Edmond Jackson's Stockwatch: Success on the cards for this discount retailer

Could Card Factory be the next Sports Direct? Since greeting card retailer floated last May, its shares slipped from an offer price of 225p to 198p and are currently around 210p. This represents 13 times earnings per share (EPS) for the year to end-January 2015, assuming it trebles (see table).

This guidance is by the company's broker Investec Securities, so choose whether you consider it "promotional" or using management guidance that ought to be prudently conservative. The prospective yield is about 3.3% on a 12-months' forward basis although it is early days also for proving a dividend record.

The stock may also be at a discount to flotation price because the balance sheet does not exactly lend support. Since raising £90 million via equity, a 7 August update has cited net debt under £150 million which compares with £218 million net assets as shown in the pro forma section on page 138 of the listing prospectus - although the balance sheet is supported entirely by £331.4 million intangible assets. When market sentiment is "risk-on", people don't fret about this kind of thing, but when it's "risk-off" then they may.

The business is currently capitalised around £700 million which is just over twice sales for the year to end-January 2014. So investors are being quite cautious to see how finances evolve, this being yet another indebted company floated by private equity. You have to weigh a sense that such flotations probably include leaders for the next stage of a bull market, with caution that private equity may have shrewdly exploited the stockmarket's exuberance up to spring 2014.

Discount retailing formula

But the intrigue here is chiefly marketing: Card Factory being positioned to benefit from a discount retailing formula that undercuts rivals. Greeting cards are not initially an appealing proposition, recalling Clinton Cards ending up in administration two years ago, yet it is possible to draw a parallel with JJB Sports' similar failure in sporting apparel and the way Sports Direct has proved a roaring success from smaller company into the FTSE 250 index.

Likewise, Card Factory has a vertical integration approach (capability in production not just shops) introducing some 4,000 new designs each year, this now extending to gift items. From a first store in Wakefield in 1997, there were 130 in 2005 and 480 in 2010, currently around 750 with plans to grow by some 50 new stores a year towards a target of 1,200. These support a growth profile in an otherwise sluggish context: the UK greeting cards market is growing only at about 2% annually, i.e. quite static considering inflation.

Gaining a substantial market share

Card Factory's 7 August update similarly cited 2.6% like-for-like sales growth, however new store openings helped total group sales rise 8.9% in the six months to end-July. The prospectus described the sales mix as 59% single cards, 2% Christmas multi-pack cards and 39% non-card items - where there is faster growth in gifts, wrapping, party decorations and the like.

The UK card market derives two-thirds of supply from Hallmark and American Greetings, major US publishers, with American Greetings owning Clinton Cards. They have so far resisted price cuts due to conflicts of interest - say if Clinton was to start discounting, which would hurt other retailers/supermarkets being supplied. So there is scope to undercut as Poundland/Aldi/Lidl have achieved versus supermarkets and like the 99p Store chain is raising its profile to take business from pricy coffee shops.

While supermarkets do offer greeting cards, these are outsourced and not their main focus - so if Card Factory can combine regular novelty designs with attractive prices then it could gain a substantial market share. Card Factory's prices are typically 40% or more, cheaper than rivals, which is also relevant amid high postage costs nowadays - especially when sending out Christmas cards.

What rivalry online?

The main suppliers appear unlikely to make the step change required to match Card Factory's prices, which would be costly and disruptive to their businesses; complacency looks likely to persist and help Card Factory take share. Such a "disruptive marketing" strategy is comparable to Sports Direct in mass-market sports goods, where its adept sourcing and selling were partly why JJB became bankrupt.

What rivalry online? While online greetings pictorials have made some progress, there is still a strong preference for written cards as a personal gesture. Card Factory does have an online presence via www.gettingpersonal.co.uk if oriented towards gift purchases and delivery. This ought to help the company grow faster than the UK card market although obviously it would help to see like-for-like sales growth better than 2.6%.As yet, the case for a growth rating rests mainly on new store openings which could test issues such as availability of retail outlets.

Other performance measures are attractive for investors: Card Factory's track record has shown strong operating margins over 20% and excluding goodwill its return on net operating assets was over 70% in the last financial year - a trait leading to very good cash conversion which should reduce debt and enhance distributions to shareholders. The payback period for new stores is less than two years and short leases help to keep rents low.

So while it is early days to define investment value, Card Factory intrigues as a medium to long-term speculation. The discount retailing revolution looks to have plenty more mileage because UK wages have yet to rise with economic recovery; and even if they eventually do, the examples of discount airlines and grocers show how consumer behaviour can change fundamentally in pursuit of better value.

For more information see cardfactory.eu.com.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.