Running Hot(ter)

A retail financial results cautionary tale

How’s this for a wild ride:

• Feb 22 - full year revenues growing 16% year over year, gross margin rising EBITDA for the year predicted at more than 10% of revenue, bank debt falling, strategy in place and being invested in

• May 22 - Q1 of the new year shows double digit increases in revenue over last year, continued improvement in gross margin, all despite the disruption of Russia/Ukraine and other supply chain challenges, full year outlook unchanged

• Jun 22 - Continue to trade in line with our expectations, new strategic partnerships in place

(Go on, at this point you’d be a buyer of the shares, wouldn’t you?)

• Sep 22 (interims) - first half revenue growth of 10.4%, gross margin still strong but EBITDA down over the prior year and an EBIT loss, outlook speaks of “tougher trading conditions in recent weeks”, likely to make a small loss (less than £1m) for the full year

• Jan 23 - Challenging conditions, revenue for the year to Feb now likely to be only up 3-4%, will now lose more like £4-5m for the year

• May 23 - putting ourselves up for sale

• Jul 23 - administrators to be called in, sold in a prepack administration.

This is the Hotter Shoes story (more accurately, the Unbound Group story but Hotter is basically all the group does over this period). It could also, though, be the story of many other retailers who have gone through challenging restructurings in recent years.

So how does it all go wrong so quickly, and what should we be looking at when examining those sunny and happy opening bullet points for signs of trouble ahead?

(Disclaimer - I have no inside knowledge of Hotter at all, what follows is an outsider’s observation based only on reading the various results and trading statements).

I was particularly struck by this example because Hotter, for those who don’t follow it, is a retail brand selling footwear to a predominantly older customer base, and Unbound as a group was attempting to build out from the strong brand relationship (and growing database) that Hotter had developed to becoming a multi-product retailer focussed at the older customer. And that’s a strategy that makes a lot of sense to me:

• the customer demographic is growing

• it is relatively wealthy

• it is relatively well insulated from higher interest rates (this group are often savers who benefit from interest rate rises not borrowers who suffer from them)

• and it is under-served by retail brands who insist on chasing cool young customers despite the fact that they don’t have any money.

So everything pointed to a winning strategy and much of the language in those early releases not only suggested that the company was following that strategy, but also that it was working. So again, how do we spot the clouds on the horizon?

Here are a few thoughts, which are also worth asking yourself about your own business:

Are you winning customers?

It is notable that in the small print of that early 16% revenue growth figure is the observation that ‘average selling prices’ in the period had also gone up by 16%.

Later, when revenues were growing by 10% and then only by 3-4%, we were in a period where inflation was higher than that.

All of that points to the fact that the business was not selling more product to more customers, but just increasing prices. That’s a perfectly valid strategy in its own right, of course, and unavoidable when costs are increasing, but for a business looking to build out based on its strong relationship with customers the fact that it wasn’t really gaining any new volume could have been an amber warning light.

How ‘real’ is your profit performance?

Also in the small print of those early results is the fact that the business received £1.5m in Covid support from the Government, and sure enough its costs popped back up by at least that amount in the following year.

Covid makes reading accounts very difficult of course - because revenues were affected as well as costs, but that should make us double check whether that (very healthy) 10% EBITDA margin from FY22 is really sustainable.

Cash is king

That cash is what really matters is the oldest investment advice in the world, of course, but is a fact that applies particularly here. Not only did Covid disrupt trading for this business, it also resulted in it carrying much less stock, not least because international supply chains were so disrupted that it couldn’t get any.

That’s innocuous enough by itself, but remember that in the following year it was therefore necessary to bring stock levels back up to the sort of figures that the business needed to operate - which is a drain on cashflow outside the P&L performance.

Sure enough, going back to those interims announced in September 22 the business had burned through nearly £3m in cash in just 6 months - a combination of poor profit performance from those rising costs and a big increase in working capital from the stock movements.

A subsequent £3m equity fundraise provided some temporary relief, but it should have been clear by then that if costs continued to rise faster than revenues there were some tricky times ahead. Eventually the working capital movement would have unwound itself, but “eventually” is a dangerous word when managing a short term cash squeeze.

The business at December 22 had £8.8m of debt, £1.3m of remaining funding headroom and was, unsurprisingly, fully engaged in a cost control and cash management crisis.

And, as it turned out, with a weaker economy to contend with, that was just not enough to avoid a painful change of hands this week.

So what?

There is plenty in the Hotter story for any of us in retail to chew on and learn from, and there will no doubt be more to learn in the coming months.

As ever, my heart goes out to everyone involved in what will have been a very painful last few quarters of trying to wrestle the business around. At every level from the boardroom to the stockroom this will have been a hideous process.

The sobering thing here is the rapidity of the shift from what looked like a strong profit margin to a messy end. Proof, for business leaders and investors alike, that it is always worth a closer look at the detail.

The great thing about retail businesses as an investment prospect is that when they work well they can be very profitable. These are highly ‘operationally geared’ businesses with high fixed costs, which means that once you get returns above those fixed costs profits can rise very fast.

But the reverse is true too - it doesn’t take a big downswing (and remember that Hotter has not reported a revenue decline at any point in this story) to unravel things when you stop being able to cover those costs.

The gulf between winners and losers in the sector is only likely to widen as this difficult period of low economic growth continues. Whether investor or operator, it is worth asking the right questions to make sure your business stays on the right side of that gulf.