Stockwatch: From momentum play to yield stock

Since I drew attention to greetings card retailer Card Factory last August the mid-250 stock has soared over 70% from 210p to 360p as the market re-rated its forward price/earnings multiple from about 13 to 18 times. My rationale was essentially marketing: that Card Factory was well-positioned to benefit from a discount retailing formula under-cutting rivals.

Investors were initially cautious of its May 2014 flotation after Clinton Cards ended up in administration in 2012, also because Card Factory had net debt of £150 million versus £218 million net assets - being one in a series of sales by private equity owners who had geared up businesses with debt. Institutions' response, therefore, was to negotiate the flotation price to a moderate rating, taking account of this risk, and see what evolved. I suggested a parallel in the way Sports Direct has proved a roaring success from the small cap indices now into the FTSE 100 index, focused on discount sportswear. Card Factory only needed to replicate a slice of this action to serve shareholders well.

Management proposes a return of capital

The stock is setting fresh highs after a latest trading update reinforced expectations for the current financial year to 31 January 2016, and proposed a return of capital towards the end of it amid strong cash generation, which has also reduced net debt to £91.9 million from £103.6 million at end-January 2015. The amount, method and exact timing won’t be confirmed until interims on 22 September, but naturally this has provoked interest as investors sense the prospect for income besides capital growth.

In terms of the ordinary dividend the stock has risen such that the prospective yield is now only about 2.2%, although the table shows 2014/15 cash flow well in excess of earnings, versus modest capital spending, and expected earnings cover over 2 times. Ideally the board would give a sense of earnings cover around which to re-rate the ordinary dividend, as with exceptional paybacks you are guessing what to expect by way of amount and nature of such "returns" over the medium term, to value the stock.

Buybacks are not strictly a return of capital, they enhance earnings per share and help managers achieve bonuses. For example, a dividend policy with a target for 1.5 to 2.0 times earnings cover would be clearer. Admittedly, Card Factory is in a growth phase and could reduce debt further, but if management is going to entertain returns of capital then a re-rated dividend is preferable.

Growth is based mainly on store openings

The update cites 19 new stores opened (on a net basis) in the first three months of the financial year, across a wide range of demographic locations, bringing the total estate to 783 stores at 30 April. Management says it is on track to deliver some 50 net new stores in the current financial year. Mind how an implied 6.4% annual increase in stores appears essential to the sense of a growth company. Otherwise like-for-like sales growth appears very modest. It isn't clarified within a 7.5% first quarter increase in sales "resulting from like-for-like sales increases, new stores and online growth" - but it certainly would be if worth attention.

From the last annual results, underlying operating profit growth was 8.9% to £79.4 million on like-for-like sales up 1.8% and revenues up 8.1% to £353.3 million. So with like-for-like growth not now being disclosed, has the rate slipped? That it "continues to track in the range targeted by management" obfuscates the issue. It's relevant when a stock rises to a growth-type rating as now.

Online is said to be doing well, with the principal business www.gettingpersonal.co.uk "building on its strong performance in the last two financial years." Mind this is small in context and a low base facilitates rapid growth: the last annual results cited online operating profit up from £1.7 million to £2.8 million, versus Card Factory stores up from £78.7 million to £85.4 million.

UK economic context is likely positive for Card Factory

My latest macro column pointed out risks to consumer spending as a Conservative majority government seeks to re-define state boundaries and cut spending early in the parliament term. The coalition government flinched at cuts when recession co-incidentally reared its head, instead resorted to more borrowing. We shall see what George Osborne is resolved to do and whether it can succeed without impacting consumer spending (e.g. public sector job losses and cuts in public services). More positively, the context appears to be disposable income steadily improving so a modest check on this would reinforce the appeal of discount retailers.

As I described in my original article, online cards have limited appeal. People would rather send and receive genuine cards. But not only has their price generally increased in recent years, so has postage which bumps up the cost of Christmas especially, and makes cheaper alternatives attractive. Not even supermarkets' cards are really competitive with Card Factory which takes a "vertical integration" approach with capability in production not just shops - introducing some 4,000 new designs each year, extending to gift items.

An enduring business, but what is it worth?

Card Factory will prosper for years to come, as wealth polarises in British society, but it must show better like-for-like sales otherwise its stock will de-rate once store openings slow. The dilemma is the UK greeting cards market growing only at about 2% annually. My expectation is the stock will continue as a momentum play for a while yet, pending wider market sentiment also. It then become a shorting candidate once new store openings slow and if a high price/earnings (P/E) multiple still applies. Ultimately, it's likely to consolidate as a yield stock with the price de-rating to a level attractive for income-seekers, and majority earnings/cash returned as ordinary dividends.

For more information see: cardfactoryinvestors.com.