As we said in IPOs: Three essential questions, the odds are stacked against prospective IPO buyers, which is why we’ve long had a general aversion to them. Thanks to recent disasters like Myer and Dick Smith, retail IPOs have suffered a particularly poor reputation. Whilst private equity owners made a fortune, the investors that took the stock off their hands have been left counting their losses. That experience should not dissuade investors from taking a look at Kogan.com.
This is a very different beast, a retailer purpose built for the online world. Moreover, private equity is nowhere to be seen, which minimises the chances of nasty surprises. And most of the proceeds of Kogan’s listing are being reinvested in the business, not used as a way to cash out. This is no repeat of the Myer or Dick Smith debacles (although with Kogan’s recent purchase from the receivers of Dick Smith’s online operation, there is a crossover, which we’ll get to).
Australia's largest pure-play online retailer
Low cost business model
Potential upside from Dick Smith acquisition
Perhaps other investors don’t see it that way. The market greeted Kogan’s listing on Thursday last week with derision: initially offered at $1.80 a share, the shares closed 16.7% down on their first day of trading, at $1.50. If you want even more evidence of why it often pays to steer clear of IPOs, well, there it is. And if you want further evidence of how we treat price falls in interesting businesses, treat this review as Exhibit A.
Like other internet success stories, Kogan was founded in a garage by an ambitious twenty-something. Refreshingly, it was the son of Belorussian immigrants in Melbourne that found an innovative way to take on established competitors rather than a bunch of trust fund enabled Harvard graduates in Silicon Valley.
|Note: 2016F and 2017F are forecasts rather than actual figures.|
That innovation came in the form of selling cheap Chinese LCD televisions under his own name, known as private-label retailing. Today, Kogan generates around $200 million in sales from 26,000 different product lines, ranging from electronics to office supplies and almost everything in-between.
Private-label products still make up around half of Kogan’s total sales but the business now offers branded products from companies like Apple and Samsung, as well as travel packages and pre-paid mobile phone plans. Kogan is more than a simple electronics retailer.
Low cost, low margin
The company strategy is as singular as its product lines are diverse: sell everything at a lower price than competitors. Kogan appears to be successful in that ambition. Its website features products, including many popular brands, at prices lower than better-known competitors. For example, a 256gb Apple Macbook, which sells for $1,998 at JB Hi-Fi, can be found on Kogan.com for $1,749. Such low prices, however, have a cost. Table 2 shows how Kogan’s margins are wafer thin.
What allows Kogan to make a profit at all is its low cost, online structure. Whilst around 16% of sales at JB Hi-i is spent on general operating expenses, Kogan forks out only 13%. With no physical stores for customers to walk into, Kogan doesn’t need to pay the high rental bills charged by the nation’s shopping centre landlords (JB Hi-Fi pays 4% of sales in rent).
Nor does it need an army of sales assistants. Kogan has only 113 employees and boasts a fully automated supply chain. From the point a product is purchased until its dispatch from the warehouse, no human interaction is required. In a price-conscious and competitive market, this delivers Kogan a substantial structural advantage.
The resurrection of Dick Smith
With its original business well-established, Kogan has turned its attention to reviving a fallen competitor. In March this year, for just $2.6 million, the company purchased from administrators Dick Smith’s online retailing operation. This effectively gives Kogan two websites but only one sales operation, something quickly revealed by a visit to dicksmith.com.au and kogan.com.au. The site branding is the only major difference.
Kogan hopes this purchase will deliver additional economies of scale, leading to greater buying power with suppliers and potential margin expansion. Kogan also acquired an extra 1.3 million new members, growing its marketing database by 57%.
What this acquisition might mean for revenues and, more importantly, profits, is unknown. Due to it being ‘not a going concern’ when purchased, Kogan assumed no revenue from Dick Smith in its prospectus forecasts despite the company believing it will lead to ‘significant financial benefits’.
As Kogan will use its existing supply chain and inventory, there’s little extra investment needed to run the Dick Smith sites. If Kogan can capture a decent slice of the $105 million in sales that Dick Smith’s online stores generated in 2015, that would be a very good outcome.
What about valuation? With its share price around $1.58, the company is trading on a PER of 368x 2016 forecast earnings and 59x forecast 2017 earnings. Whether that looks attractive or not depends very much on how the Dick Smith business performs. If Kogan is successful at converting a good proportion of those 1.3m members to purchase items from either of its online stores, current prices could make Kogan look cheap.
The contrary argument is hinted at in table 1. Whilst the company is quick to talk about its growth potential, revenue in 2016 is expected to be largely flat. Also, assuming all variable costs remain as a percentage of sales, a 4% fall in sales would erode all of 2016’s operating profit. This is unlikely, but it does illustrate how sensitive the business is to changes in sales. Such is the life of a low margin retailer in a competitive market.
Nevertheless, Kogan’s low-cost structure is attractive and we’ll be watching out for its upcoming results. Evidence regarding its ability to capitalise on the Dick Smith purchase, general sales growth and margin expansion are the key things to watch out for. If the price looks attractive after that, we’ll be sure to let you know, but don’t expect future coverage of this business until that happens. Right now, Kogan offers more risks than rewards.