Stories about star discretionary retailers usually feature names such as JB Hi-Fi and Breville Group. Furniture retailer Nick Scali barely rates by comparison, even though it is outperforming its closest peers.

This column has been bullish on property-related stocks for the past 18 months, and identified Nick Scali last year has a key beneficiary. Nick Scali has rallied from $2 in May 2013 to $2.97. I also thought Fantastic Holdings looked better value, but got that one wrong. Its share price has fallen over 12 months after earning downgrades.

Chart One: Nick Scali

Chart: ASX

Nick Scali seemingly has no right to have an average annual total shareholder return of 25 per cent over three years to September 19, 2014, given tough retail conditions.

Industry forecaster IBISWorld says annualised sales for furniture retail fell 0.4 per cent over five years to FY13. Weak consumer sentiment, price deflation, and greater competition from department stores and online retailers were headwinds.

IBISWorld’s forecast of annualised growth in furniture sales – an anaemic 1.7 per cent in five years to FY18 – seems increasingly unlikely. The economy faces a painful adjustment as the resources boom fades and other sectors are slow to pick up the slack.

Low or zero medium-term sales growth is an awful backdrop for any industry, let alone furniture retailing that is confronted by myriad cyclical and structural challenges. It is taking a toll: Nick Scali’s nearest listed peer, Fantastic Holdings, is down from a 52-week high of $2.53 to $1.71.

As other retailers struggle, Nick Scali has barely missed a beat, rallying from $2.40 in June to $2.97 after another strong full-year result. Sales for FY14 increased 11 per cent to $141 million, and net profit rose 16 per cent to $14.2 million.

Management said: “The current financial year has opened with a strong pipeline of orders to be delivered which is expected to underwrite robust results in the early months of FY15. Consistent with recent periods however, market volatility remains and customer orders in July were subdued. Whilst it is expected that continued low interest rates should drive a larger volume of housing construction and sales which are drivers for the furniture industry, ongoing market volatility makes it difficult to predict future results at this stage.”

It’s always a good sign when small-cap companies can grow in difficult markets by taking share off competitors. Management that performs in up and down markets is a precious, under-rated asset. All too often, the market gushes about companies that grow when industry conditions strongly favour them, and does not sufficiently reward companies that go against the tide.

Nick Scali’s fortunes began to turn in 2009, after plunging from about $2.50 to 50 cents during the GFC. Return On Equity (ROE) leap from 26 per cent in FY09 to 52 per cent in FY10 and 45 per cent in FY11, according to Morningstar. The FY14 ROE was 35 per cent – an excellent result for any company, let alone a retailer.  

There was barely any long-term debt at the end of FY14 and $36 million in cash. Issued shares (81 million) have not changed in a decade. Simply put, Nick Scali has produced a stellar return on every dollar of shareholder funds invested, without taking on more debt or tapping shareholders for new funds through share issuance and diluting their ownership.

The performance has been underpinned by a strong product and brand, and tight internal management. Nick Scali is partly growing by taking share from weakened competitors or those that have exited the industry.

The other big sales drivers is store openings. Nick Scali Furniture Store network has scope to double in size before it reaches saturation.

Its emerging chain, Sofas2Go, has good prospects and is aimed the budget sofa market, while Nick Scali Furniture is positioned as a more upmarket furniture offering.

It’s a classic retail strategy: expand the mother brand through well-located store openings, launch or acquire a discount brand to create a second profit engine, and benefit from improving margins as a bigger store network spreads fixed costs.  But this strategy is deceptively hard to do well.

Nick Scali looks better placed than may retailers to combat the threat of online commerce. As cheap sofas are increasingly bought online, it seems less likely that Nick Scali’s $3,000 lounges, or dining room and bedroom furniture will be bought over the internet, without first visiting one of its stores.

This explains why Nick Scali decided not to sell its lounges online: plans to boost its online presence and digital marketing spend are designed to get customers into its showrooms. It says online selling product opportunities could come in products that are not part of the business.

Nick Scali clearly has a strong strategy and good execution. Prospective investors, however, need to consider the short-term outlook for furniture sales and Nick Scali’s valuation, which has already factored in significant growth.

Investors need to be patient and watch and wait for better value in Nick Scali. It looks fairly valued at the current price. But sharemarket pullbacks, such as the latest one, have a habit of turning into 10 per cent corrections and creating a fleeting opportunity to buy exceptional companies at bargain prices.

A 10 per cent markdown on Nick Scali’s share price would make it a lot more interesting for long-term value investors.

Tony Featherstone is a former managing editor of BRW and Shares magazines. The column does not imply any stock recommendations. Readers should do further research of their own or talk to their adviser before acting on themes in this article. All prices and analysis at September 17, 2014.

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