Shoe Zone: Why This £69m Shareholding Could Be Worth Watching

02 March 2015
By Maynard Paton

Today I’m continuing my hunt for Watch List shares with a look at Shoe Zone (SHOE).

Here are the initial attractions that prompted this research:

Simple business: It’s a retailer of cheap shoes
Cash-rich: Latest balance sheet showed cash of £9m and no debt
Owner-aligned bosses: Family management boasts 55%/£69m shareholding

As usual, I’m applying a question-and-answer template to help me pinpoint companies that match the criteria set out in How I Invest. I’m looking for as many Yes answers as possible.

Activity: Discount shoe retailer with 500-plus UK stores
Website: www.shoezoneplc.com
Share price: 250p
Shares in issue: 50,000,000
Market capitalisation: £125m

Does the business boast a respectable track record?

Possibly not.

SHOE was formed back in 1980 but came to the stock market only last year. As such, detailed financial information is limited to the Admission prospectus and the subsequent 2014 annual report.

Those documents showcase a mixed performance:

52 weeks to	1 Jan 2011	1 Oct 2011*	29 Sep 2012	5 Oct 2013**	4 Oct 2014
Sales (£k)	239,071	155,995	221,114	193,882	172,861
Operating profit (£k)	9,363	(8,657)	4,566	5,307	11,505
Exceptional and other items (£k)	-	-	-	-	(936)
Finance income (£k)	(338)	1,445	(1,041)	(249)	(70)
Pre-tax profit (£k)	9,025	(7,212)	3,525	5,058	10,499
Earnings per share (p)	-	-	-	-	16.1
Dividend per share (p)	-	-	-	-	3.6

(*39 weeks **53 weeks)

The downward sales performance has been caused by shop closures — the store estate was reduced by 158 during 2013 and by a further 25 during 2014. In fact, the chain operated more than 700 outlets a few years ago and at the last count the number was down to 545. The fact SHOE has had so many “underperforming” locations to close is somewhat disappointing.

Still, profits have risen during recent years through higher margins — in part due to SHOE either negotiating lower-cost rents or relocating stores to cheaper landlords.

Has the business grown mostly without acquisition?

No.

Here’s a potted history from the Admission prospectus:

 

The prospectus describes three of the acquisitions as “major”. For what it is worth, the latest balance sheet shows no goodwill.

Has the business mostly self-funded its growth?

Possibly.

The latest balance sheet displays net assets of £32m, of which £29m has been funded by retained earnings. The group carries no debt.

Does the business possess an asset-strong balance sheet? 

Yes.

The latest balance sheet shows cash of £9m, no debt and freeholds of £10m.

Something to note: SHOE’s cash position is flattered by significant trade and other payables — that is, money SHOE owes to suppliers and other creditors. At the last count, such sums came to £30m — versus just £8m effectively owed to SHOE by its customers and suppliers.

The accounts also contain two defined-benefit pension schemes. However, the latest combined deficit of these schemes came to £5m, which looks a manageable liability to me given recent profit levels. Plus, SHOE’s pension contribution for the current year is not that substantial at £300k.

I always find it worth evaluating leasehold liabilities when looking at retailers. That’s because being locked into high-cost, long-term leases can become very troublesome should sales start to falter.

SHOE’s leasehold liabilities do not appear problematic:

52 weeks to	1 Jan 2011	1 Oct 2011*	29 Sep 2012	5 Oct 2013**	4 Oct 2014
Property lease expense (£k)	38,665	28,017	34,176	29,171	25,153
Minimum lease payments due:
Within one year (£k)	34,785	34,512	33,586	25,130	22,866
Between one and five years (£k)	110,680	107,006	97,059	70,314	59,867
After five years (£k)	67,845	68,880	54,927	30,258	19,516
Total (£k)	213,310	210,398	185,572	125,702	102,249

(*39 weeks **53 weeks)

I’m pleased the bulk of future lease commitments last for less than five years, as it should allow SHOE greater room for manoeuvre with any further underperforming stores.

Dividing the total future lease commitment (£102m) by the lease payment for 2014 (£25m) suggests the average lease has 4.1 years left to run.

Does the business convert profits into cash?

Yes, or at least it has during the last few years.

52 weeks to	1 Jan 2011	1 Oct 2011*	29 Sep 2012	5 Oct 2013**	4 Oct 2014
Operating profit (£k)	9,363	(8,657)	4,566	5,307	11,505
Depreciation (£k)	6,053	5,544	8,755	6,497	4,527
Cash capital expenditure (£k)	(10,918)	(6,081)	(2,034)	(2,827)	(2,008)
Working-capital movement (£k)	(673)	1,234	2,558	(3,398)	922
Net cash (£k)	(1,501)	(10,423)	4,752	4,864	9,114

(*39 weeks **53 weeks)

I see the aggregate depreciation charged against earnings has been well ahead of actual cash capital expenditure, and the Admission prospectus partly explains why:

“Low cost store refit programme: Shoe Zone intends to continue to implement its low cost store refit programme at an average rate of 50 store refits per annum between 2014 and 2017. The Directors expect that the £2.5 million annual capital expenditure refit programme will be approximately half of the £5.0 million depreciation charge anticipated for the 2014 financial year”.

There are no problems with aggregated working-capital movements either.

Does the business enjoy a competitive advantage?

Not really.

Everything boils down to management — as it always does with retailers. I suppose the board’s long-standing relationships with various Chinese manufacturers may be helpful.

A 6.7% operating margin for 2014 seem impressive for a discount retailer, and suggests the group employs a welcome, low-cost mindset. That, too, may keep SHOE ahead of its rivals.

Does the business produce a respectable return on equity?

Yes, or at least it did during 2014.

Return on average equity for 2014 was £8m/£32m = 25%, and even adjusting the denominator for the pension deficit still gives more than 20%.

A lack of working capital tied up in the business — stock of £29m is counterbalanced entirely by the aforementioned £30m of trade creditors — is the main reason for the impressive percentage.

Prior to 2014, SHOE’s return on equity was a so-so 12% or less.

Does the business employ capable executives?

This depends on your view of SHOE’s track record.

The group is led by brothers Anthony and Charles Smith. Anthony has been chief executive since 1997 and Charles has been a board executive since 2001. Both Smiths are in there 40s and, backed by their major shareholdings (see below), could be heading this business for some time to come.

Does the business employ good-value-for money executives?

I think so.

Anthony Smith collected a £225k basic salary last year and is on £250k for this year. Meanwhile, his brother Charles collected £188k last year and is now on £200k. Those pay packets do not look outrageous to me at an £11m-profit business. I see last year neither Smith received any pension payments nor any bonus — suggesting some restraint pay-wise.

Does the business employ owner-orientated executives?

Yes.

The Smiths sold 45% of this business during last year’s flotation and presently retain a 55% stake with a current £69m market value.

I like the fact SHOE’s maiden 3.6p per share dividend gave the Smiths an aggregate dividend (of £1m) that was well ahead of their combined basic pay.

I also like the lack of an option scheme.

Does the business enjoy reasonable growth prospects?

I’m not sure.

Anthony Smith last reported:

“Despite the well publicised warm start to the Autumn/Winter season we believe that 2015 will be a year of continued growth for the Group.

We have continued to optimise our store portfolio and so far we have opened six stores (two relocations, four new) and have agreed terms on 10 stores (seven relocations, three new). 

Our successful multi-channel offering continues to grow ahead of forecast. The falling oil price is already having a positive impact on the cost of logistics and should also impact the price of raw materials. 

The Board continues to see significant opportunities ahead and remains confident that the business will perform in line with market expectations.”

As far as I can tell, opening four stores and agreeing terms on another three is not going to make a great impact on a 500-plus outlet estate. Indeed, SHOE’s Admission prospectus stated just five new stores a year could be opened until 2017.

It seems future gains are more likely to emerge via re-locating smaller stores into larger stores. According to the Admission document, keen lease negotiations and other economies of scale following a re-location can double a shop’s margin.

The Admission prospectus claims such relocations and other management actions “will assist to improve the average cash contribution per store from approximately £54,000 currently to approximately £70,000 by 2017.”

A 30% profit uplift between 2014 and 2017 certainly sounds impressive. I am awaiting clarification from SHOE about the definition of “cash contribution per store” — I presume it represents gross profit.

I am also awaiting clarification as to whether the directors still expect a £70,000 ‘cash contribution’ per store by 2017. This projection was not mentioned within SHOE’s recent results or City presentations — which makes me wonder whether it has been quietly dropped.

Does the share price stand a good chance of becoming a bargain?

Possibly.

Operating profits for the 52 weeks to 4 October 2014 were £11.5m. Less standard 20% tax gives earnings of £9.2m or 18.4p per share.

I do not deem SHOE’s cash pile to be ‘surplus to requirements’, so on a straightforward P/E basis the rating is 250/18.4p = 13.6.

Not an obvious bargain, especially given the modest potential for extra stores.

However, assume all 545 current stores do indeed improve their ‘cash contribution‘ to £70,000 by 2017, then gross profits could be £38m. Less administration and distribution costs of, say, £20m (currently £17m), and tax at 20%, then earnings could rally to £14.5m or 29p per share.

Apply a middling P/E of 12 on that 29p per share estimate and the share price comes to 349p. That equates to 40% potential upside over three years from 250p, which with dividends could reach 45% or more. Such possible returns do not look that bad to me.

Something to consider: I’ve seen many specialist retailers stumble in the past… and it is not uncommon for such shares to significantly de-rate to single-digit P/Es as the market frets about relentless competition. I can’t see Shoe Zone being immune to a depressed rating if trouble emerges.

Is it worth watching Shoe Zone?

Probably.

The real attraction here is the long-standing family managers. They presumably know the industry inside out and look to be the owner-orientated types with £69m still riding on the share price. The tone of their annual-report commentary is reassuringly clear-cut as well.

But SHOE does have drawbacks. In particular, I’m surprised such veteran bosses allowed themselves to reach a point where 100-plus underperforming shops had to closed. What’s more, I suspect re-locating stores to improve profits will never attract the same investor enthusiasm — and possible premium P/E rating — as growing profits by rolling-out new stores.

My gut feel on SHOE is to bide my time and perhaps see if a cheaper buying opportunity occurs. I also want some clarification from SHOE about the £70,000 per store ‘cash contribution’. Similar to purchasing a pair of the group’s shoes perhaps, I feel a good investment result here will be dependent mostly on bagging a cheap price.

Maynard Paton

Disclosure: Maynard does not own shares in Shoe Zone.