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CARD.L - Card Factory Plc


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Anyone on the board taken a look at Card Factory? It's a low cost producer and retailer of greeting cards based in the UK. They've run into some liquidity issues due to COVID, and they might have to raise some additional equity. I'm thinking about the business on a post-raise basis. You would essentially own a great business with low debt and a stable end market that has historically distributed all of its owner's earnings as dividends. They are going to raise prices on their cards (still much much lower than their competitors and no impact on demand based on test runs) so I anticipate margin expansion from 2019 levels in the future. My math indicates that even if they raise equity at 50% of current levels and their historical owner's earnings drop by 50%, you would still receive 8.2% annually in dividends on your current cost basis. The biggest risk, in my opinion, is the equity raise doesn't happen and they ultimately default with their lenders. They have until July 2022 for the raise which gives me some comfort. Worth noting, after some digging around it looks like Michael Burry has taken a position here as well.

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  • Parsad changed the title to CARD.L - Card Factory Plc

I've looked into this one before and for me the time to invest has passed. Online competition is strong.

But I'm not saying that it can't be a good investment opportunity. Just saying that it isn't for me any longer.

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Followed for years, always passed. Hard pass today. Never seemed cheap enough considering the headwinds. Operating plus financial leverage plus business decline can be a recipe for disaster. Think there are much easier hurdles to clear unless one has a view that headwinds are cyclical and not structural.

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Posted (edited)

Thanks all, very much appreciated. At first glance there is no doubt this is a hard pass, but as I dug deeper I was able to get more comfortable. It is entirely possible I am overlooking risks due to the low price here, but I just struggle to see how this doesn't work out to at least an 8.0% return and likely substantially higher. Please see below to address some points.

 

Operating Leverage: There is definitely some operating leverage here, but outside of a massive hit to sales due to a pandemic it's really not that extreme. Cost of sales as a percent of revenue increased from 64.2% in FY2019 to 71.7% in FY2021. The increase was entirely driven by an inventory write-off that increased cost of sales by 7.2%. Part of this was without a doubt due to unsold inventory from COVID-related store closures, but it appears that a large chunk was simply due to a recently implemented ERP system that is more granular in terms of what is actually selling well. They also received two forms of government benefits this year. The first was a job retention scheme to keep employees on during the pandemic which decreased their store wages expense, and the second was business rates relief of $18.1m which reduced their store property costs. I would argue that the store wages are not truly fixed costs as the employees could have alternatively been furloughed or let go, but the business rates are true fixed costs. Net net I think the inventory write-off is offset by the business rate relief benefit, and the figures in the financials are probably pretty close to accurate if this extremely depressed sales environment were to persist. Other operating expenses and depreciation are pretty fixed as well. Taking all of this into consideration, about 35% of total annual costs are fixed based on my numbers. 

 

Financial Leverage: I don't consider their financial leverage aggressive at all on a normalized basis. The business earns about $60m after-tax in a normalized environment vs. current net debt levels (excluding leases, which I really don't consider financing that will "run" due to the constant need for a tenant) of ~$140m. They could essentially be debt-free in two years time if they used all of their excess cash to pay down debt. On a net debt to EBITDA basis, they're at about 1.0x normalized EBITDA. The company is working on a "best effort" capital raise of $70m based on their most recent lender negotiations, which indicates to me that if financing completely dries up for whatever reason and they cannot raise they will not default given they will have put in their "best effort." The only way I see a default occurring is if more lockdowns are put in place and the business does not recover to some sense of normalcy. Worth nothing, management addressed this in the most recent annual report. Please see below.

 

There is still uncertainty over how the future development of the pandemic will impact the Group’s business and customer demand for its products. The Group has therefore modelled a number of severe but plausible downside scenarios involving further closures of its stores, including scenarios where government imposed lockdowns require a two-month closure during the winter period and a separate scenario where the Group’s stores are closed for the whole of the peak trading month of December 2021. The impact of a December lockdown is the most severe and, in such a scenario, without assuming the availability of government support (including the coronavirus job retention scheme) during this period of enforced closure, the Board would be required to take mitigating actions to reduce costs, optimise the Group’s cash flow and preserve liquidity, including laying off retail staff during the period of closure and deferring or cancelling any potential bonuses. Additional cost saving measures such as deferring non-essential capital expenditure, which have not been modelled, would also be available to the Group.

 

On the basis of these mitigating actions the sensitised forecast cashflows indicate that, even on the basis of full closure in December and no government support, the Group would continue to be able to operate within the terms of its facility and to settle its liabilities as they fall due for a period of at least 12 months from date of approval of these financial statements. Based on these factors, the Board has a reasonable expectation that the Group and the Company have adequate resources and sufficient loan facility headroom and accordingly the accounts are prepared on a going concern basis.

 

Business Decline: The U.K. singles card market physical store channel has decreased in value from $1,257,000,000 to $1,226,000,000 from 2016 to 2019. This is projected to further decrease to $1,181,000,000 by 2024. If I had to choose a business to invest in with a slowly declining end market, it would be the low cost producer that has been steadily taking market share from less efficient competitors. My view is that the physical store channel will continue to decline (albeit modestly, I truly do believe people like to pick their cards in person due to the emotional element) but Card Factory will grow market share while this occurs due to their significant pricing advantage.

 

Summary: Taking all of this together, we can quickly do some back of the envelope calculations to figure out what dividends will likely be in one years time and beyond. Assuming they raise $70m of equity at a price of $0.30 (~50% haircut from current share price) and pay off a significant portion of their debt, shares outstanding would increase by 233.3m from 341.7m to 575.0m. We can further assume that normalized revenue drops 15% from FY2019 levels, and that 35% of annual costs are fixed. Management has indicated they are increasing prices with no impact to volume, so I view this type of sales drop/margin compression as extremely unlikely, but I wanted to stress test for margin of safety purposes. That would leave us with approximately $383m in annual revenue, $340m in annual costs, and $43m in operating profit. Assuming a conservative tax rate of 30% gives us $30m in net earnings. I would argue that in futures years leases would not be renewed for unprofitable locations and operating profit would likely increase, but we can assume it stays consistent into perpetuity to be conservative. That leaves us with annual distributions of $0.05 vs. a current share price of $0.60, for an annual dividend yield of ~8%.

 

All insights are appreciated, and thanks for everyones thoughts so far.

Edited by widenthemoat
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  • 3 weeks later...

One more follow-up here, I think the price increases they are implementing are really being ignored by the market. Per their Capital Markets presentation, they've been able to raise prices 17% (59p to 69p) with zero impact to volume and they are still the lowest priced cards available by a long shot. 10p means nothing to their customers. If we go off FY19 numbers, they have revenue of $436m and EBIT of $85m. Assuming revenue rises 10% to be conservative and volume stays constant, EBIT would increase to $128.2m, or 50%. 

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Just spent a tiny amount of time, but you did good work and deserve some constructive pushback:

Per their liquidity/refinancing update, first 5 weeks of reopening revenue was broadly flat compared to 2019. Less people offset by higher transactions (possibly price?). I don't think taking price is sustainable in the long run, though you might be right there is some room to run shortterm. But if I was long I'd be scared about less traffic compared to 2019 considering folks have been forced to stay at home and savings are record high. You would think there was massive pent up demand - or behavioral trends have accelerated, magnified by less foot traffic from increased ecommerce.

 

As for their debt levels, you somewhat dismissed that as an issue before. But looking at their refinancing deal it is obvious lenders are of another opinion. Those terms are tough and having to raise 70m equity at these levels is a tragedy. 

 

Anyway, I think the real question to ask (unlessa short term punt): What is the terminal value? Do you think there's a need for dedicated postcard retailers in a couple of years? Or did grandma perhaps learn how to use Snapchat with her grandkids during lockdown?

 

I really think there are much easier longs out there. GL.

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