Description

Recommendation: Long Dixons Carphone PLC (DC/ LN); target price of GBP2.50/shr

Overview:  Dixons Carphone (“DC”) is the leading retailer of consumer electronics in the UK, Ireland, Greece, and Scandinavia (the Dixons business) and the largest independent retailer of mobile phones in the UK and Ireland (the Carphone business). A 2014 merger of equals between Dixons and Carphone Warehouse created DC. This transaction has been a disaster for legacy Dixons shareholders. Carphone profitability has fallen from hundreds of millions of pounds 5 years ago to approximately breakeven today. Therein lies the opportunity. Carphone’s business model, discussed more below, means that it can generate ~GBP800mm of cash in run-off. Net of these proceeds, the consumer electronics retail business is trading at ~6x EBIT vs. global electronics retail peers at ~9x and the broader UK retail sector at ~10x. Assuming the remaining Dixons business rerates closer to peers – consistent with its historical relative multiple before the Carphone issues – implies >50% upside.

Carphone Warehouse: We are going to focus on the opportunity at the Carphone Warehouse business because that is where we believe we have a differentiated view. As noted earlier, Carphone is the largest independent (i.e., not affiliated with any wireless carriers) retailer of mobile phones in the UK and Ireland. The business sells phones at a loss and recoups this loss and a margin through a share of the monthly payments consumers make to the carrier. From an accounting prospective, profit is recognized upfront whereas the cash comes in over time, approximately 2 years. This leaves a GBP1.1bn asset on DC’s balance sheet, “net network commission receivable,” representing the company’s estimate of the present value of future cash due from the carriers. These counterparties are investment grade credits (BT, Telefonica, and Vodafone). Exit costs are manageable. The average lease term is short at less than 2 years. We estimate that the GBP1.1bn asset less 2 years of lease expense, other assumed exit costs, and ~GBP200mm of negative networking capital means that a run-off of the Carphone Warehouse business would generate ~GBP800mm in cash over the next 2-3 years. There is actually a precedent for a similar liquidation. In late 2014, Phones 4u, Carphone’s largest competitor, entered administration. While still ongoing, the process has generated significant cash.

So what happened at Carphone Warehouse that means it is worth more dead than alive? There were two key drivers. One, contracts with the carriers specified minimum volume targets. This was not a problem when the number of mobile phones sold in the UK was growing. As replacement cycles lengthened, however, these volume targets became difficult to hit and Carphone was forced to cut price to drive volume leading to pronounced gross margin pressure. Two, increasing share of “sim only” contracts where customers purchase phones separate from mobile contracts pushed more volume to lower margin standalone phone sales (gross margin more similar to traditional consumer electronics retail) and away from higher margin (but more cash consumptive) bundled sales. The company argues that the later trend is a positive for their Dixons business; however, it is clearly negative for Carphone.

To be clear, the company has not formally announced a liquidation of the Carphone business. We think it is reasonably likely that the company announces a plan to accelerate the shrinkage of this business and extract value of the receivable in December, when the new CEO provides a more detailed strategic plan. The company has acknowledged that Carphone’s current capital-intensive model is suboptimal and demonstrated a willingness to close or sell businesses (e.g., honeybee sale, sale of European mobile phone retail businesses, Sprint Connect sale.) Regardless, for the reasons noted earlier, this business is not worth zero as is currently implied by the market.

Dixons: We estimate that the remaining Dixons business has generated between GBP300mm (FY’19E) and GBP375mm (FY’17) of profit over the last four years. It is worth noting that the company does not specifically disclose Carphone profitability (it is reported with the Dixons business in the UK and Ireland segment) but it can be estimated through company commentary and Companies House financials. After a painful pricing adjustment earlier in the decade to reach parity with online competitors, the electronics retailing business has stabilized, and as Best Buy has shown in the US, offline electronics retail can have value even given online competition.

Valuation:

Note: Multiples and enterprise value in header are excluding Carphone earnings and net of liquidation proceeds

Risks:

UK marco / Brexit – As a retailer of consumer discretionary goods, Dixons performance is highly leveraged to the health of the UK consumer. Recent economic data points have been weak and consensus is that a “hard Brexit” at the end of March will be very negative for the UK economy. We do not have a view on the ultimate outcome. However, for those concerned with this risk we recommend shorting a basket of UK retailers exposed to UK consumer spending.

Online share gains accelerates – The company has been forthcoming that currently online sales are less profitable than offline sales (primarily driven by lower services and accessories attach). If the rate of online penetration growth increases this will be a headwind.

General retail headwinds – While retailers worldwide are facing a variety of pressures, including online competition, the broad sector is less “over-stored” in the UK than the US, where the number of malls grew twice as fast as the population from 1970 to 2015.  The US had 23.5 square feet of retail space per capita (as of 2015) vs. 4.6 square feet of space in the UK.

Catalyst

Resolution of Carphone business