Naked Wines released their full earnings last week and the result was a full disaster with the share price down a whopping -43% despite the fact that the headline numbers were already known. It is a good reminder that even being down more than -60% from its top, a stock can still fall another -40% on one day. Although the stock was only a 2,9% position prior to that drop, it still warrants a deeper dive than usual.
Q1 2022 hedge fund letters, conferences and more
The signs were already obvious
Before moving to the actual numbers and the report, I have to criticize myself for not acting on the stock despite the following issues that I had identified already some time ago:
- “Thesis Creep”
My original investment thesis was a bet on the Naked Wine founder Rowan Gormley. Unfortunately, I never really “refreshed” my opinion of the company when Rowan had to step out end of 2019. That was clearly a mistake. - Informational disadvantage
These days, for almost any online retailer, very specific credit card details seem to be available for anyone who will pay certain “service providers” some money. So a significant part of the institutional investors have almost a “real time” view on sales and a clear information advantage to retail investors like me. Thus has been bugging me for some time and that is why avoided other E-Commerce or retail stocks to a certain extent, but I didn’t act on this for Naked. - Overemphasis on (BS) alternative Performance measures
As a lot of other “growth” companies, Naked has introduced a lot of alternative performance measures. Many of them in my opinion don’t lead to better understanding but were rather used to make things look better than they actually are. A good example is the “stand still EBIT” which should show profitability if the company doesn’t grow anymore. Now as the company doesn’t grow, stand-still EBIT is shown at 20 mn USD, “real” EBIT is zero. - Investor base
Another observation where I didn’t act enough on was the fact that among the investors more and more “hot hands” appeared. Especially the Lightstreet pitch in November turned the stock into a “hot stock” which is something I try to stay away from as far as possible. I sold some but unfortunately not enough.
If I put all these aspects together, I should have clearly acted on Naked Wines earlier or at least I should have dedicated more time into analysis.
The report & numbers
Following one of my favorite “Wild West Movies”, I would summarize my takeaways under three categories: The good, the bad and the ugly.
The Good:
On the positive side one can list:
- Naked indeed showed a GAAP profit after two years of losses
- Sales and “active angels” still grew slightly in 2021/2022 despite a tough “Covid comp”
- Gross margins and contribution margins stable despite inflation pressure
- The CEO still aims to “double the company within the next 5 years”
- Some reflections on mistakes made (e.g. failed low price strategy in the UK etc.)
The Bad:
- Excessive use of alternative Performance measures (including 2 year growth rates etc.). Why do they show a “standstill EBIT” of 20 mn when EBIT in the current stand-still mode is only 2 mn ? In addition, using suddenly 2 year growth rates is honestly embarrassing
- Inventory increased significantly, soaking up a large portion of the cash balance. The explanation (supply chain issues) does not fully explain the amount. It rather looks like over stocking, similar to Target & Co
- Sales in the most important market US actually decreased
- General costs have significantly increased without a real good explanation or some rather bad explanations (Marketing R&D)
- Acquisition cost seems to have increased dramatically, leading to a significant lower payback, also retention rates have declined
- Outlook for 2022/2023 is “muted”. On the surface they say that they expect more or less unchanged sales
and the ugly
- I have to say that I am still irritated about the “going concern” section on page 31 of the Document. A company only writes something like this if someone (usually the auditor) has concerns. This is how this reads
On this basis the Board believes it is appropriate to prepare the financial statements on a going concern basis. However, this material uncertainty may cast significant doubt on the Group’s ability to continue as a going concern and therefore to realise its assets and discharge its liabilities in the normal course of business.
- In combination, the resignation of 2 board members on the date of publication, which as far as I understand was not planned, also puts another question mark on top of this case
- Although the new 60 mn credit line should lower any liquidity risks, the covenants that are coming with this are clearly not positive, especially as they mention that in a downside scenario, they might break the covenants.
Some thoughts:
Some investors clearly got scared from what they heard or read. This is from an FT article from yesterday:
Wayne Brown, an analyst at Liberum, said the company’s forecasts for 2023 reflected “the poor quality of customers acquired [in the last financial year]” and said the balance sheet was also a concern. “There is a risk heading into a downturn that weak demand and potential cancellations combine to force the company to discount stock more in an attempt to turn the inventory into cash,” he wrote in a note to clients.
The numbers and the outlook do not look great or at least not as great as Management wants to make them look. Clearly, almost all other D2C E-Commerce companies have the same issues but in my opinion Naked should have done better than that.
I am mostly disappointed that capital allocation is clearly not as good as they always claim. The fact that for instance they increased investment into new customers in the UK where margins are lowest and decreased investments in the US and Australia with higher margins does not look good.
Overall, I also question that they invested so much money into gaining new customers despite rapidly decreasing economics. Yes, they promise to correct that but I would have assumed that they can react quicker. I assume they wanted to increase sales and number of angels as a priority which in my opinion is not good capital allocation. They could have scaled back and maybe tried to find a better way to invest this money instead.
Their stated policy, to invest all cash produced into acquiring new customers now seems a little bit too simplistic.
The growth strategy also doesn’t sound so convincing. Trying to bring back old members as a “new strategy” brings into my mind the saying “no shit Sherlock”. I would have assumed that this is part of the toolkit already.
The Webcast
I also listened to the Webcast which I found quite weak. The CFO should be fired outright as he states that granting options to employees is “Not a cost” but that they are “Very exited” about it and “perfectly aligned” with share holders. My feeling is that they not act as owners but very clearly as “agents”. This is also confirmed by the statement that they “of course” will not return any cash to share holders.
According to management, the Going concern section had to be included because they failed a stress test scenario from the auditor. They sounded relaxed but in my opinion they shouldn’t. In the past, cash always had been higher that customer deposits. In 2021/2022 however they seemed to have used these deposits to finance inventory, which clearly adds significant operational risk. One major risk with customer deposits for Naked Wines is that they promise a direct refund at any time as stated on their website:
You can cancel your Naked Angel Account at any time, and get your money back – with no penalty whatsoever (see point 9).
The big risk here is that if Naked Wines, for whatever reason, would get into real trouble, the probability of a “bank run” is high. If you, as a client, have any doubt at the credit worthiness of Naked Wine, you will pull your deposit unless you forgot about it. I think that is the reason why the Auditors rightfully assume that in case of problems, Naked needs to cover the deposits with cash and not hard to sell inventory.
Interestingly they mentioned that they sold some London real estate after the end of the FY and already drew on the credit line which is clearly an indication that the Auditors pushed them really hard.
Another low light was the comment with regard to the covenants of the credit line. It is the job of a CFO to negotiate covenants in a way that they are not breached so easily and that’s the reason why you negotiate credit lines in good times and not when you really need them.
With regard to inventory, management claimed that what happened is “re-stoking”. In March 2020 (pre Covid). Naked had ~70 mn GBP in inventory on 200 mn trailing sales, or 35% of (trailing) sales. Currently, at 350 mn sales, they have 140 mn of inventory which translates into 40% of sales. So this is clearly more than re-stoking. In addition they mention that inventory might even increase in 2022/2023 which clearly points to problems. Maybe they have over-committed to Wine Makers ?
Outlook
For the Year 2022/2023, Naked expects the following “mid point” estimates: 350 mn GBP Sales, G&A of 46,5 mn GBP, Contribution from existing customers of 88 mn GBP, cost for new customers of 35 mn GBP and extra costs of 9 mn GBP for “Maketing R&D” and Equity incentive. If I plug in these numbers, I get to this forecast in comparison to 2022:
| 21/22 | 22/23 | |
| Sales | 350 | 350 |
| Contribution exist | 86,2 | 88 |
| Investment news | -41,3 | -35 |
| G&A | -43 | -46,5 |
| Extra cost | 0 | -9 |
| EBIT | 1,9 | -2,5 |
So maybe this has in addition to the going concern freaked out investors even more: Naked is spending less on new customers but costs are increasing even more. These is clearly a weak outlook. For a company that does not grow, cost discipline is really important and it is clearly not visible in this outlook.
It is also proof, that the “stand still EBIT” is pure BS. This will be the second “stand still” year with no profit of all.
One positive aspect is that I think that indeed, Naked could be hit less by a recession that stationary wine trade as they might have higher income customers that don’t need to cut down so much.
What to do now ?
This is very difficult. Naked has become a small position for me. So at some point in time I would need to decide to either increase or sell. I still believe that the underlying business is good (not great) but it needs to be well managed.
For me, the current management hast lost a lot of credibility and I am not a 100% sure that they know what they are doing. They clearly have a cost problem that they don’t address and granting themselves 4 mn of equity at the current valuation, not cutting any costs and telling investors to swallow it, doesn’t sound right.
I think what would be needed now would be a tough activist investors and either a tough supervisory board and/or new management to make sure that they take this more serious. There is of course also the possibility that a strategic buyer might show up.
With regard to valuation, I would be very cautious to deduct any cash on the balance sheet from the valuation as long as it is smaller than customer deposits. As mentioned above, especially in a potential hard recession, this cash could disappear in a second if customers loose trust.
For the time being, I am on “aggressive watch”. I haven’t given up yet, but in the current set-up, i am also not prepared to allocate more money into them either, despite the relatively low valuation. I am looking for real change, otherwise I would sell into a potential “relief rally”-
Article by Value and Opportunity.
