Disclaimer: We are shareholders of Card Factory.
How would you like to invest in a UK greeting
cards retailer with its entire store base closed because of COVID? Yes,
you have read that sentence correctly. And no, we have not gone mad. Pinch your nose and let us introduce you
to Card Factory.
Elevator Pitch
Card Factory is Britain’s leading specialist
retailer of greeting cards, dressings and gifts, with an estate of over 1,000
operated stores. It was set-up in 1997 to provide a lower cost, higher quality card alternative to incumbent chains. Key to this formula
was to vertically integrate the supply chain in order to lower production costs,
shorten lead times and get more relevant card designs. These efficiencies were then
passed onto the customer and allowed Card Factory to undercut competitors on
prices by 50% to 70%. The business model was successfully rolled-out across the
UK and the company went on to capture 33% of the market by volume (20% by
value) in less than 25 years. Speaking of the market, it is important to
understand that there is an ingrained culture of sending cards in the UK, with
approximately 87% of adults purchasing cards and each person sending on average
20 of them per year[1].
It is a macro-resilient industry, as demonstrated by its growth throughout the GFC[2],
and volumes have been rather stable despite increased online communications (down
only 5% since 2012). Online penetration so far is low at 14% and is essentially
focused on categories unavailable in stores. Given the highly experiential
component of a card purchase (touching and comparing) as well as the c.£5 average
basket value, we expect it to stay low in the longer-term. We therefore believe
that Card Factory’s business should come back to near historical levels post-COVID
and potentially better (two of its biggest competitors are in administration and
plan to significantly reduce their footprints). Do not mistake us, Card Factory
is far from being a good business, it has flat to slightly negative
like-for-like sales while costs creep up by 2-3% per year, meaning constant
margin pressure. On the other hand, everything has a price and despite its
challenges, the company should generate c.£45-£50m of free cash flow in the
medium-term (for a £110m market capitalization). Mr. Market however hates
uncertainty and is so focused on the group’s near-term cash burn and debt load
that no matter the price, it is simply unwilling to buy the business. Unsurprisingly,
Card Factory trades at 2x normalized earnings. Our work on cash burn indicates
that the business has enough liquidity to last until end of May with its stores
closed while our analysis of COVID new cases, hospital ventilator beds
occupancy and vaccinations indicates that the UK lockdown should be lifted by
early/mid-April (an announcement is expected in the week of the 22nd
of February). We believe that this is a
typical case of ‘time-horizon arbitrage’, where high uncertainty is
mistaken for high risk. This set-up provides one of the best risk/reward we
have ever seen, with immediate and tangible catalysts that could propel the shares
significantly higher: If we are right, we believe the stock can quadruple and trade
at 8x normalized earnings (Card Factory traded at 11x-12x earnings in 2018 and
2019) for a 12% free cash flow yield. If we are wrong, the business will need
to raise up to £40m (c.35% dilution at current prices) to make it to the other
side of the lockdown. At a similar 8x P/E, the shares would still end up being
a 2.5 bagger.
