Findel — Update 3 August 2016

Although we have trimmed our estimates for Findel, that change reflects the effect of sterling’s fall versus the dollar following the referendum vote for Brexit rather than concerns about trading performance. Indeed, although the net effect of the various changes to the structure of our FY17 estimates is that there is no material change to numbers beyond the currency effect noted a moment ago, we draw considerable encouragement from the fact that Express, by far the group’s most important (c 98% FY17e EBIT) and most powerful business, performed strongly in the first 17 weeks of FY17, providing the foundation for further progress.

Express entered FY17 with the aim of adding 100k new customers and spreading that recruitment more evenly during the year than has traditionally been the case. To that end, it has invested in discounted product offers and marketing campaigns, including TV advertising. The results in the first 17 weeks of FY17 are encouraging: Express believes it is on target to hit its recruitment goal and it increased product sales by 14.5%. Financial Services’ revenue growth was also strong, benefiting from the product sales growth and the roll-out of risk-based pricing. Of course, one of the effects of the increased number of new customers is likely to be an increase in the bad debt charge for the year. Management cautions that the rate of sales growth is likely to moderate as Express moves into its peak trading period. It further acknowledges that some gross margin and additional marketing costs have been invested to drive growth in the year to date. Nevertheless, other things being equal, the strong trading start to the year would have suggested an increase to our divisional estimates for Express. However, other things are not equal. Sterling has fallen sharply since the vote for Brexit, affecting import costs and, thereby, gross margins. This vindicates management’s decision to cover 80% of its FY17 dollar needs at $1.44/£. Unfortunately, the impact of sterling’s fall on the uncovered 20% of dollar needs is likely to knock c £1m off our previous divisional operating profit estimate. This offsets the benefits of the solid trading start to the year. We model no material change in FY17 operating profit, which we continue to estimate at £35.2m.

Education endured difficult market conditions with increased pressure on the proportion of schools’ budgets being allocated to educational resources within schools in recent weeks. After adjusting for timing differences on the Sainsbury’s Active Kids scheme, year-to-date sales are c 8% lower than during FY16’s equivalent period, which marks a weaker performance than the -2% that we had modelled for H117. Although Education believes it is close to halting its market share decline, and its warehouse and systems integration projects remain on track for completion in CY16 and to deliver the planned benefits for FY18, its target of maintaining FY17 sales at prior year levels is unlikely to be achieved. We have therefore lowered our FY17 operating profit estimate for Education from just below £2.3m to a little over £0.6m.

While Findel has suffered from the fall in sterling following the Brexit vote, it has gained from the lower interest rates and interest rate outlook that partly explain sterling’s weakness. We estimate the benefit to net finance expenses at c £0.5m.

After reflecting both the strong trading in the first 17 weeks of FY17 and the effect of sterling’s decline versus the dollar, we model no change in operating profit for Express. However, we have reduced our operating profit estimate for Education by c £1.6m. The net interest saving of £0.5m reduces the net pre-tax impact to £1.1m. Hence our FY17 PBT estimate reduces from £27.0m to £25.9m. Exhibit 1 summarises the impact of our estimate changes.

Sports Direct owns 29.9% of Findel. It has sought previously to put its nominee on Findel’s board, a move that shareholders defeated. Nevertheless, exploration of a satisfactory resolution to the situation between the two groups continues.

On 1 July Findel’s board announced that it was in early-stage discussions regarding a possible commercial supply agreement with Sports Direct and a proposal that Mike Ashley be appointed Findel’s chairman to replace David Sugden, who had previously indicated his intention to step down from the board at the conclusion of this year’s AGM. Findel’s board is convinced that there is merit in a commercial supply agreement with Sports Direct. There would seem to be obvious value for Sports Direct in access to Express’s customer list and its consumer credit expertise. Nevertheless, Sports Direct is unwilling to progress this until Mike Ashley’s role on Findel’s board is determined. Findel reports that discussions on both topics are ongoing.

Findel’s board has decided not to appoint Mike Ashley as chairman and is therefore seeking to appoint an independent executive chairman. As a result of the delays to this appointment, David Sugden will continue as executive chairman beyond his planned departure date until such time as a replacement has been appointed. The status of the relationship with Sports Direct seems unlikely to ease the recruitment process.

Our sum-of-the-parts valuation of Findel, shown in Exhibit 2, is broadly unchanged, standing at 240p per share compared to the previous 238p. Following the referendum on 23 June, the rating of benchmark N Brown has fallen sharply. We have therefore reduced the rating we apply to Express from 9.5x to 8.5x. This is still higher than the FY17e P/E of 7.6x (on consensus estimates) on which N Brown trades, but Express is growing faster than N Brown and has the infrastructure to sustain superior growth for many years. On the other hand, we now value the education business on the basis of its estimated EBITDA. In a sector that seems likely to consolidate, we expect any deals to be based on EV/EBITDA multiples. The new group valuation represents 9.6x FY17e earnings and 8.0x FY18e earnings. These remain ungenerous ratings against 13.4x CY16e for the FTSE 350 General Retailers index. Although the absolute level of debt within the group is high, this reflects the substantial, high-quality consumer credit book that sits within Express. Core net bank debt is less than half of the total debt, represented c 0.8x EBITDA in FY16 and has been on a reducing trend since current management took over. Even if one ignores this fact, the EV/EBITDA ratios of 8.3x FY17e and 7.4x FY18e, including total group debt within EV, are not excessively high by retail sector standards. The FTSE 350 General Retailers index is currently trading at 7.6x CY16e and 7.3x CY17e EV/EBITDA. On our estimates, the price to book ratio is 1.4x in FY17e and 1.2x in FY18e.