Matalan - The bet

All,

Please find our substantially updated analysis of Matalan here.

The bet with Matalan is mean reversion. If it happens within three years, then the bonds return 23%. But we write “happens”, because it requires the return of the great British consumer, which is a reasonable assumption, but is ultimately outside management’s control. So would an equity return compensate for the risk? Is all of the SSN equity anyway? 

Investment Rationale:

- We continue to hold ca. 0.5% of NAV in Matalan shares and just under 1% in the SSNs. We are buying another 3% of Matalan SSNs at 76.5c/€ for a 23% yield to maturity. The latest cash injection has also postponed the maturities of the smaller S. Sr. / Priority tranches to give three years of runway. The bet is that UK retail normalises somewhat in that time to allow the company to refinance. The exit for the equity could be further away.

- The bet is an equity-natured bet on the improvement of top line, which in turn is mostly a macro derivative. However, we do not consider all of the SSNs to be equity, even in a restructuring scenario. So the 23% YTM, including a 10% cash coupon is highly attractive for a trade that essentially only aims at mean reversion.

- For clarity, to make an equity return, we do not (need to) believe in the €150m budget EBITDA to cover the debt and equity so as to refinance and sell the company at attractive rates / valuations. 

- From 20,000 feet: A budget retailer should be making between 7.5% and 9% EBITDA and Matalan has historically fit this profile. We think the format remains valid and as equity bets go, this ought to be a bit volatile, but in the end one of the simplest.

- On the downside, if EBITDA does not improve, the SSNs at 75p/£ create the company (assuming no cash) at 6x (and more likely 5x if some residual cash remains on the balance sheet). S.Sr. and Priority debt would stand at 3x (2x). But debt carrying capacity would be minimal. Still, in a similar situation two years ago (no debt carrying capacity) the market left £335m of debt outstanding. That would put the bonds at 75p/£ - the level at which they trade today.

Higher Level:

- Ordering the 2024 collections at intake prices 15% below prior year was brave. But even though Matalan could not hold on to all of the benefit and had to accept 7% lower sales, this proved to be absolutely the right decision. The ensuing quality deficit in the women’s collection need to be addressed, however.

- Arithmetically and at constant purchasing volumes (as quarterly USD futures suggest), dropping intake prices by 15% should have produced a £45m uplift. By contrast, Revenues have dropped by £80m and on a roughly 50% GM that should have by itself dropped Gross Profit by £40m. The net figure of the two would have been +£5m. We can, however, see COS improving by £21m and once adjusting for the £13.5m shipping surcharges, we come to £35m. So there is a £30m or 3% of Revenue outperformance that we cannot explain. We are curious as to what drove that outperformance and if it was a one-off or will remain constant going forward. We have yet to speak to management about this.

Budget Projections:

- Matalan's new budget underlying the latest cash injection allows for more time to rebuild revenues. While details are scant, we can rationalise the first year as a continuation of this year with slightly better sales and no Suez surcharges. Our only concern here is that the resulting gross margin would appear unsustainably high - approaching the low to mid 50% range. This is significantly above the historic highs of 48% and we are not sure for how long this can be upheld. 

- We have no trouble modelling revenues grow to £1.3bn over four years, except that Matalan has been going sideways since the financial crisis. We are modelling revenue to budget.

- We do find it near inconceivable, however, that Matalan achieve £150m EBITDA at an 11.5% margin. This has been done once before, but it was a historic outlier. Our EBITDA projections primarily differ from Matalan's on account of the implicit Gross Margin in the budget. We think it more prudent to assume that the market requires a return to the high 40s. So our EBITDA projection for 2019 struggles to exceed £120m.

FY25/26 Guidance:

- Management have guided EBITDA for 2025/26 to be in the range of £65-70m. This could theoretically be achieved if everything remains constant and only the freight surcharges fall away. However, Matalan and its competitors would give a good part of that up to the market and we think some revenue growth will be required to achieve this target.

Tariff Terror:

- According to Chinese trade data, close to $30bn of China's apparel exports go to the US ($36bn if including accessories).

-Matalan imports primarily from Bangladesh and to a lesser extent from Vietnam and from Turkey.

- As regards, the non-Chinese S.E. Asian exporters, a total outflow from China would add 1/3 of demand.

- We imagine some reluctance from non-Chinese suppliers to spoil their long-term customer relationships with potentially short-term arrangements. But there could be upward price pressure. if tariffs become more permanent. But as a mitigant, European importers would find extremely competitive prices in China in about the same time frame.

Here to discuss this opportunity with you,

Wolfgang

E: wfelix@sarria.co.uk
T: +44 203 744 7003
www.sarria.co.uk