Investment Analysis | Fontana Limited.
Fontana Limited’s (Fontana) stock performance throughout 2019 has been exemplary. The company’s shares were offered to the public at a price of J$1.88 per share and was listed on the Jamaica Stock Exchange’s Junior Market in early 2019 and closed the year trading at J$7.02 per share. This indicates that throughout the year, the company’s value appreciated by just short of 275%. Much of the appreciation was attributable to positive economic performance of the company and positive investor sentiment surrounding the company’s, now completed and operational, expansion plans.
However, despite the stock’s positive performance (i.e. capital appreciation) and the company growing its income in 2019, it is our opinion that there are fundamental concerns surrounding Fontana going forward. Paramount among these concerns is management’s ability to curtail the rate of growth of expenses. The retail industry is generally one characterised by low margins, and consequently sustained expense management plays a vital role in laying the economic foundation for sustainable growth. However, between financial year (FY) 2014 and FY 2019, Fontana’s administrative and other expenses, combined with its selling and promotion expenses, grew at a compound annual growth rate (CAGR) of 17.41%. Comparatively, revenue grew at a CAGR of 15.70%. Essentially, the rate of growth of expenses during the outlined period was faster than that of revenue. This was a theme which repeated itself in the company’s recently concluded financial year 2019 when the aforementioned expenses combined to increase by 8.44% year over year (YoY). Comparatively, revenue increased by a lesser degree, 8.31%. Consequently, operating margins contracted during that period to a four year low of 35.76%. We are also particularly concerned about the rate at which some of these expenses increased. Shop rental, for example increased by almost 61%, or J$44.0M, YoY in FY 2019 with no notable additions to the company’s real estate portfolio during the period. In fact, the only material changed was mentioned in the company’s IPO prospectus when Fontana Limited outlined that it transferred ownership of real property assets (being land assets) to a separate and privately owned entity called Fontana Properties on July 2018. Put simply, we conjecture that Fontana Properties, increased the rental cost to Fontana Ltd. resulting in the whopping 61% YoY increase in lease expenses. Consequently, Fontana’s bottom line (i.e. net profit) only grew YoY as a consequence of tax return stemming to the tax reprieve companies listed on the Jamaica Stock Exchange’s Junior Market are entitled to.
Another point of concern was Fontana’s level of indebtedness. As at the end of FY 2019, Fontana reported debt totalling J$164.31M, which was a 36.75%, or J$44.16M, increase relative to the previous year. Of some concern is the fact that over 90% of that debt was due within the next twelve months. However, this concern somewhat alleviated by the fact that the Fontana reported holding in excess of J$380M in cash and cash equivalents as at the end of FY 2019 and that the debt only represented a mere 13% of equity. Nonetheless, all other things being equal, payment of this obligation is likely to negatively impact the company’s cash flow.
With the company reporting on its performance from the first quarter of FY 2020, the aforementioned concerns have not been alleviated. At the end of the quarter, Fontana reported operating income of J$20.17M, a 60%, or J$30.55M, decline from the corresponding period in the previous financial year exclusively attributable to increases in expenses. Operating expenses rose 20.91% YoY to J$296.34M and the operating margin contracted from 6.0% to 2.19%. The company explained that some of the increase in expenditure was attributable to the recruitment and training of new team members and for store set-up and for increased marketing and promotional activities ahead of the October opening of the Waterloo Square Branch.
The company’s total debt also grew by an additional 34.48%, or J$56.65M, since the end of FY 2019 to J$220.96M as the company borrowed more funds short term, causing the debt to equity ratio to increase to approximately 17%. The additional borrowing also cause the percentage of short term debt to total debt to increase to 95.53%, relative to 92.62% three (3) months prior.
Despite the opening of a new retail location and our expectation a great second quarter (i.e. Christmas quarter), overall we anticipate Fontana’s short term earning potential to be curtailed by the aforementioned factors. Our outlook is further weighed down by our assessment of the industry’s competitive threats which we assed as being high. Consequently, when we factored in the threats facing Fontana, we estimated the company’s fair value per share at J$6.11. This fair value implies that the stock, which is currently trading at a price of J$7.06 is trading at a premium of 15.55% relative to its fair value. Therefore, because of the factors outlined, we are rating Fontana’s shares as a SELL at this time for risk averse investors wary of capital losses. Investors with a stronger risk appetite could consider holding on to the company’s shares in hopes that the company reports a strong second quarter, which may result in further price appreciation of Fontana’s shares at which point they could seek to liquidate their holdings for potentially greater profits.
|Estimated Fair Value||J$6.11|
|Potential Capital Gain/Loss||-13.46%|
|Projected Dividend Yield @ Current Price||0.87%|
|Estimated Total Annual Return||-12.59%|