Truworths released FY20 results on Thursday (3 September). Although the result was slightly better-than-expected, predominantly due to impressive SA cost management (where it reduced employment and occupancy costs by 7% and 17% YoY, respectively), it was still a mixed bag with good cash generation and the declaration of a dividend attempting to distract the market from some concerning trends building in its business model. A revenue decline of 9% YoY, was slightly better than expected after the various company updates painted a far more grim picture. However, these positives were more than offset by a significant increase in debtors’ cost, as the Group’s debt provisioning ballooned to 30.1% – its highest level since listing.
Still, Truworths remains extremely cash generative and, even in this very tough operating environment, the Group increased cash generated from operations by 7% YoY. The balance sheet is also in a net cash position of R2.15bn even after the share-buyback programme of R583mn, which is set to continue. The Group’s gross margin remained resilient, falling from 51.6% to 50.8%, despite the gross margin in its UK business, Office, collapsing from 42.3% to 38.7%. This was due to an impressive local performance, where Truworths managed against all expectations to increase the gross margin! The Group operating margin declined to 22.8%, mainly due to an increase in debt provisions.
However, Truworths’ longer-term business trends are concerning. Return on assets, return on equity, return on capital, and asset turnover have all been trending downward at an alarming rate over the past few years. The key culprit here, we believe, is that its business model is under real strain. Truworths is being disintermediated by the banks in supplying credit and its merchandise is too expensive to compete with other retailers on a cash basis. This has resulted in the business being unable to increase its trading density in 9 years, during a period where SA experienced an average inflation rate of c. 5%. In addition, volume growth has been lacklustre for a decade and Truworths has not had product inflation in SA since Winter 2017.
Truworths’ acquisition of Office, which operates mainly in the UK, with stores in Germany and Ireland, is also turning out to be a disaster for the company. Earlier this year, management guided that the firm will be looking to offload its investment in Office. However, this has now turned into “we are investing a further GBP6.5mn in the business.” We presume that this is because it has been unable to find a buyer for Office. Truworths is now expecting to shrink this business over the next few years and planning to close 28 unprofitable stores in FY21 and a further 30 stores before FY24, as the leases come up for renewal. This will leave Office with only 70 stores! The Group has also been investing heavily in e-tailing, but this is doing very little to stop the bleed.
Similar to SA banks, Truworths took a severe hit in its credit book. However, Truworths’ hit was probably worse than that of local banks since its customer base is largely younger than 30 years of age, suggesting that it can only get the credit consumer after these consumers have been rejected at all the other, cheaper, credit providers. These customers will then, in all likelihood, close their account at Truworths once they qualify for more affordable credit products. The closing of physical Truworths stores during lockdown was also detrimental to its credit book as more than 80% of credit customers repay their accounts in-store. April was thus a disastrous month for collections.
Moving to the outlook for the business, this remains pretty dire. Since the end of June, Truworths’ revenue is down 11%, with credit sales declining by 14% and cash sales 3% lower over the same period. This compares extremely poorly to other SA retailers that have given the market a trading update recently. The Office segment’s sales also decreased by 30% since 30 June in pound sterling! Here, management gave the reason as being due to store closures and a phased reopening of some stores, but it remains concerning to us. To change this, management said it will be looking to copy Foschini and bring more manufacturing to SA. Management will also attempt to pivot more to the value segment of the SA market by investing in larger Identity stores, launching a more affordable Uzzi range and expanding its children’s wear offering. Of more concern to us is the fact that Truworths will be losing three very senior executives over the next 2 years including its CEO, Michael Mark. The board has said that they will continue to communicate a succession plan to the market in due course but, in our view, currently the succession plan leaves a lot to be desired.
Truworths’ business model is facing some severe challenges in the COVID-19 environment. The company’s overreliance on credit, its relatively high price points, and its significant exposure to women’s business and evening wear are making Truworths extremely vulnerable. Its acquisition of Office in the UK is also proving to be a disaster with the firm’s initial announcement that it wishes to sell Office being reversed into GBP6.5mn in further investment. We believe the reason for this is that there are no buyers for Office and Truworths also cannot get out of its leases. Nevertheless, Truworths’s share price is very cheap and, even after considering the impairment of Office, the business still has a very strong balance sheet that is in a net cash position. In our view, an investor will make money over the medium term if they buy Truworths at current price levels. However, we also believe that there are far better opportunities currently floating around on the JSE.