Why Nick Scali (NCK:ASX) is on my Watchlist

Nick Scali is an Australian business that imports and retails household furniture. Nick Scali’s product suite is catered towards those between the ages of 35 and 55, concentrated in the middle to upper income bracket. Primary economic factors that influence the companies in the furniture business include the real estate market, interest rates and GDP growth.

Nick Scali's business model is underpinned by the network of its physical showrooms. Showrooms are  strategically beneficial as it gives customers a tangible experience with the available product suite. Showrooms invite customers to test the furniture, where they can quickly assign their level of personal comfort and gauge aspects of price to quality. Customers are also less inclined to return their purchased furniture after testing them. This is particularly important to those in Nick Scali’s target market: customers who are updating, upgrading or purchasing their furniture for their own optimal enjoyment. In terms of working capital, Nick Scali will have less potential inventory increases and write-downs from these returns. Ultimately, showrooms are a representation of visual honesty and a means for customers to gain a better sense of value.

To keep pace with current furniture trends, Nick Scali invests time and money travelling to key centres around the world and attending relevant trade fairs. In an interview with Alan Kohler in 2019, Managing Director, Anthony Scali, stated that the importance of identifying trends and updating the product suite accordingly. Although furniture trends change slowly in comparison to that of retail fashion, Scali notes that closely monitoring trends and capitalising upon them as they emerge is critical. 

Nick Scali operates a capital-light business model with an effective working capital arrangement. When customers make a purchase at a showroom, a payment is often made in advanced and the goods are delivered months later. On the contrary, Nick Scali pays their oversea supplier months later due to industry trade terms. In effect, the company advantageously receives a low-cost float from the customer deposits. Floats can often expand the moat of a negative working capital company such as Nick Scali by enabling the company to grow without incurring additional capital for growth.

This float is confirmed by the company’s Cash Conversion Cycle (CCC) over the last 10 years as seen in the figure below. Nick Scali’s negative CCC over the years demonstrates the competitive positioning it has over its supply chain. It is also a testament to its business model; the company sells 90% of its lounges as custom. The company therefore is not required to hold inventory more than is necessary. The custom lounges are made in the overseas factories before being shipped to the relevant distribution centre.          

Figure 1: Nick Scali’s Cash Conversion Cycle from 2009 to 2019. Average Inventory, AR, AP, Sales & Cost of Goods Sold are in thousands ($'000)

Although impressive, it is important to compare Nick Scali’s calculated CCC against its competitors. Operating in different market segments of the furniture and retail business, there are two other ASX-listed retailers whose operational efficiencies can be compared to that of Nick Scali. The first is Harvey Norman (HVN:ASX), the multi-national retailer of furniture, bedding, appliances and consumer electronics. Harvey Norman is well known for the convenient finance terms available with the purchase of its products. Customers are eligible for several payment terms depending on financing amount and type of product. At a maximum, customers may be eligible for up to an extensive 60 months payment option that incurs no interest and requires no deposit. These lenient credit terms are evident in the figure below where the Days Sales Outstanding (DSO) is significantly higher in comparison to Nick Scali.

 

Figure 2: Harvey Norman’s Cash Conversion Cycle from 2009 to 2019. Average Inventory, AR, AP, Sales & Cost of Goods Sold are in thousands ($'000)

Harvey Norman, unlike Nick Scali, has a larger product suite and caters towards a wider target market that includes the likes of both individual and corporate consumers. The convenient credit terms can be attractive to customers for two reasons: to provide better personal cash flow management or to make an immediate purchase they may not be able to afford. The convenience of the customer, however, comes at an expense to the company’s working capital structure. This damage is certainly evident in the history of Harvey Norman’s CCC. Although seemingly unfavourable, Harvey Norman leverages this value proposition in its competitive market where customers have more choice homogeneity and therefore higher bargaining power. 

The other listed company that is comparable to Nick Scali is Temple & Webster (TPW:ASX). Listed in 2011, Temple & Webster's business is primarily aimed at capturing the general household goods and furniture market in the e-commerce space. The company is also capital-light and displays superior Days Inventory Outstanding (DIO) & CCC to that of Nick Scali due to its no-inventory model; the company sources products directly from wholesalers and ships directly to the customer. Unlike Nick Scali and Harvey Norman, Temple and Webster do not offer any additional credit terms to its customers. As a result, Temple and Webster has enjoyed an impressive CCC record in its short history compared to Nick Scali. This is evident in the figure directly below.  

Figure 3: Temple & Webster’s Cash Conversion Cycle from 2016 to 2019. Average Inventory, AR, AP, Sales & Cost of Goods Sold are in thousands ($'000)

In Nick Scali’s 2004 Annual Report, Scali states that the products are sold at a ‘value for money’ price. Scali claims that is made possible by choosing the right product from the appropriate manufacturer using our volume buying power, sourcing directly from our manufacturers and shipping direct to customers’ homes via Nick Scali distribution centres. Attesting to their consistent gross margin of approximately 60%, Nick Scali’s moat appears to be attributed to their economies of scale and therefore low-cost advantage. Scali calls this the ability to buy well. Nick Scali is a direct importer of furniture and buys directly from overseas factories; this allows for Nick Scali to save on any middle-men costs. Nick Scali has been able to these maintain consistent gross margins by by avoid margin leakage and disciplined inventory control.    

In addition, Nick Scali’s operating margin also improves as they increase their store network. Typically, a distribution centre will have approximately nine showrooms in proximity. Optimizing the number of stores is crucial to realizing the cost benefits that result from sharing the distribution centre overheads. Additional stores also contribute to the advertising budget, which enables stronger marketing and advertising strategies that, in turn, drive further sales growth in each store. Nick Scali’s infrastructure build and a disciplined approach to network expansion is and has been key to achieving economies of scale. In the past five years (from 2014 – 2019), Nick Scali has enjoyed an operating margin expansion from 16.0% to 22.6% and therefore a decrease in Cost of Doing Business (CODB).

Anthony Scali, currently holds a significant interest in the family business that his father, Nick D. Scali, founded 50 years ago. In 2016, the stake of his siblings, Nicky and Yvonne Scali, were relinquished from the family holdings that initially constituted 50% of float. Anthony Scali continued to hold and even increased his stake by purchasing a portion that his siblings sold. In 2018, Anthony Scali sold 50% of his shares to long-term supplier Jason Furniture, better known as KAKU. Scali stated that this would help Nick Scali realize its long-term growth strategies. In 2019, KAKU offloaded its entire stake in the open market, raising concern amongst investors regarding the future of Nick Scali. Currently, owner-operator Anthony Scali holds a stake of 13.6% and continues to run the company with a conservative renumeration structure. 

In the short term, management are incentivized by maximizing annual Net Profit After Tax (NPAT). In the long term, management are incentivized to compound Earnings Per Share (EPS).  Interesting and also quite odd, Anthony Scali does not participate in any long-term incentives and receives a mediocre salary in comparison to other listed similarly sized companies. Ultimately, the entire executive management team have fairly long tenures and are paid a conservative sum that makes up less than 1% of all sales. 

The management team have also demonstrated great capacity in operating the business by generating high Returns on Tangible Equity (ROTE). As seen in the figure below, ROTE has varied over the years due the variations in annual capital expenditure. This is a result of different number of new showrooms, distribution centres or clearance stores being opened each year. These costs are dependent on whether the property is purchased or leased and the location. Store openings are deliberated on management’s ability to identify and capture sensible opportunities and hence, the increases in store locations were rather ununiform. 

Figure 4: ROTE from 2010 to 2019. Owner's Earnings and Tangible Equity are in thousands ($'000).

In terms of capital allocation, management allocate a fraction of the free cash flow cash generated to buy or lease new stores, fit them out, maintain existing stores and to pay the remainder in dividends. When Nick Scali opens new stores, whether it be buying or leasing, the setup cost is approximately $300,000 for the floor stock and $300,000 for the fit out. Anthony Scali is targeting 6 new stores per year and has a long-term target of 85 stores. Given the calculations, the capital expenditure requirements are quite minute compared to net earnings. Additional aggression when opening stores may lead to cannibalization and a potential decline in brand value. It therefore makes sense for Nick Scali to pay out its earnings in dividends. This is, of course, if management continues to strictly focus on retail and no other lines of business or investments. 

The long-term favourability is essential to the valuation of any company. Considering the fact that Nick Scali's target customers are looking to gain optimal enjoyment from the purchases of these long-term investments, Nick Scali’s business model appears to be sustainable. The ability to tangibly examine and perceive the product as described above is important for customers to make a confident purchase. The consumer behaviour for this segment is more sensitive to personal appeal and less sensitive to price than those who look for more affordable furniture options. 

The company has achieved a significant amount of earnings growth since its Initial Public Offering (IPO) in 2004. Assessing the growth retrospectively, the company has achieved an operating profit growth of approximately 13.9% per annum since IPO. Since IPO, Nick Scali has been able to secure 59 locations throughout the key Australian capital cities and has a long-term target of 80 to 85 stores. Nick Scali has also secured 3 locations in New Zealand (2 in Auckland and 1 in Hamilton). The expansion objective in New Zealand is also identical to that of Australia. In total, the long-term objective will be 80-85 stores in each country. 

A 10-year history of Nick Scali’s Return on Capital (ROC) is displayed in the figure below. An Adjusted ROC has also been included which uses 0 for the working capital if it is negative. This is purely to adopt a conservative assumption on the standard ROC. 

Figure 5: ROC and Adjusted ROC from 2010 to 2019. EBIT, Working Capital & Net Fixed Assets are in thousands ($'000).

Evidently, the Adjusted ROC has been a tremendous over the past 10 years. Although significant, there has a been a noticeable downwards trend that has occurred over the same period. The marginal increase in EBIT has been outpaced by the marginal increase in the capital base. This could be due to less customer spend per new opened store; this makes particular sense as their store network expands from the CBDs outwards. Generally, there is a larger concentration of wealth in the inner cities and therefore higher capacity for discretionary spending. Alternatively, this could be a due to increases in competitive forces.

Nick Scali’s main competitors are companies whose target market are also in the middle to upper income bracket. Unfortunately, these furniture retailers, that include the likes King Living and Space Furniture, are privately owned and do not have released financial statements. This poses an issue where the required information is unknowable but important to the analysis being conducted. This lack of information can be compensated by drawing upon the financial statements released on Nick Scali, comparing to similar listed retailers and employing a margin of safety when estimating the intrinsic value. 

As at December 30, 2019, Nick Scali reported an ample cash balance of $44 million against a total book value of $78 million. The long-term borrowings of $33.7 million that were drawn on the purchase the 9 properties can be comfortably covered by the cash position. Nick Scali also began the adoption of the accounting standard AASB 16 which requires lessees to recognize assets and liabilities for all leases with a term more than 12 months. The total lease liability reported on the balance sheet is $196.6 with $11.5 million paid in the past half year. Extrapolating this information, Nick Scali has annual lease payments of about $23 million (included in the property expenses of the consolidated statement of comprehensive income) and an average lease tenure of 9 years. The lease liability, in essence, is a non-interest-bearing obligation recorded to reflect the true amount to be over the subsequent years. This could present Nick Scali, and any other business with lease liabilities, with the probability of bankruptcy risk. In light of the sound business model, high profitability, moat-like characteristics and a conservative balance sheet, the probability of this occurrence appears to be low.   

Assessing the specific risk factors are also important in this regard to ensure Nick Scali continues to operate under a going concern. To evaluate the business and assign a intrinsic values based on several probabilities, two scenarios have been outlined below given the current COVID-19 pandemic:

1. The national lock down persists into the distant future due to additional coronavirus waves and Australia experiences its first deep recession since 1990-91. Asset prices, including property prices, will decline and cause the wealth effect to take its course. Naturally, discretionary spending will decrease and cause Nick Scali sales to decline significantly. In contrast to affordable furniture items, Nick Scali items are labelled as big ticket items and have a stronger ties to economic performance. This has a reasonable probability of occurring.
2. The national lock down is slowly lifted, and no significant additional cases are recorded. Australians resume work fairly promptly as they did prior to COVID-19 and the economic engine is slowly rebooted once again. This also has a reasonable probability of occurring.

Since the future is unknowable, estimating with conservatism is critical in providing a margin of safety. In estimating the intrinsic value, the following assumptions will be made: the current year ROC adjusted by half from 65.21% to 32.61%, a discount rate of 15% and a long-term growth rate of 5%. Using the implied Gordon Growth formula directly below, this therefore yields a justification Price to Net Tangible Asset (NTA) of 3.26x.

Figure 6: Perpetuity formula with growth consideration

At the current NTA of $85.81 million, the justified acquisition price would therefore be an Enterprise Value (EV) of $279.83 million. In comparison to the current EV at $454.04 million, the deal does not leave a sufficient margin of safety. This justified acquisition price was available earlier this year, but a lack of preparation meant that a missed opportunity cost was the only price that was paid. 

At this point in time, Nick Scali can only be one for the watchlist.