Card Factory: Be Greedy When Others Are Fearful

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 22^nd 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.

Business Description & Supply Chain

Sales reached £451.5m in FY’20 (ended Jan- 2020) and are split between greeting cards (54%) and a complementary range of items such as gift wrap/bows, helium balloons and other soft toys (46%). The proportion of the latter increased in recent years (it used to be 38.5% at the IPO in 2013) as the company improved its merchandising and cross-selling abilities. By channels, stores represent 95% of revenue while online and partnerships with other retailers account for 4 and 1%, respectively.

The company has 1,015 stores as of H1’21 and a plan to reach 1,100 by FY’25. The pricing range goes from £29p to £179p with most of the volumes being in the £89p and £99p range and around 20% coming from the lower-end prices (£29p and £59p). The average basket value is £5 (online is slightly higher). The seasonal breakdown of sales is as follows: 15/20% for Christmas, 10/15% spring seasonal occasions such as Mother’s Day, Father’s Day, Valentine’s Day and Easter and 65/70% for everyday occasions such as birthdays and weddings.

Card Factory’s competitive edge lies in its vertically integrated supply chain. It prints nearly all of its non-handcrafted ‘everyday’ and seasonal cards (60% of volumes) at its internal facility called Printcraft.  The rest, mainly handcrafted cards and the non-card merchandise, comes from third party suppliers in the Far East. Additionally, Card Factory designs 98% of its greeting cards thanks to its in-house design team, allowing for faster lead times and greater agility regarding changing customer tastes. This unique set up in the industry has allowed the company to generate mid-60% gross margins, while providing customers with more relevant content at prices 2 to 3 times below competition. To put it into context, Clinton, Card Factory’s biggest competitor, reported gross margins of 53.4% and 54.2% in FY’17 and FY’18.

In recent years, the company has been pressured by subdued like for like growth (-0.5% and -0.1% in FY’20 and FY’19) and an ever-increasing cost base. There were two significant drivers for the latter: the pound devaluation following Brexit (50% of COGS are paid in US$) and the rise of the UK minimum wage. This drove gross margin from 68-69% five years ago to 66% in FY’20 while EBITDA margin (adjusted for IFRS16) fell from 25% to 19% in the same period. Despite these challenges, Card Factory did not raise prices for the last 5 years. However, since 2018 and the rollout of an EPOS system across its store base, Card Factory has experimented with price increases in test stores. What it found was that raising prices on the £39p, £59p and £149p range (to £49p, £69p and £179p respectively) would lead to only slight declines in volume that would be largely offset by the price increase. The company therefore implemented the new pricing strategy for these ranges in FY’21 across the entire estate. Going forward, it also plans to increase the contribution margins of the £89p and £99p range. Given the £1 psychological barrier, the company intends to “disguise” the price increase as a slight reduction in the card quality (and hence COGS), which should boost gross margins. Cutting card costs by 10% while keeping prices constant would be akin to a price increase of c.3% (see below).

 The result of these pricing initiatives would enable the company to raise its sales per store by c.6% (see below), enough to maintain margins for the next 3 years and sustain £50m annual free cash flow.

 Market & Online Threat

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 [3]. The market has been rather stable since 2004, going from £1.5bn in 2004 to £1.35bn in 2020, a CAGR of -0.7%. Excluding online sales from 2020 numbers would point to a CAGR of -1.6%. Overall, this is a macro-resilient industry, as demonstrated by its growth throughout the GFC[4], and volumes have been rather stable despite increased online communications (down only 5% since 2012). We continue to expect a downward trend in the coming years.

  

Card Factory is the market leader, with c.20% of the market by value, followed by Clinton Cards and Paperchase at c.9% and 2%, respectively. The remaining players are grocers (40% of the market), other high street retailers (25%) and then online specialists (7%). As we mentioned in the introduction, the company’s competitive positioning is extremely differentiated from peers with its low cost, high quality business model (see below on the right).

 

 

As is easily observable, Card Factory has been able to take significant market share and its like-for-like performance has therefore significantly outperformed the market (see below).

 In addition, we believe that Card Factory like for like sales could materially improve in 2021 and 2022 since its 2 main competitors are currently in administration. Clinton entered administration in December 2019 (for the second time since 2012) and has since reduced its estate from c.350 stores to 270. It was still heavily loss making after its previous restructuring and given its low gross margin, we do not see a path to profitability going forward. However, the owners (the Weiss family) also own Clinton biggest supplier, which creates strong incentives to keep the business going for as long as possible. We expect that the lockdown will be the last nail on the company’s coffin. Paperchase, the #3 specialty card retailer, also entered administration in January 2021 and plans to reduce its store base from 127 to 90. The group is EBITDA positive for both FY’18 and FY’19 and while its leverage is unsustainable at 6/7x, we believe this is a capital structure issue rather than a business issue and the company should stay in business in the near-term.

Regarding the online penetration of the market, it stood at 14% in 2019 and we expect it to stay low in the longer-term given the immediate and experiential nature of a card purchase. Customers want to touch the product, compare the quality across the price points and do not want to wait (85% of store visits are planned in advance). In addition, the complimentary range provides customers with a one-stop-shop for special occasions where they can buy both a card and party items (like helium balloons, card wrap/bows etc..). We think this is why online players predominantly cater (65% of sales) to the personalized card market (think printing a card for your parents with their grandkids on it), a category unavailable in stores. We think personalized cards have a low overlap with traditional cards and are largely used for different life events.

 

 

 

 

 

 

 

 

Liquidity, Debt Load & COVID reopening

Having done significant work on Card Factory’s cash burn, debt load and covenant breaches, we do not share the market concern and consider them heavily overblown.

First, we estimate the company monthly cash burn to be £7.4m per month from end of January onward. See below the numbers and related assumptions.

 Second, Card Factory reported in its January trading update net debt of £90m as of end of December (down from £142.5m at the half year results). This is the result of both a seasonal low in working capital in December (see below on the left in green) and aggressive cash management (rent and taxes have been deferred). We assume net debt for FY’21 (end January ‘21) to be 121.5m (below on the right in green). This figure is derived by adding to the £90m end of December net debt our estimated cash burn for January as well as a working capital adjustment similar to last year’s differential between December and January net debt position.

 

 

 

 

Putting the above estimates together indicate that Card Factory has enough liquidity to withstand the closure of its stores until at the very least the end of May (see below).

 

Our base case is a reopening of non-essential shops in the UK by mid-April. Indeed, as of the 14^th of February, NHS weekly data  showed that 95%  of the >70 years old population received its first vaccine injection (see below).

Given the current trends and the daily incremental vaccinations, we would expect 100% of the >50 years old population to have received their first vaccine shot by early March. This milestone would pave the way for a reopening of non-essential shops by early April.

In addition, a key indicator in whether a reopening is possible or not is the number of COVID patients in mechanical ventilation beds (MVB). The figure currently stands at 2535. Back in April 2020, it took c.50 days for MVB occupancy to go form this number to less than 400 (when the UK reopened on the 15^th of June). Assuming a similar 50-day timeline would point to a MVB occupancy reaching levels consistent with a reopening by the 12^th of April. This is in line with our above assumption.

Based on our forecasts for a reopening of stores by April and because of the highly cash generative nature of the business, we expect Card Factory to quickly bring down net debt to 1.6x by FY’23 (on a profit before tax basis). This would be at the lower end of the company’s target range of between 1.2x and 2.6x, allowing for a return of dividend payments as soon as 2022. As a reminder, the company last ordinary distribution to shareholder in 2019 was £48.9m, a 42% dividend yield based on today’s prices.

Lastly, we believe concerns around the covenant breaches are highly exaggerated. Indeed, looking at the situation from a bank perspective, we see little logic in recording a loan loss provision in this environment and forcing an otherwise solvent business into administration for short-term liquidity  issues. We expect the loan officers to be heavily incentivized to avoid such an outcome and, like in January, provide the company waivers for as long as the lockdown last.  

Valuation

Our model here is pretty straightforward. We assume a progressive return to normal by FY’23 (end January 2023), with sales per store reaching 96% of the FY’20 levels. We think this is quite conservative given the company’s historical like for like performance and the FY’21 c.6% price increases. We expect the company to continue its store rollout plans and add 35 stores (2.8% growth vs FY’20) by FY’23, while online sales should stabilize at FY’21 levels (COVID effect being offset by the rollout of the new website in FY’21). Retail partnerships should expand as the company closes new customers. We expect costs to grow at a 2% clip for the period, with the increase in minimum wage being partly offset by cost initiatives at the supply chain level (distribution, warehouse and printing). See below our model for more details.

                      

                                                                                                                                 

As can be seen, the company currently trades at 2.1x earnings and 48% free cash flow yield pre growth investments. In the past 3 years, the stock traded at c.10%  free cash flow yield pre-growth and c.9x earnings, multiples we would expect the company to reach again once it puts COVID behind it.

Conclusion

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 conservative 8x normalized earnings for a 12.5% free cash flow yield. Even if we are wrong, and assuming a worst-case capital increase of £40m (c.35% dilution at current prices and more than enough to survive 5 additional months of lockdown), we expect the shares to more or less triple.

 

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[1] Mooping IPO prospectus

[2] Ibid

[3] Ibid

[4] Ibid