Today I want to look at two stocks operating in the same sector but with very different characteristics.
One is a company I’ve previously owned shares in, but am now avoiding. The other is a business that I believe could help you to build a market-beating pension pot and retire early.
Good news or bad?
Shares in convenience store operator McColl’s Retail Group (LSE: MCLS) fell by more than 10% in early trading on Monday. Investors appeared to be disappointed with the firm’s half-year results, which showed a further 2.7% fall in like-for-like sales for the six months to 27 May.
One of the reasons for this decline is the failure of wholesaler Palmer & Harvey last November. P&H supplied 700 of the group’s 1,300 stores, so its sudden closure caused a lot of disruption. The transition to receiving wholesale supplies from Morrisons is only just being completed.
A second challenge facing the group is the integration of 300 Co-Op convenience stores, which it acquired last year.
The combined effect of these pushed the group’s adjusted earnings before interest, tax, depreciation and amortisation down by 3% to £16m during the first half of the year. Adjusted EBITDA for the full year is now expected to be similar to last year, despite an expected 10% increase in total sales.
It’s hard not to be a little disappointed by these results. Although they do reflect one-off challenges that are unlikely to repeat, I think they also highlight some of the risks for investors in this business.
What could go wrong?
In today’s half-year results, the company said that as it heads into 2019, “it will remain important to manage intense cost pressures in the business, whilst also investing in the customer offer to maintain our competitive position.”
In other words, McColl’s management expecst to continue facing tough competition on prices from supermarket rivals.
As you’d expect, this is already a business with pretty slim profit margins. The group generated an operating margin of 2.2% last year. During the first half of this year, that figure fell to 1.1%, or 1.6% if you exclude costs the company says are one-offs.
These low margins wouldn’t worry me so much if the group was able to generate a high return on capital employed (ROCE). This ratio measures profits compared to the capital invested in the business.
However, McColl’s ROCE has fallen from 12.8% in 2015 to 7.3% last year. Today’s half-year figures show that the group’s trailing 12-month ROCE has been maintained at 7.4%, so at least the decline has been arrested.
However, net debt is still relatively high at £112m — almost unchanged from the same point last year. The company says that this is lower than expected, as it’s secured “improved supplier terms” from its new wholesaler Morrisons. Essentially, this means that McColl’s has been able to agree longer payment terms with its new wholesaler. When a retailer does this, it generates a one-off cash windfall.
Even with these gains, net debt equates to about 2.5 times forecast EBITDA for the year. I prefer to see this multiple below 2 times, especially for low-margin businesses that are vulnerable to aggressive competition. My concern is that McColl’s won’t find it very easy to repay the debt it used to fund the acquisition of the Co-Op stores.
Buy, sell or hold?
I estimate that McColl’s shares trade on about 10 times forecast earnings after today’s fall. The interim dividend has been left unchanged at 3.4p per share. Based on last year’s dividend, the stock now offers a yield of 5.6%.
This may seem cheap, but I believe the group’s low margins and substantial debt mean that the risks to shareholders are growing. The shares look fully-priced to me, and I think there are better options elsewhere in the food and drink market.
A market-beating star
The problem for McColl’s is that customers only use its stores if they are cheap and located in the right place. If there’s a rival store nearby with lower prices, customers will go there instead.
Customers don’t really feel much brand loyalty. This makes it hard to protect profit margins. For my second stock, the situation is quite different. Soft drinks producer Nichols (LSE: NICL) makes a number of branded drinks, such as Vimto, Sunkist and Levi Roots. These all have loyal customer followings in the UK and a number of overseas markets.
Nichols’ customers appear to prefer these branded drinks to cheaper rivals. The company generated an operating profit margin of 20.1% during the first half of this year. Return on capital employed was 21.7%, highlighting how profitable this business really is.
Why this matters
Nichols’ high returns mean that it generates a lot of cash. The company had net cash of £37.1m and no debt at the end of June. This enables management to fund investment in new products or pay dividends without borrowing money. So there’s very little risk that the company will run short of cash or experience financial difficulties. Funding everything from net cash also tends to make it easier for a profitable company to beat the market, as equity returns aren’t diluted by higher levels of debt.
Nichols is a good example of this. Despite concerns about the impact of the sugar tax, the firm’s shares have risen by 40% over the last five years. This compares to just 15% for the FTSE 100.
So £10,000 invested in the Vimto-maker in July 2013 would be worth about £14,000 today. In contrast, a £10,000 investment in a FTSE 100 tracker would only be worth around £11,500 today.
A long-term buy
Nichols’ stock doesn’t look cheap. Shares in the soft drinks firm currently trade on a 2018 forecast P/E of about 21, with a prospective yield of 2.4%.
However, I think the risk of a dividend cut or share price collapse is much lower that at McColl’s. I believe that the soft drink firm’s valuable brands, high profit margins and strong balance sheet simply make it better quality business.
In my view, Nichols’ market-beating performance is likely to continue. So I’d be happy to buy the stock at current levels for a long-term portfolio.
Roland Head has no position in any of the shares mentioned. The Motley Fool UK has recommended McColl's Retail and Nichols. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.