How we sold Vita Group above $5

Vita Group's (ASX:VTG) share price crash was not a surprise.

If you're surprised by the recent crash in Vita Group’s (ASX:VTG) share price you shouldn’t be. The looming risk that torpedoed its share price by 70% has finally reared its ugly head.

Let’s recap how we got here. Twelve months ago, Vita Group, a telecommunications retailer, had become a small cap market darling. A lot of its success was due to Telstra (ASX:TLS).

Vita used to operate a multi-branded business, including Next Byte and FoneZone stores. But after successfully running a few Telstra branded stores, management decided to concentrate heavily in this area. By 2016, over 70% of its stores were Telstra branded, up from 28% just five years earlier.

Management did so for good reason. Selling data and voice plans involves very little inventory, so Vita could operate a large network without tying up much working capital.  Demand for Telstra’s products was improving (partly thanks to Vodafone’s missteps) which put a tailwind behind per-store sales, and Telstra generously shared a large chunk of this with its resellers (Vita’s gross margins exceeded 35% in 2016).

These attractive features made Vita look like an investor’s dream, with rising margins, rising cash generation and a rising share price. But hiding behind the enticing headline numbers lay a concerning fragility. Again, due to Telstra.

As Vita concentrated on Telstra stores, its earnings became increasingly dependent on its arrangement with Telstra. Michael Porter, the creator of the porter’s five forces framework for assessing competition, calls this supplier power. And if the slash of a supplier’s pen can erode a big chunk of value, the business is far from robust.

We weren’t predicting a change to Vita’s arrangement with Telstra when we downgraded it to SELL at $5.32 (Vita Group: Result 2016); but it was always a glaring risk and one that was not compensated for at 23 times trailing earnings. The company also gave clues that all was not well, like its peculiar expansion into IT services and men’s apparel and the significant selling by insiders.

This week we learned that Telstra has finalised its raid of Vita’s cookie jar, taking things from bad to worse. Telstra will claim more of the profits in its branded stores and even take back the most profitable ones in response to margin pressure in its mobile business. Perhaps Vita’s success was its undoing as, when Telstra needed to restore its margins, Vita stood out as an easy place to find it.

This highlights an age-old investing lesson that price matters. A business setback can be an inconvenience to a low-priced stock but downright devastating to a high flyer.

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