Why I’m Long The Hut Group

Posted In: Investing on December 23, 2020  Comments: 0

The Hut Group (THG) came to my attention after their successful IPO in September – the largest UK public listing since The Royal Mail in 2013.

October got busy and it was only in mid-November that I got a chance to give the company a better look.

After a deep dive that included reading parts of their IPO Prospectus, their 2019 Annual Report, their 2020 Q3 Trading Statement and various other investor commentaries, I decided to invest.

Here’s a summary of my thinking.

The Hut Group – A Snapshot

Founded by Matthew Moulding and John Gallemore in 2004, THG is a Direct-to-Consumer (D2C) eCommerce and technology group, with a global footprint and an impressive vertically integrated business model.

The company has grown incredibly fast, consistently adding 20-30% revenue year on year, and in 2019 had a turnover of £1.14B and EBITDA of £111m.

Although a UK company, over 60% of their sales come from outside the UK, with Europe accounting for 34%, Asia 24% and N. America 16%.

Below is my analysis of THG based on the six factors I always consider before investing in a company:

  • Strategy and Positioning
  • Management
  • Market Context
  • Financials
  • Risk
  • Price

Strategy and Positioning

THG has grown through a combination of smart acquisitions, significant investment in technology, infrastructure and people, and aggressive marketing.

The company splits into three broad verticals – Beauty, Wellness and Technology.

In the Beauty segment, they own a number of popular brands like ESPA, Christophe Robin, Perricone and Grow Gorgeous, which they sell along with other 3rd party brands on their eCommerce platforms, which include Lookfantastic, SkinStore and Glossybox.

Their Wellness segment consists of brands and eCommerce platforms like MyProtein, MyVegan and MyVitamin.

These are some of the fastest-growing wellness and beauty brands in the world.

Their Technology segment consists of Ingenuity, an eCommerce technology on which all of THG’s 200+ owned and operated websites run, and through which other major brands and retailers sell online – like Disney, Walgreens, Clorox and Nestle.

The latter segment is truly impressive. Apart from Amazon, I’m not aware of any other player in the market that has such a compelling end-to-end D2C eCommerce solution that rivals Ingenuity.

Ingenuity is not just an eCommerce platform like Shopify, Magento or BigCommerce. It is a fully integrated eCommerce ecosystem that includes a Customer and Service Layer for distribution, marketing, warehousing, fulfilment and logistics; a Data Layer for analytics and consumer insights and a Product Development Layer for R&D and manufacturing.

It’s hard to appreciate how big of a moat THG has until you truly understand Ingenuity, so here’s a snapshot.

  • THG owns manufacturing facilities and laboratories in the UK, US and EU, where they make their own brands and manufacture on behalf of other companies
  • THG owns seventeen distribution centres located in the UK, EU, US and Asia Pacific, all integrated with proprietary warehouse management software, and with the ability to support same day, next day or 2-day delivery service across every territory globally
  • THG owns a network of seven end-to-end digital brand building and content creation studios that power their own brands, in addition to providing brand creation and digital content services for a wide portfolio of beauty and wellness brands including Estée Lauder, L’Oréal, No.7, Procter & Gamble, Johnson & Johnson and Nestlé plus a diverse range of consumer product and content brands, such as Diageo, Disney, Kingfisher and Walmart.
  • THG owns 200+ websites that receive over 600m annual visits and through which other brands can sell and distribute their products (although 50% of THG sales are from their own products)
  • THG owns Language Connect, a technical translation service for their own brands and 3rd parties ensuring technical content is accurately and efficiently localised. In 2019, they translated over 25 million words for their own brands, as well as provided translation services for UK financial, legal and professional advisory institutions, the National Health Service, pre-eminent wellness and beauty groups (Nestlé, J&J, Deciem, L’Oréal) and a number of other sector-leading groups (Kantar, Ipsos, Hilton, ExxonMobil and Thomson Reuters)
  • THG owns a proprietary eCRM, Marketing and Influencer platform – again used by their own brands and for third party customers.
  • THG owns 29 data centres in the UK, EU, US and Asia Pacific, where they host their own sites in addition to hosting 10,000+ 3rd parties, which include pre-eminent technology brands. Yeah, you read that correctly, they are a hosting company as well.

With Ingenuity, THG have been able to achieve economies of scale in their value chain, thus improving margins and cross-selling opportunities for their own brands.

At the same time, Ingenuity allows THG to acquire other brands and eCommerce platforms that they can then seamlessly plug into their ecosystem to drive growth. In fact, THG aims to double revenues of an acquisition in the first year. I suspect they do this by leveraging their massive 23 million worldwide customer database and global reach.

These characteristics of Ingenuity on its own would be a major strategic advantage.

But I believe the biggest play in town for THG, and their strategic focus going forward, is 3rd party brand owners.

They have only in the last 2 years connected Ingenuity up into an end-to-end eCommerce solution for 3rd parties.

Hence this segment is currently their smallest (17% of their sales).

However, armed with a vertically-integrated technology and operating platform built to retail brands globally direct to consumer, I believe THG is uniquely positioned to become a major eCommerce player.

They are selling Ingenuity as a SaaS on long-term contracts that range in value up to and more than £100m. In the first three months of 2020, Ingenuity has secured a pipeline of over £200 million of contracted SaaS revenues. Clients include Nestlé, Johnson & Johnson, Procter & Gamble, Walgreens Boots Alliance, Groupe L’Occitane, Nintendo, Mercedes, Honda and Daily Mail.

Given the need for digitalisation across all retail sectors, it’s fair to assume that demand for their eCommerce solution by 3rd parties is at an all-time high due to the pandemic and will likely remain so into the future.

In short, I believe THG is one of the only companies in the world (apart from Amazon) that can offer major brand owners a seamless end-to-end eCommerce solution at scale. And they can do so at a time when demand seems insatiable. This, combined with the underlying Ingenuity infrastructure, gives them an advantage on other big eCommerce plays (like WeCommerce) to aggressively expand their own brands and platforms through acquisition.

Management

Matthew Moulding must be one of the most ripped 48-year-olds on the planet.

He’s the guy in the red shorts.

His impressive physique says a lot about his character. He clearly is a very determined, disciplined and focused individual.

This reflects in his company.

In 16 years he has managed to grow THG from a start-up to over £1 billion in revenue and 10,000 employees.

This is nothing short of exceptional.

He’s done so with the financial support and guidance of some major investors, including KKR, Balderton Capital and BlackRock. All preeminent private equity firms that have seen a significant return on their investment from THG’s large IPO.

Moulding comes from a financial background, having worked as the Finance Director for Caudwell Group (another privately-run UK company that made John Claudwell a billionaire).

Although there is not a lot of information on Moulding or John Gallemore (his co-founder and THG’s CFO), from what information I can gather it is clear that Moulding has no intention of slowing down and has a powerful strategic vision for THG, and Ingenuity in particular, that I think is inspired and timely.

Since going public he has surrounded himself with A-Team players on the board and continues to heavily invest in people.

I’m particularly bullish on Moulding as his track record to date is amazing, he has proven that he can adapt his style to an ever-changing organisation (from 2 to 10,000 employees shows incredible versatility), and he has and continues to aggressively invest free cash flows into the business and achieve high returns on capital.

Of course, this is a 30,000-foot view of the man. He may be a complete nut job!

Market Context

It doesn’t matter what statistic you look at – total retail sales, digital penetration, number of buyers, revenue per buyer etc – when it comes to eCommerce every chart since 2000 is up and to the right (that’s not entirely true: CAGRs are slowing).

The pandemic has provided rocket fuel for eCommerce and has only served to speed up the inevitable – that is eCommerce and online sales are eating the offline retail world. In the 3rd quarter of 2020, nearly $1 in every $5 spent in the US came from orders placed online.

The pandemic has almost made access to goods via online channels a basic need in every household, globally. Many of these households had never tasted the fruits of online shopping – the ease, convenience and low prices – and won’t be switching back to ‘normal’ so readily.

For THG this can only be good!

As the saying goes, ‘a rising tide lifts all boats‘, except in the case of THG it’s a mega-ship, and the tide is a spring high.

Financials

THG’s revenues have grown year on year since launching in 2004, and in 2019 grew to just over £1.14 billion, showing a 3-year CAGR of nearly 25%. Gross profits were £511m in 2019, representing a 45% gross margin and 34% 3-year CAGR.

What I particularly like about THG’s business model is that it’s fairly high margin and to some extent, recurring.

Their core segments in Beauty and Wellness constitute high margin, easy to ship products that many customers buy on a repeat basis. This means that they don’t have to constantly find new customers and can invest in lifetime customer value instead.

The fact that they are also vertically integrated means that efficiency gains and economies of scale will drive margins up as the company gets bigger.

Their Ingenuity segment holds great promise to be super high margin as well, with consistent and predictable cash flows as they reach scale and onboard more 3rd party brand owners onto their long-term SaaS contracts.

Given the level of investment THG that has made in technology, infrastructure and people, it’s quite impressive how cash-generative they are. Adjusted Free Cash Flows, before growth investments, is approximately 40-60% over each of the last three financial years.

Debt at THG stands at just under £900 million (£700 million of which is non-current). This is easily serviceable and provides significant facility for THG to continue investing for growth.

One concerning number I found was THG’s fairly sizeable net loss in 2019 (£43m).

According to their financial statements, this was due to some exceptional one-off items. I dug a bit deeper here and the exceptional items included investments in warehouses and distribution centres, financing and legal costs for M&A activity, share-based payments (seems they have an employee share scheme and paid themselves out a whack in equity), and refinancing costs.

All told though, THG’s finances seem strong. I’m no financial expert, but the top-line numbers for me stack and reflect a company that has healthy growth rates, margins, cash flows and serviceable debt.

Risks

THG has many standard business risks: security risks, supply chain risks, credit and currency risks, and general commercial risks.

I’m not going to cover these here.

Instead, I want to focus on three risks that concern me a little.

Governance

THG’s IPO followed what is termed a standard listing to allow Moulding to retain control of the group via a “founder share”. In the UK this is an unusual move (although, from research, I believe it is quite common in the US).

Essentially the founder share does two things: 1. it provides an incentive scheme that will hand him additional equity if certain conditions are met, and 2. other shareholders have weaker corporate governance safeguards should Moulding decide to go rogue.

A standard listing also means that THG doesn’t qualify for inclusion in FTSE indices, which is a shame as many tracker funds can’t invest in shares of standard listed companies.

Moulding has also retained his position as chairman and chief executive, a break with the conventional practise for publicly listed companies. And he is the landlord on a number of THG’s properties, allowing him to collect £19 million in rent every year.

Unsurprisingly, these issues have spooked some analysts and investors, despite Moulding repeatedly explaining the rationale for the founder share as a safeguard against a hostile takeover, and committing loads of money to employee-schemes that have already minted over 200 THG employees. He has also responded quickly to governance and remuneration concerns by forming a respected and credible independent advisory panel to oversee pay and bonus policies and made a commitment to strengthen the THG board of directors and non-execs.

From my perspective, I’m not hugely concerned by Moulding’s veto golden share. The man has the most to lose by taking his company over a cliff, and if his track-record has anything to say, he has been exceptional in leading his company from start-up to eCommerce behemoth. The founder share also expires in three years, which means THG will then be eligible for inclusion on the FTSE100. As I’m long, I look forward to this day!

Digital

As a digital marketer myself it would be remiss of me not to consider the inherent digital risks associated with eCommerce and online businesses in general.

The digital landscape is a rapidly changing space, which means keeping up with trends can be very challenging and exposes companies to disruptive forces that are less prevalent in non-digital industries.

One area of particular concern is traffic. For example, an over-reliance on Google search could expose THG brands to major downside risk if an algorithm update were to de-rank their properties.

I spent some time looking at their flagship sites, like Lookfantastic, Coggles and MyProtein. All seem to have very diversified traffic sources and don’t have a heavy reliance on organic search.

Digging deeper into their digital strategy it is clear that social media, influencer marketing and email are much bigger plays for them. This, combined with THG’s diversification in brands and platforms, and their move to 3rd party SaaS contracts, make me less worried than a pure digital eCommerce play.

Over-Diversification

One of the concerns I have with THG is over-diversification. In general, I think diversification is a good thing. It makes a company more antifragile and reduces the risk of a single product or brand failure.

But in the case of THG, one could argue that they are over-diversified.

They have loads of brands; 100s of websites; warehousing and fulfilment centres; digital marketing, brand and translation agencies; hosting companies and data centres; manufacturing facilities; and health spas and hotels.

There’s a clear logic for how all these discrete businesses connect up, and as I’ve argued above, provide a strategic advantage. But the cynic in me worries a little that THG may be spread too thin, and risks becoming a jack of all trades but a master of none.

Price

And so that brings us to the all-important question of price. Like most high growth companies, establishing fair value is very difficult.

But that has never stopped me from trying.

Standard methodologies around the value of assets, multiple on earnings or discounted cash flows are very nebulous when a company is growing rapidly, reinvesting all retained earnings and has a clear strategic advantage in an expanding market.

Multiples for technology companies vary widely but a common figure I see referenced a lot is 20x. Based on THG’s 2019 EBITDA of £111m, that would give a valuation of around £2 billion, significantly less than the THG’s IPO that valued the company at £5.4 billion and its current Market Cap of £6.8 billion.

In terms of growth, in the past three years, THG’s revenue and adjusted EBITDA CAGRs were 24.5% and 31.2% per annum respectively. Assume they can maintain this level of growth in the short to medium term, then based on an expected return of 20%, THG should be trading at around 30x earnings.

Clearly they are not doing that either. This isn’t looking good.

But as I said, getting a fair value in a high growth company is not straightforward.

Ultimately, the question of what price to pay hinges on THG’s ability to achieve high returns on invested capital.

My analysis of the company leads me to believe that they are very well positioned to take significant market share through their own brands and products. And through their Ingenuity technology become a major player in the D2C eCommerce market, offering a compelling end-to-end alternative to Amazon or partial solutions like those offered by the major eCommerce platforms.

What’s that worth in my mind?

A lot more than their current £7 billion valuation, and potentially a clear shot at alpha!

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