Hello everyone, I’m David Walker from StocksInValue.
Nick Scali’s 2016 earnings result is a star result from the August 2016 reporting season and the stock is one of our model portfolio’s best successes. We took a 4% weighting at $3.32 when we launched the portfolio in March 2015 and at the time of recording our capital return before dividends was 75%. The share price today is around $5.82 and the stock is attracting strong interest from new investors.
We were always confident we were onto a winner with Nick Scali and it’s worth examining how StockInValue gave us this confidence to buy and hold.
Figure 1. NCK five-year history (click to enlarge)
Source: StocksInValue, Key Stats tab
The chart on your screen should be familiar if you’ve come to our masterclasses or been reading our research for a while. It shows earnings before interest and tax margins (in the green box) which are consistently high for a retailer. There’s also solid conversion of reported earnings to operating cashflows. If you divide the operating cashflows in the red box by the earnings in the black box you’ll see the ratio was greater than one every year. Dividends paid in the blue box were less than earnings in the black box, so Nick Scali didn’t pay an excessive payout ratio and wasn’t forced to cut its dividend, and investors received franking as you can see in the purple box, where grossed-up dividends exceeded cash dividends every year.
Finally Nick Scali didn’t have to raise equity from shareholders to grow. In the brown box you can see no ordinary share capital was raised during the last five years.
Now those were the quantitative features we liked. We also admired the quality of the business and the growth potential. We liked: the record of strong profitability; annual new store openings but plenty of distance left to a long-term target of 75 stores, so plenty of growth left. We also liked the strong and stable gross margins, how management is focused on same-store sales growth; the pricing power to pass on the higher costs of imported inventory due to Australian dollar depreciation; growing bargaining power with suppliers; the ability to conceive and execute a strategy; strong operating cashflows able to fund growth capital expenditure and higher dividends, and the niche market focus without the distractions of size and diversity for their own sake.
So, StocksInValue’s quantitative screens, and our own qualitative analysis, showed us why this was a quality company worth putting on the watchlist. But was it cheap enough to buy? Well, now to valuation.
Figure 2. Nick Scali valuation metrics
The chart on your screen now shows the history of Normalised Return on Equity (or NROE in the green box), a primary input to our valuations. “Normalised” ROE means the inclusion of franking credits, which have value to investors resident in Australia for tax purposes so they should be in the valuation. NROE has been very high for five years at 47-73% and the improvement from 55.6% in FY15 to 58.7% in 2016 TTM (which means Trailing Twelve Months – the sum of the 2H15 and 1H16 results) gave us confidence to upgrade our ‘adopted’ NROE (the one we use in our valuation) from 55% to 60% in March this year. However the smaller 55% figure still left the stock undervalued in March last year, when we bought the stock for the model portfolio. At that time the forward-looking valuation was well over $4.00 with the share price at $3.32.
At the same time the valuation used a 13% required return. This is a percentage measure of earnings risk. Higher required returns reduce valuations by increasing the rate at which future profits are discounted to present values. 13% is low relative to many other companies in StocksInValue but at the upper end of the ‘low’ range, mainly to reflect NCK’s small size and sensitivity to consumer confidence.
So the valuation wasn’t aggressive. The adopted NROE was reasonable given long-term trends and we didn’t have to inflate it or dubiously lower the required return just to make the stock look cheap enough.
So that’s how our happy experience with Nick Scali began. The lessons are:
- StocksInValue provides a history of profitability measured by NROE. When a valuation uses a future NROE assumption which is reasonable given a company’s record
- A valuation uses a required return which is not so low as to artificially bias a valuation higher
- The company is of high quality, and
- The stock is still materially undervalued…
It could well be a good buy!
As always with our video presentations, if you have a query or a comment please post it below the transcript on your screen. Thank you for watching, and I’ll see you next time.