The Brick BRK.T
August 17, 2011 - 2:03pm EST by
deerwood
2011 2012
Price: 2.28 EPS $0.00 $0.00
Shares Out. (in M): 129 P/E 0.0x 0.0x
Market Cap (in $M): 295 P/FCF 0.0x 0.0x
Net Debt (in $M): 132 EBIT 80 85
TEV ($): 427 TEV/EBIT 5.5x 5.0x

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Description

Investment Thesis                                                                                                                                                                        

The Brick ("BRK" or the "Company") presents a very compelling long opportunity as it trades at a severely depressed valuation (22% FCF yield, 4.5x EV/ EBITDA-capex) yet is a growing, industry leader with low 40s ROIC. There is significant upside to equity of +75% even in a flat growth scenario with sound downside protection.

Reasons for Mispricing                                                                                                                                                              

A number of non-fundamental factors have obscured BRKs underlying performance and have led to a significant disparity between market price and business value. (All prices C$.)        

  • Conversion from an income trust to a c-corp on 12/31/2011 caused turnover in shareholder base
  • Large warrant overhang from 2009 recap that is no longer a factor following June cashless exercise
  • Under the radar as a TSX-listed $2.30 stock with a $300M market cap
  • Legacy investor stigma as a financially struggling industry laggard during the 2008-2009 period
  • Limited sell-side coverage and intuitional following

Catalysts

Near-term catalysts to value realization include: 1) broader market awareness for the removal of warrant overhang - FD shares from 171M to 129M; 2) continued share repurchases - another 5% to be repurchased starting this month; 3) refinancing of 12% senior notes; and 4) reinstatement of dividend - with $136M in excess cash, both refinancing and dividend to be addressed at August BOD meeting per management. Prospective medium-term catalysts include: 1) additional analyst coverage; 2) appreciation for the quality of the business, its management and the fact that BRK is now a demonstrated industry leader; and 3) improved corporate communication.    

Overview & Background   

BRK, primarily operating under The Brick and The Brick Mattress brands, is one of the largest household furniture retailers in Canada by sales and the largest if you exclude the lower end (eg. Walmart). The Company has 238 owned stores and 54 franchise locations.

Leading up to 2008, The Brick pursued an aggressive sales growth strategy to gain market share. Management at the time was less focused on product mix, lacked effected inventory and overall demonstrated poor fiscal discipline. Weak management compounded by the economic downturn caused BRKs performance to suffer severely. Facing an imminent covenant breach on its senior notes, tightened vendor terms and likely insolvency, the Company was recapitalized in May 2009. This transaction resulted in the assumption of $120M in12% notes and the issuance of 121M warrants to Fairfax Financial and BRKs former CEO and Chairman, Bill Comrie. From a peak of $9 in 2007, the stock incrementally sank to its present $2.30 as the warrants have remained an overhang on the stock price.    

To support a turnaround and refocus the business, BRK overhauled its management team. This included the addition of Bill Gregson as CEO (formerly Reebok) in July 2009, Violet Konkle as COO (the former CEO of Walmart Canada) in February 2010 and Dave Merkley (the former CFO of Sears Canada) in June 2010. Konkle will become the CEO in January 2012. This was a huge upgrade to the management team, as evidenced by the subsequent financial performance and operational improvements.

In December 2010, the Company converted to a c-corp to more appropriately match its financial profile as a retailer, improve operating flexibility and remove the punitive tax consequences of being a unit trust not making distributions.

Investment Merits

  • Improved Operations and Management: Subsequent to joining, the current management team implemented a number of very meaningful improvements that repositioned BRK competitively. The inventory mix has been focused toward higher margin items where price competition is not as intense (eg. mattresses and furniture rather than electronics). Gross margins have increased 400bps from pre-recession levels in 2007 to +44% at present, EBITDA margins have increase 230bps to 7.6% over the same time period. Margin improvement has also been attributable to better vendor contracts and much tighter inventory controls (inventory turns from 3.7x in 2007 to close to 5x LTM). The Company also continues to invest in more efficient distribution/ IT systems and customer service with $16M to be spent in this area in 2011. SG&A expense is down to 38.5% of sales and should normalize at 38% once the cost benefits begin to be realized later this year. The strength of its cost control initiatives are further demonstrated by the fact that despite Q2'11 comp store sales being down 1.5% (vs. it primary competitor Leon's at -4.1%), gross margins were up 210bps and EBITDA margins were up 140bps.
  • Competitive Strength & Recent Fundamentals: As noted, BRK is the largest Canadian furniture retailer in the non-discount segment with more than twice the sales of its closest competitor, Leon's Furniture (LNF.T). The Company's other main competitors are BMTC (GBT.T), Sleep Country and to a lesser degree Sears Canada (SCC.T). Since Q2'10, BRKs sales growth has meaningfully outpaced its competitors enabling it to regain almost all of the market share that it conceded in 2008-2009 (~8% share of total market). Meanwhile this has been at a much more disciplined and sustainable level. BRK benefits from regional economies of scale with operating density in each market, purchasing power as reflected in its favorable vendor terms and higher gross margin, brand strength and customer loyalty supported by its credit cards. Comps for Q2 were down 1.5% despite a very high hurdle from last year when the Home Renovation Tax Credit Program was still in place. The Program expired toward the end of the second quarter so will no longer be relevant in future comps. In less dense areas where it cannot exploit its scale, BRK franchises its stores. It is currently in the process of converting six owned stores to franchise. This enables it to retain less profitable stores and grow in more rural markets while not risking capital or compromising margins.
  • Financial Services Segment: BRK generates ~20% of its EBITDA from financial activities. The largest component being warranty underwriting (~60% of financial revenue). This business results in deferred revenue and fees for the upfront premium with revenue recorded over the term of the contract (2-5 years). The remainder of the financial services revenue comes from branded credit cards, customer property insurance and credit insurance. Credit management in this area is fully outsourced to HSBC, so the Company does not assume credit risk. Overall EBITDA margins from financial activities are 25% with an ROA of +60%. Upfront payments and a revenue tail provide a stable source of cash flow and earnings.
  • Strong Cash Flow Profile: Very limited cash taxes until 2013 due to transition from a unit trust (~$1M in 2011), lower maintenance capital needs ($6M/ year, ~0.5% of sales), upfront cash from warranties, improving margins and appealing vendor terms should generate $110M of FCF in 2011. The prepayment of the 12% notes could also increase levered FCF by $15M per year. BRK had $100M of cash at 6/30 + $75M of availability on its undrawn ABL - $50M of internally mandated cash reserves = $125M of excess cash.
  • Share Count Reduction: There were 170.8M FD shares outstanding at May 31 (down from 180M after the 2009 recap). Following the June 29 cashless exercise of 104.5M warrants there are now 129.3M FD shares outstanding (assuming full conversion of the $0.82 strike price warrants). BRK has also indicated it intends to repurchase an additional 5% of S/O beginning this August.

Valuation

On both an absolute and relative basis, BRK is trading at a substantial discount. The Company trades at an EV/ 2011E EBITDA multiple of 4.2x (assuming 129M FD S/O) versus comps at 6.5-8x despite BRK being an industry leader with the strongest growth profile of the group. If BRK were to trade in-line with its peers at 7x EBITDA, the implied price per share would be $4.50, a +90% premium to current. The Company is trading at an LTM, 2011E and 2012E FCF yield of 23.4%, 26.1% and 25%, respectively. This assumes 2% sales growth, 100bps of improvement in EBITDA margins and annual maintenance capex of $7M. This seems like a very appealing price for a growing business generating 40% ROIC with a high quality management team and a stable source of income from its financial services segment.  

(CAD$ in Millions)    
2007A 2008A 2009A 2010A 2011E 2012E
Income Statement Summary 






Retail Revenues


 $1,405  $1,375  $1,159  $1,301  $1,327  $1,354
Growth




(2.1%) (15.7%)  12.3%  2.0%  2.0%






















Financial Revenues


 $53  $65  $76  $86  $88  $89
Growth




 23.0%  16.1%  13.8%  2.0%  2.0%











Gross Profit


581 581 505 590 616 628
Gross Margin


 40.1%  40.7%  41.2%  43.0%  44.0%  44.0%











Total EBITDA


77 68 32 88 101 109
EBITDA Margin


 5.3%  4.8%  2.6%  6.4%  7.2%  7.6%
EBITDA Growth



(11.1%) (52.9%)  175.5%  14.1%  8.2%











Free Cash Flow








Unlevered FCF






 $110  $111











Operating Metrics








Corporate Stores


177 183 184 183 171 176
Comps



 6.4% (3.6%) (20.1%)  10.4%  1.0%  1.8%











Franchise Stores


33 47 52 54 61 65

Investment Considerations & Risks 

  • Management: Management and insiders own 28% of the Company and hold 6M options. Compensation structure is 40% base and 60% incentive (options and stock) based on achieving annual EBITDA targets.
  • Risks:
  • While the Canadian economy and its consumers are in a position of relative strength to that of the US (lower unemployment at 7.2% and higher real GDP growth at 3.9%), BRKs performance is still going to be highly correlated to consumer spending and secondarily to housing starts. That said, this opportunity is not predicated on growth (with no sales growth for the rest of 2011 the stock still trades at a +20% FCF yield). Housing starts in Canada have been improving with a 4.3% annualized growth reported in July. Downside protection comes from the strong balance sheet and stability of its high margin, high ROIC financial services channel.
  • Currently Fairfax Financial owns 63M shares (49% S/O) and Bill Comrie owns 33M shares (26% S/O). Comrie has been a shareholder since 1971and was the Company's Chairman and CEO up until 2004. He resides in the US, has an appointee on the board (JP Geisbauer), a son on the management team, but no direct control. He appears to be a long-term, stable shareholder. Fairfax largely got involved at the recap and now owns 49% of the diluted shares. Fairfax is a $7B Canadian insurance company regarding as being conservative, passive, long-term oriented investors. Paul Rivett is Fairfax's independent board appointee. Despite the large shareholdings between these two parties, the Company is not controlled. While this may reduce the float and liquidity, it also adds support and stability.
  • Foreign exchange volatility: This is largely muted by the fact that only 20% of costs are non-C$ denominated.

Catalyst

Near-term:
1) broader market awareness for the removal of warrant overhang - FD shares from 171M to 129M
2) continued share repurchases - another 5% to be repurchased starting this month
3) refinancing of 12% senior notes
4) reinstatement of dividend
 
Medium-term:
1) additional analyst coverage
2) appreciation for the quality of the business, management and the fact that BRK is now a demonstrated industry leader
3) improved corporate communication
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