Vita Value or Vita Trap? A quick glance at Vita Group (ASX:VTG)
- Vita Group (VTG) share price has been falling and the grapes on the vine are babbling about it. We thought we’d silence them with a quick look.
- On appearance it seems a value stock with uninterrupted growth since 2012, ROE increasing yearly, strong cash conversion, and little long-term debt.
- Strong management has developed a competitive advantage in Vita’s ability optimise and operate branded retail services.
- Given the above we were tempted to look further and see if these factors reveal an opportunity for a value investor or pose a potential value trap?
Vita Group share price has been suffering resulting in the grapevine whispering temptation in our ear. A quick inquiry into whether there is a potential value thesis to be developed was warranted.
Vista Group is essentially a continuation of the licensee retailer operating Telstra’s store network, FoneZone, having changed names in 2008 to aid its development and brand independence. The company has an impressive record of maintaining high customer satisfaction ratings and delivering growing ROE.
The group expanded its operations by taking its core advantage (optimising performance in retail customer service) and pursuing a growth strategy of acquiring brands and licenses to which it can apply this competency with effect to grow returns. Vita Group has been executing its growth strategy with success since 2012, with particularly notable equity growth since 2014. Further, it has driven growth through good management and effective optimisation without fuelling it with excessive debt. On present conditions long-term debt would be paid off in two years of FCF.
Vita currently has four main areas of operation: ICT (with Retail ICT being the main focus), Sprout, SQD Athletica, and Clear Complexions.
Vita Group’s revenue is existentially dominated by the Telco segment and that in turn is dominated by Vita’s Telstra contract. This is evidenced by the fact that 1H18 revenue dropped by 4% due to Telstra remuneration reductions of 5% and poorer Telstra store sales due to delays in iPhone shipments. Notably this is the only exception in yearly sales growth for Vita which has historically increased their ROE annually. Vita management acknowledged the sever dependence on the Telstra contract and is pursuing a strategy to diversify its earnings engine.
The Telstra partnership will last by contract for at least another three years. This is of little consolation, however, since the remuneration is not fixed (with Telstra setting it relative to market conditions) which poses a serious risk to Vista’s earnings as mentioned above. Given Vita’s success at optimising its operation of Telstra’s retail network and delivering impressive customer satisfaction results it is unlikely Telstra would lightly depart from the partnership given the costs to its branded customer service which would result. Vita drives earnings in this area mainly through optimised sales, marketing, and store placement, rather than grunt footfall and ground scale, having only opened three stores so far in FY18.
Sprout is an ICT accessories brand begun in 2011. It has no stores and is likely an operation to utilise the logistics capability Vita has from servicing the Telstra store network for some additional revenue for little capital expenditure. The company pairs reporting sales from Sprout with those from its Telstra operations under “Retail ICT” making it difficult to see the importance of Sprout to the business. In absence of information we induce Sprout is likely nearly entirely dependent on the Telstra operations to catalyse sales.
In 2016 Vita Group created a men’s athletic-leisure brand, SQD Athletica, seeking to apply its efficiency in retail service to a new niche. We see this as a somewhat misguided approach given that this business is not confined to client service and consultation where Vita thrives, but a tangible asset heavy consumer goods venture. This is a competitive and low margin area. With a few mistakes Vita may end up with significant inventory excess dooming the venture. Fortunately the venture has not grown and while costs sunk into SQD are not disclosed they are likely a small portion of assets.
In November 2017 Vita concluded an acquisition of a non-invasive cosmetic skincare business, Clear Complexions, with the acquisition comprising 6% of group assets. The acquisition cost $9.8m serviced largely by cash ($8.5m in cash and $1.1m in equity), a small acquisition from Vita’s $177m in assets. Like SQD this is part of the growth strategy to apply its core advantage to a new business and diversify its exposure. Clear Complexions seems to be gathering a good customer reputation. While in a completely different industry to Vita’s traditional Telco operations there is potential for Vita to grow the business by applying its processes and systems from running a lean Telstra retail network to Clear Complexions clinic network. This is a small business which only contributed $1.2m in sales to total of $329m in 1H18. Aesthetic skincare treatment is a profitable industry with high product premiums. The business at present only has 6 stores across two cities (Canberra and Sydney). Should Vita successfully execute an optimisation of the business retail operations there is a lot of track to run on and build an alternative earnings driver.
We welcome this acquisition as a sign of management clarity on the need to diversify exposure being partnered with restraint in utilising small portions of assets to pursue opportunities where their competence in retail service optimisation can generate earnings growth.
In case you missed them lunging at you, it’s worth commenting on some large risks.
The Telstra partnership is a major if not existential source of revenue. By existential we consider sources of revenue which were they to be stopped would result in severe medium to long term capital loss for shareholders. The remuneration is not fixed, with Telstra saying it will be set relative to market conditions. The risk of Telstra reducing remuneration is major and has been referenced before. It the reason that led to the company’s first year of falling sales. Telstra is a large and stable company but at present Vita Group’s future is dependent on Telstra.
Vita Group is without any hard moats with the only arguable moat being the cost to Telstra in loosing Vita Group as a licensee given its established Telstra branded retail network and stores. This presents high switching costs to Telstra making it likely Vita will hold that contract for years to come but when push comes to shove Vita is far the more vulnerable partner in any price negotiation. To their credit Vita management always highlights the dependency on Telstra in communications, which leads us to the other major risk.
Vita Group’s main strength is the “soft moat” it has in its proven management team and ability to optimise efficiency of retail service operations. This core advantage is crucial to the company without which it would not be the same business. The growth thesis on Vita is entirely dependent on the maintenance and successful implementation of this competency to operations other than the Retail ICT (aka Telstra) business segment. This leaves Vita Group at huge risk to losing its core advantage with a change in management, deterioration of culture, or a too few many human mistakes in execution (with arguably SQD Athletica being an example). The results of the Clear Complexions business over the next two to three years will be crucial to proving an investor this risk is not a black stain to a prospective investment.
We did a quick DCF, far shy of conducting a thorough valuation, for a rough idea whether the current price is severely discounted. We were conservative and assumed for FY18 to be the first year of revenue declining in light of 1H18 results, using a growth rate of -1.5% and then gradually raising it to 4% by 2021. With a WACC of 11%, Cost of Debt of 4.5%, Cost of Equity of 12.2%, and terminal growth rate of 3%, we came to a rough price of $1.60. This suggests a discount in the area of 22.5% at the time of writing. Given our preliminary qualitative assessment this potential upside contrasted with the lack of downside protection does not suggest a compelling risk reward ration to us.
Vita Group appears to have competent management and is positioning itself to create value into the future. It has a proven competency to optimise retail operations and has been having success in applying this to industries outside of its traditional focus of ICT retail under the Telstra brand. The company has pursued product diversification through expanding the brands it operates as well as the consumer markets it is exposed to. This shows that management is aware of the pressing needs to diversify its revenue sources if it is to establish some enticing downside protection.
This is where we stop. We are not tempted to look further into Vita despite its exciting and promising growth potential. With all due respect to Vita’s management and the expansion they have thus far executed, at the end of the day Vita is still a licensee operator existentially dependent on its Telstra account. Vita does have a good chance of driving earnings growth with good execution by proven management but its earnings engine is lacking security. It is dependent on execution leaving it liable to an Icarus scenario of a few too many mistakes by management, or culture deterioration, resigning it to the ASX historical records. Fatally, it is existentially dependent on one large account.
All in all, despite the price reduction, Vita is an unattractive investment for our long-view value sentiments on a preliminary glance. The business quality is impressive but it lacks sufficient, if any, defensibly at present to entice us into looking further and assessing business price. The company is not a Sell. With strong cash flow, proven management, and a flexible balance sheet it is well positioned to grow and establish value in the future through product and client diversification. We recommend a Hold and may look into it again when dependency on large client accounts is no longer an existential risk. Vita Group is not a rotten apple, but it’s no crisp Rockit four either.