Superdry PLC – Time to buy or is this a value trap?

Superdry – a once thriving brand brought down to earth by the reality of fads and market trends.

It would appear the whole high-street clothing industry is falling to tatters bar a few strong performers lead by exemplary leadership, mainly Next PLC.

This has led to many investors speculating as to the true value of the listed high-street retailers with many screaming “buy” at these “bargain prices” or “sell” because “high-street retail is dead”.

With the current troubles at Superdry, I thought it would be a good time to dive in for a deeper look.

Are Superdry shares a buy here?

A few years ago, I would have already bought Superdry shares at this point and would be hashing out a justification ready for this blog.

My once fixated value approach to investing would be pointing out the apparent value of the shares here.

After all, the prospect of a miracle turnaround by Co-founder Julian Dunkerton (pictured left) is an attractive one. Superdry isn’t a brand that’s going to disappear anytime soon, even if it is as old and tired as I suspect.

I speculate that the main problem facing the brand is the damaging manner in which its largest intangible, the brand name, was treated by the outgoing management team.

Constant discounting has doubtless reduced the brands value in the eyes of consumers.

Alarmingly, instead of following the successful margin-led strategy of Lord Wolfson at Next – Superdry management had opted for revenue vanity exemplified by a stack ‘em high and discount them ‘till no tomorrow strategy so disastrously followed by failing retailers such as Debenhams.

Before we even think about valuation, we must put our business hats on and take a look at Superdry as a company.

In order to assess a company, I like to ask one questions as part of my initial screening.

Does the company have an economic moat and if so is it narrow or wide?

As you will read in the remainder of this article, I believe the damage to the most valuable of intangibles, the brand, means that any idea of a moat that Superdry might have once enjoyed has all but disappeared. As such, the balance of risk and reward in the investment remains stacked against the investor despite the appearing bargain basement valuation of Superdry at present.

If you remain unconvinced by my new ‘moat’ approach to investing, here are the two main reasons as to why moats are important.

a) Moaty businesses have the ability to generate excess returns well into the future by defying one of the fundamentals of capitalism “excess returns are competed away to the cost of capital”.

b) Moaty businesses are more forgiving when management make terrible decisions. This is down to superior economics. Just look at Microsoft’s venture into mobile.

Microsoft had such an outstanding economic moat, it survived having this guy run it…

Think about it this way, if you put the best jockey in the world in charge of a donkey, it still wouldn’t win the grand national. Put me on a champion horse in a race against donkeys and I’m pretty confident I would win the grand national!

It’s the underlying business that matters – nothing else (until we come to valuation that is).

The key is to look at the business before the valuation.

In my experience, value stocks are usually cheap for a reason and nowadays I’m not really interested in turnarounds unless the company has a moat that is intact or can be repaired.

Of course, a moaty business at the wrong price is still a poor investment and the best businesses are moaty businesses selling at deep value, but they are often very hard to find.

This isn’t a rant against value investing by the way, I have just found from experience that it is incredibly hard to determine accurate fair value for stocks and that value stocks are often cheap for a reason.

So, let’s take a look at Superdry, a beaten down beauty or cheap for a reason?

When looking for the existence of an economic moat I like to look at the following metrics.

Return on Equity (ROE), Return on Capital Employed (ROCE), Gross Margins and Operating Margins.

On top of this I take a look at the company’s industry and the economics of that industry as well as the company’s market position and intangibles (brands, patents and talent).

I then try (knowing that I will fail) to foresee what the future of the company may be and to haphazardly estimate the potential cashflow of the company 5 to 10 years from now.

What I would say at this point though, is that it is often obvious when a moaty company is undervalued. Some of you may think that this is a somewhat lazy, blasé statement but from my experience there is a conviction ‘feeling’ that one gets when an incredible company is going for cheap.

Like Facebook at $140 and Altria at $45, it just knew that the market was being far too pessimistic for reality and size of the companies’ economic moat.

Saying this, there is still plenty of time for me to be proved wrong here!

So, let’s take a look at the metrics

ROE & ROCE

Looking at the company’s ROE we can see some evidence of a potential economic moat.

With ROE ranging from 11.34 – 18.65% are getting a return on their capital which is above that of the cost of capital and above that of most retail peers but notably below ‘exclusive’ luxury brands such as Burberry (more on that later on!)

The apparent weakness in 2014 and 2018 does worry me a little despite 2015 and 2017 providing exceptional returns. I like to see ROE which is consistently in the high teens and although the degree of variation here is a little worrying it’s not enough for me to cast aside the idea of investing in Superdry. With ROCE also being modestly high we can be confident that Superdry has historically put capital to good use.

To summarise ROE and ROCE – These are not the best numbers I have ever seen but they’re pretty decent.

Margins
While a gross margin of 58% is encouraging, it had been as high as 61.6% in 2016, I’m also troubled by the steady decline in Superdry’s operating margin. Down from 14.3% in 2014 to 11.5% in 2018.

Declining margins are a sign of an eroding moat or no moat at all!

How come?

Well, these declines indicate higher operational or product costs that can’t be controlled or passed on to the consumer. Either that or the need for the Superdry to cut prices to compete. Moaty businesses on the other hand can easily pass on increased costs.

Other clues

Looking for clues as to the brand’s underlying strength we find a troubling trend.

It would appear that management has tilted to a ‘revenue growth at all costs strategy’ which may have deteriorated the brand.

One such sign that worries me with retail companies with deteriorating margins and constant sales to be seen in-store is when account receivables balloon.

We can see that in 2014 that receivables accounted for just 9.26% of Superdry’s non-current assets. In 2018, receivables make up 16.21% of total assets. To me, this suggests that the company is extending more favourable payment terms (possibly in its wholesale arm) as a way of increasing revenue.

The industry and Superdry’s competitive positioning

To me, Superdry is somewhat of a unique company.

On one hand it is a brand and on the other hand it’s a ‘mass-market’ retailer.

It’s a company that’s squeezed between the mass-market retailers themselves such as Next, Zara, Topshop e.t.c and the more exclusive designer labels such as Burberry.

This squeeze is evident when we compare Superdry’s core ratios that I detailed above against that of a true designer brand – Burberry for example.

Whereas it was a once fashionable brand that could maintain prices and hold very little sale events, it has morphed into Sports Direct, desperately trying to flunk its stock.

It now has an image crisis and it’s hard to see if it will ever recover.

This is the core question for me;

“Is this really a case of bad management or has the brand simply had its day?”

Tying this article back to the criterion I set out, a company with a true economic moat should be able to hold up despite poor management, Superdry clearly hasn’t.

To summarise

Whilst ROE and ROCE remain relatively healthy, declining margins and increased receivables are a cause for concern.

Looking at the industry we can see that Superdry has an image problem and we’ll have to wait and see if the brand can still shift stock at full price now that Euan Sutherland’s discounting days are over.

For me, there is little reason to look further than the business.

With the brand in crisis and margins declining, Superdry has no moat and as such is not a company that I would consider investing in.

If you’re good at valuing shares and judging turnarounds on the other hand, let me know if you think shares are trading at bargain basement prices here!

FRUGALSTUDENT VERDICT: DON’T BUY