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Analyst: Demo Analyst (1.)
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Author: Demo Analyst
Time: Jan 8, 2009 8:34 PM
Subject: Deteriorating market conditions put Stockmann at high risk: proof of profitable growth needed
Message Following starts with hold -recommendation: the Russian growth opportunities are offset by the weak economic prospects: proof of profitable growth needed

· Stockmann Group: cash generating established operations in Finland, Sweden and Norway, growth seeking strategy in Russia and Eastern Europe

· Lindex acquisition in 2007: debt-laden balance sheet due to overpriced acquisition and current amount of goodwill exceeding equity book value

· Introducing the Lindex concept in Russia has been slow so far

· Stockmann likely to take substantial impairment charges on goodwill reflecting the deteriorating market conditions

· Consumer demand in Russia has remain strong in spite of the economic turbulence until now

· Competitors postpone their investments in Russia: Stockmann might even be able to capitalise on the crisis

· Consensus has remained optimistic: Q4 performance likely to fall short of expectations

· Expected profit warning on Jan 8, several factors put pressure on margins

· Share price moderately valued: recommendation hold, target price 10.00 euros

Strategy introduced

The group has its established operations in Finland, Sweden (Lindex) and Norway (Lindex). Each area shows good profitability with solid cash flows, but the growth potential is very limited. The department store division has a strong market position and customer loyalty in Finland: 65% of sales from loyal customers, 1 million loyal customers in Finland.

The non-core mail order business Hobby Hall shows weak profitability and declining sales, a unit likely to be divested in future.

The Group seeks growth from the emerging markets of Eastern Europe and Russia. The key of the growth strategy is to acquire strong position in new shopping malls by having a department store, Seppälä and Lindex under the same location. The successful customer loyalty program is carried out also in the foreign markets with 0,7 million loyal customers abroad currently.

Key competitive advantages: established operations, high customer loyalty, strong profitability in Nordic market, long expertise in Russian market (since 1989)

Key growth driver: Russian market

Stockmann has posted increasing sales in Russia in spite of the financial turbulence, most likely because households in Russia have little debt and their purchasing power is more dependent on employment. However, I consider that the risk of collapse in consumer purchasing power is significant if the Russian real economy follows the plummeting oil price.

The operating environment in Russia is challenging but not as difficult for operations categorised strategic by the government. Grey economy, double invoicing, high import duties and litigations are main concerns, Russian's WTO membership would make the situation better for Stockmann.

Three reasons why the Group might be able to capitalise on the financial crisis in Russia:
1) local operators exit the market or face problems financing their operations 2) unlike its local competitors, Stockmann is likely to be more trusted by its suppliers, 3) competitors postpone their investments in the market creating competitive advantage for Stockmann, this advantage, however, might be offset by the weakening consumer demand.

Lindex acquisition

Lindex is currently having a strong market position in its existing markets that maintain a strong cash flow. The main driver for the acquisition was to establish the Lindex concept in Russia by exploiting Stockmann's experience in the market. Also, possible cost synergies with Seppälä exist.

Proof of profitable growth needed

The Group now combined with Lindex is eager to expand in Eastern Europe, Russia and even in Saudi Arabia. The acquisition that was carried out at the peak of the cycle was substantially overpriced and brings Stockmann's into much weaker financial position. In 2007 financial statements, Stockmann said it aims to open 20-25 Lindex stores in Russia in 2008, so far only one has been opened.

Stockmann likely to take substantial goodwill impairment charge in Q4

Due to the EUR 850.9 million acquisition cost of Lindex, Stockmann is currently carrying over EUR 800 million of goodwill in its balance sheet. The debt financed acquisition put Stockmann into a much weaker financial position (Q3 gearing 130%) and the company is currently carrying a goodwill higher than its equity book value. In spite the company has re-arranged its long-term financing (release 19.12.2008), I am expecting that some of the Lindex goodwill is likely to be impaired this year.

A quick back-of-the-envelope calculation shows this to us: the recoverable amount (NPV) of Lindex exceeded the carrying amount (EUR 895 million) by EUR 73 million in Dec 31, 2007 impairment testing. The applied discount rate (WACC) was 8.1%. Using Q3 figures, Lindex's invested capital was EUR 987.4 million and 12 months rolling EBIT was EUR 53.4 million, which yields a 5.4% ROIC. Since the current and my estimated ROIC are clearly below the discount rate, the NPV of Lindex is likely to not meet the current carrying amount in this year's impairment testing. The probable impairment is not taken into my estimates.

Q4 estimates: consensus looks too optimistic

I expect Stockmann's Q4 sales to decline slightly on y-o-y basis, if Lindex consolidation is not taken into account. The sales reports posted during Q4 indicate highest sales decline in department store (approximately -7%) and Hobby Hall (approximately -10%).

My estimate for Q4 EBIT is EUR 58 million, lower than consensus (77 million) and in line with management outlook (lower than in Q4'07, 71 million) posted in the recent profit warning. I base my pessimistic expectation on the following factors: 1) December sales report indicates weaker sales, 2) Slomenskaya department store remains closed 3) devaluation of the rubble affects purchasing power of Russian customers in both Finland and Russia 4) rapidly weakening consumer demand in Finland has forced the stores to discount sales earlier than usual. Also, the weakening sales currencies SEK, NOK put pressure on margins and the erosion of krona-denominated loans will affect 2008 EPS.

Management has not given outlook for 2009, my EBIT estimate ( EUR 123 million) is below consensus (EUR 147 million). I expect 2009 sales to increase slightly supported by openings of new stores.


My estimates for 2010-2013 operating margin (8-9%) are clearly below management target (12%). I remain cautious in the estimates due to the possibility of a protracted recession in main markets and failure of the leveraged acquisition-driven growth strategy. If the targets are achieved, the share would appear to be extremely cheap. The value of Russian growth opportunities is offset by the high risk for impairment, rapidly weakening short-term prospects and the risk of protracted recession. My recommendation is hold, target price at 10.0 euros.

  Last edited on Jan 8, 2009 8:34 PM, 1 time(s) in total

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Deteriorating market conditions put Stockmann at high risk: proof of profitable growth needed Demo Analyst Jan 8, 2009 8:34 PM Reply