow the chairman and buy this increasingly popular retailer as a hedge for troubled times?

A vigorous stock market rebound affirmed my 24 March comment about how a slowing in the rate of new infections of Covid-19 would be the crux for sentiment, rather than fatalities.

The story driving expectations is moving toward how lockdowns can be lifted. Desperate for good news, markets have latched onto Italy and Spain consistently improving, and also New York showing a sharp fall in those “newly hospitalised” (versus apocalyptic fears barely a week ago) despite Singapore and South Korea experiencing new cases as they test ways out of lockdown.

Bulls versus bears among investment bank strategists

Big beasts are divided. Yesterday, Morgan Stanley, a staunch bear for the last couple years, turned bullish on a 6-12 month view, arguing “Bear markets end with recessions” and trawling up the adage: “Never let a good crisis go to waste”.

Its key strategist pushes an inflationary case for risk assets (as have I) and the time to buy is already here after a forced liquidation in the past month. Technically, within only a few weeks, a 20% fall - defining a bear market - has led to a 20% rise, heralding a return of the bull.

Yet JP Morgan counsels against buying all but defensive stocks, on the basis that past recessions show it takes stocks at least 18 months on average to reach a final low.

“Trying to buy simply based on technically oversold levels and admittedly larger by the day policy support might be missing the elephant in the room – the first consumer and labour market down-cycle in 11 years.”  

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A recessionary feedback loop is likely also the risk that renewed economic activity sparks fresh Covid-19 infections. JPM’s kudos is based on having been bullish on equities for the last decade, turning firmly bearish last month.

A compromise would be drip-feeding cash into stocks while ensuring reserves also defensive plays.  I’ve argued that the case for food retailers rests on the duration of “lockdown”, and the last few days have signalled a revelation for those smaller/local operators.

Smaller local grocers enjoy revolutionary footfall

Most people are experiencing lengthy queues outside supermarkets, for half an hour or more, now that numbers inside are limited. Research has emerged showing smaller grocery shops such as Co-op and McColl’s (LSE:MCLS) enjoying a surge in revenues – partly for topping up on essentials, and as some people leave supermarkets alone.

Supermarket panic-buying peaked three weeks ago, with transactions up 15%, then returned to normal around 21 March. I’m surprised at that given the extent of meals now requiring substitution at home, though if borne out it does undermine big food retailing stocks as defensive.

The choice of smaller listed equities like these is scant however, it essentially boiling down to McColl’s Retail, a low-margin and highly leveraged turnaround play, off-limit to disciplined investors but which now offers speculative intrigue should the Covid-19 episode sustainably help transform its revenues.

This could tilt the risk/reward profile on its shares positively after becoming seen as mere option money: down below 15p on 16 March versus 295p just over a couple of years ago.  

Source: TradingView Past performance is not a guide to future performance

Despite risks, the chairman buys £18,750 of equity

At 36p currently, the market cap is around £40 million versus annual revenue of over £1.2 billion, but there’s also net debt of £94 million. Yet the chairman buying 75,000 shares at 25p on 25 March exemplifies a case for upside. Market cap is only just above £37 million of balance sheet cash, outweighed by debt, albeit which provides some margin of safety and should help McColl’s improve its estate.

A key question is, can the Covid-19 crisis help transform McColl’s trading fundamentally better versus the bigger supermarkets? The group owns over 1,400 McColl’s convenience stores and Martin’s newsagents, and is also the largest operator of Post Offices in the UK.

Troubles accumulated however after acquiring 298 shops in 2016, integrating them in 2017, then to experience supply chain disruption in 2018 – hence a whopping £98.6 million goodwill impairment charge that smashed “headline” figures.  

It looked somewhat like a “kitchen sinking” exercise as various projections were de-based and which linked to the cost base, including a rise in the National Living Wage.

Yet the chairman proclaimed last 26 February with the 2019 results, “a strong platform for future growth.”

Source: TradingView Past performance is not a guide to future performance

Partnership with Morrisons is a second catalyst

Speculative interest in McColl’s had previously related to a trial arrangement with Morrison (LSE:MRW), effectively towards a rival chain of decently-stocked smaller grocers, as an alternative to Sainsbury's (LSE:SBRY) Local or Tesco (LSE:TSCO) Express. This is small beginnings, however: Morrison said in January that the first 10 Morrisons Daily stores had shown ambivalently “strong” sales with the trial being extended to another 20 or so imminently. But the timing is fortuitous, and also bridges the marketing gap where small grocers can be seen as offering a much narrower range with fewer fresh items, all at higher prices.  

McColl’s medium-term aim is an estate of some 1,100 stores, larger than they have been in recent years, hence better choice. In the last financial year to 24 November, 23 stores underwent “refreshes”, only 10 new related to Morrisons, and 120 were closed or sold.

Between 400 and 500 still require updating, meaning costs as well as benefits.

The last two years’ cashflow statements show acquisitions of property, plant, equipment etc in the high-teen millions of pounds, albeit more than offset in 2018 by business sales proceeds. So, an estate currently of over 1,400 outlets implies investment needs should at least be mitigated by continued disposals.

Adjusting for non-cash items impacting profit, 2019 gross cashflow from operations rose 23% to £26 million, although after working capital movements it fell from £66.7 million to £21.2 million. Strong “cash generation” in 2018 was, however, boosted by a £48 million rise in trade payables.

Marketing opportunities may (more than) offset financial risks

McColl’s reckons over half its customers live within just 400 metres of its stores – a big plus for people to buy what they need, especially elderly and vulnerable customers.

So, continued revamping plus expansion of the Morrisons offering could work well. It seems likely that many shoppers will adhere to changed habits for a year, maybe two, partly for fear of big supermarkets while Covid-19 remains at large.

Otherwise, 2019 revenues were pretty flat despite recognising store closures. Working with Morrisons was said to help a gross margin improvement in the second half year, although, fundamentally, the business remains low-margin – the table showing past years stuck around 2% at the operating level.  

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2019 administrative expenses, as a percentage of revenue, were steady at around 25% amid living wage inflation of 5% and £3 million additional rent from sale-and-lease-back programmes. More positively, there’s a new chief financial officer and chief commercial officer.

Some investors will be deterred by two glaring issues

Finance costs of £8 million swallowed just over half of 2019’s operating profit in a context where net debt only edged down 4.6% to £94.1 million.

The interest cost seems excessive considering 85% of debt is structured long-term, which demands explanation in the financial review, having been the same as 2018. Otherwise, and considering huge monetary stimulus underway, indebted companies are being offered a reprieve. 

The other oddity is an eye-popping £215.5 million trade payables versus £39 million trade receivables, an imbalance that very slightly worsened over the year and queries what to extent McColl’s has accumulated delayed payments to suppliers which also should have been explained in the financial review.

The firm’s true level of gearing can therefore be regarded as significantly higher than around 240% on a net basis, and where £38.7 million net assets are swollen by £156.9 million intangibles. More positively, on 28 February, bank facilities amended and extended to May 2022.

A call option on shopping restrictions persisting

Despite inherent risks, McColl’s has a big opportunity to capitalise on potential reward and to re-rate its longer-term marketing. Continued recovery in its share price – the rating around 3x 2019 normalised earnings – could enable an equity capital-raising (that would not be so dilutive) to cut what seems to be expensive debt.

A 24 March Covid-19 update cited all stores currently open, and a pro-active response with wholesale partners while investigating complementary channels to supply essential products.

As a small recovery punt and portfolio hedge lest hard times persist: Buy. 

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.