The big threat to Kathmandu

PORTFOLIO POINT: As Kathmandu heads for an IPO a competitor is growing that could constrict its margins.

The big fund managers have all had the dog and pony show for Kathmandu by now. Kathmandu, a specialty retailer that sells clothing for camping and outdoor activities at a premium price, is looking to get $350 million from the float hot on the heels of the Myer IPO (click here).

Goldman Sachs, which bought the company with a consortium in 2006, has been saying this, that and the other to justify the pricing of $1.65–1.95 a share. But as the institutions go off to crunch the numbers, all they really need to ask themselves is just one question: what is Morry Fraid going to do to them?

As the driving force behind Spotlight, Fraid is the owner of a chain of more than 100 fabric stores across Australian and New Zealand and BRW Rich Lister with an estimated net worth of $710 million. He opened the first store in Armadale, Melbourne, in 1973 with his brother Ruben Fried (who died earlier this year).

Five or six years ago he started up a camping and outdoor superstore business called Anaconda with a strategy similar to Bunnings: the stack ’em high, sell ’em cheap approach. Growth has been steady and he tends to open a new store every six months. If Morry decides that this is his next thing and wants to keep throwing money at it, then he can. And he can have a big impact on the other players in the industry.

Morry has always been very good at cost control. Spotlight got quite a few headlines back in the day when it used the Howard government’s Work Choices legislation to remove penalty rates. It was hugely controversial but a good example of just how tough a businessman he is.

Anaconda only has 18 stores in Australia, versus 45 for Kathmandu, so its ability to affect competitors at this stage is limited. Kathmandu also has exposure to New Zealand and a few stores in the UK. Yet if Morry keeps up the approach of launching more and more of these big outdoor warehouse stores, he will start making an impact, and if he can keep doing these really, really low price things, he probably is going to have some impact on Kathmandu.

Now Kathmandu is very much a premium brand in the outdoor sector. Most of their product is made with only their brand on it and it’s not sold to any other store, whereas Anaconda’s approach is bringing together commonly available merchandise in the one place. What people are telling me, though, is that Anaconda is going out there and chasing a very big market share in this industry and that their pricing on their product lines is very sharp. It might not have Kathmandu on the label but it could be 30–40% cheaper.

One of the highlights of the Kathmandu business is its fat gross margins. The gap between the buying and selling price is stratospheric. According to the prospectus, the gross margin it is targeting this year is about 64%. Now you compare that to a globally recognised premium brand like Ralph Lauren, which might get up into the 50–60% level, and 64% is a very, very high gross profit margin. Is this going to be sustainable over the long term?

There’s no question that these are good times for these vertically integrated import/retail businesses like Kathmandu and Anaconda. Consumer confidence is up and people are prepared to lash out on luxury items again. The fall in the Australian dollar has made imports about 30% cheaper and if you have no debt then the savings flow straight to the bottom line.

At $1.90, Kathmandu is being priced at about 15.8 times earnings in 2010. This is the same kind of multiple you find among the top-end speciality retailers. The names we are talking about here are Solomon Lew of Premier Investments, Gerry Harvey of Harvey Norman and Richard Uechtritz of JB Hi-Fi – all proven operators in a difficult industry.

Source: IRESS

Investors have been disappointed by private equity floats of retail operations before and Pacific Brands is a good example. CVC Asia Pacific bought the company from Pacific Dunlop for $730 million in 2001 and floated in 2004 for $1.25 billion. Not bad for a few years work. The issue price was $2.50 and it never really did anything. Five years later it’s worth $1.43 a share.

This is still a very fragmented industry. All it might take is for someone like Morry Fraid to establish a beachhead and change the rules of the game. If Anaconda keeps doing what it’s doing and becomes the Bunnings of outdoor, then Kathmandu’s margins are going to come under serious pressure, which is almost funny considering that the real live anacondas overpower their victims by constricting them to death.

At this stage I’m not taking a firm view one way or another, but it seems to me that really, if I was a big institution contemplating whether or not to take a stake in Kathmandu, I’d want to have a cup of coffee with Morry because if he took Spotlight from one store to 100 he can something similar with Anaconda.

Ivor Ries is head of research at EL&C Baillieu Stockbroking. He may have interests in any of the stocks mentioned.