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Time to wake up and smell the roses - Dusk Group Limited

Updated: Feb 27, 2021

Disclaimer: This is not investment advice.

As I opened up yet another dogecoin article last week, it became apparent to me that perhaps my time would be better served identifying high quality businesses with attractive economics, that could (at the right prices) warrant investment. It was in undertaking this pursuit that I stumbled across Dusk Group Limited (ASX:DSK) (dusk).

The ramblings that follow are simply intended to articulate my views on dusk from the perspective of a potential (amateur) investor.

Source: Google Images

1. A simple and predictable business model

dusk is an Australian specialty retailer of home fragrance products which offers a diverse range of branded premium products at competitive prices (think 'affordable luxury'), via both its physical store network and via its online store.

Product offering

The company benefits from a differentiated product offering, with more than 450 active product lines available in store at any point in time, and approximately 1,400 different product lines sold each year due to seasonal product additions and limited edition products etc.

Although many consumers would be quick to associate dusk with its mainstay scented candles, the company's products can essentially be segmented into 5 key categories: (1) candles; (2) diffusers and consumables; (3) mood reeds; (4) homewares; and (5) other.

Source: Dusk Group Limited Prospectus dated 2 October 2020

Whilst the sale of candles generates healthy revenues for dusk, it was the company's exposure to the adjacent diffusers and consumables category that delivered the most promising results for the company in FY20, which together with its mood reeds, homewares and other categories (i.e. "non-candle" sales), accounted for approximately 67% of total revenue.

With a 54.9% revenue CAGR between FY18 and FY20, the growth of dusk's diffuser and consumable products has been impressive. Devices such as ultrasonic diffusers are typically of higher value than traditional candles and reed diffusers and also require consumable refills. Importantly, they can be aesthetically designed and made with materials in way that align with trends in home decoration and personal preferences.

On the other hand, management have been quick to identify declining customer demand for products in the homewares category over the same period and have therefore taken steps to narrow dusk's range of homewares. Floor and shelf space has been consciously redistributed to higher margin categories in order to drive repeat purchases and improve margin performance.

Vertical retail model

dusk's vertical retail model is unprecedented in the national home fragrance market and makes it a unique investment proposition relative to its peers. The company leverages its internal product formulation and design capabilities (which includes fragrance expertise) with the outsourcing of third-party contract manufacturing and logistics functions to support a capital light operating model that is focused on delivering quality control, design innovation and competitive pricing. By maintaining control of its supply chain, dusk is able to remain agile and react quickly to changes in consumer tastes.

Further, by maintaining longstanding relationships with its third-party contract manufacturers, dusk has not only been able to extract cost-efficiencies over time (typically in the form of volume based supply discounts), but has also been able to grow its business without being compelled to allocate vast sums of capital to its supply chain.

dusk also preserves its brand ownership through the exclusive distribution of its home fragrance products through both its extensive store network and online channel, which affords it control over pricing, product positioning and marketing. This decision not only contributes to higher margins but means that dusk is able to extend its customer reach without any reliance on third party brands or distribution channels.

Physical store network

The company currently operates 115 physical stores across its network in Australia with aspirations to expand to 160 physical stores across Australasia by 2024. A visual representation of dusk's store count is set out below, noting the company intends to open a further 3 stores by the conclusion of FY21 (taking its total to 118).

Source: Dusk Group Limited Prospectus dated 2 October 2020

By taking a prudent and targeted approach to its store roll out strategy dusk has been able to ensure that none of the stores in its network are consistently loss-making, which is rather unique for a retailer of its size, given the prevailing market conditions for brick and mortar retailers. In fact, the average profit (being gross margin less operating costs) contributed by each store in the company's network which traded for a full year in FY20 was $320,000 (notwithstanding Covid-19 shutdowns).

Even more impressive is dusk's historical like-for-like (LFL) store sales which have increased by a CAGR of circa 9% since FY17. Such growth supports the company's prospects of delivering organic revenue growth on the back of the continued roll-out of its physical store network. Over the past 5 years, dusk has sought to modernize its store fit out to a more contemporaneous design with an aesthetic that better reflects the current product range, provides more flexibility and maximizes space to enhance customer experience.

dusk has also recently sought to better leverage landlord incentives (given changing leasing dynamics) to effectively reduce its capital employed per store. Each new store now has an average payback period of less than 12 months

Online channel

The rapid growth of dusk's online sales via the company's website has been nothing short of remarkable and represents the company's fastest growing channel. Convenience is paramount to the online shopping experience and the dusk website has been developed and refined to encourage repeat purchases and allow new and existing customers to comfortably navigate the company's diverse product range.

Unsurprisingly, online sales growth was strong during the Covid-19 pandemic and whilst the surge in online sales across the broader retail environment is unlikely to be sustainable, logic suggests that more sales will be captured online as consumers become more accustomed to purchasing online.

Source: Dusk Group Limited Prospectus dated 2 October 2020

dusk's online revenue grew at a very healthy CAGR of 84% between FY17 and FY20. Critically, as its online sales begin to make up a more meaningful proportion of its total sales, their contribution to the company's underlying profitability and margin improvement will be substantial, given the unit economics of an online sale are far superior to a sale made in a physical dusk store.

2. A durable competitive advantage

Economic moat

dusk is fortunate to posses characteristics that Warren Buffett famously referred to as an "economic moat". Put simply, it benefits from distinct competitive advantages that help to preserve its returns and profitability from being eroded by competing firms.

In my view, dusk's competitive advantage is supported by three fundamental pillars:

  1. the strength of its consumer brand;

  2. the stickiness of its customer base; and

  3. its vertical retail model.

Consumer brand

Over the years the company has established and enhanced the strength of its brand in the minds of consumers, one that is now synonymous with a high quality, differentiated and premium product offering at competitive prices. In short, dusk products are positioned for consumers as being an affordable luxury.

dusk's ability to differentiate its products from its competitors and create customer demand for its higher-value product range (i.e. ultrasonic diffusers) is well supported by its average gross margin of 65.4% between FY18 and FY20, a feat that occurred alongside a growing market share across different categories. Accordingly, the company's exemplary margin performance, which is a function of price increases for customers and negotiated volume discounts with suppliers, suggests the company has been blessed with pricing power (i.e. an ability to raise prices without losing market share).

Without the challenge of managing a capital intensive supply chain, management have been able to re-align their focus towards generating more customer demand and creating brand recognition. Ultimately, it is the combination of the company's demand-side and supply-side competitive advantages together that have helped to create an ostensible 'flywheel effect', such that as the company's revenues grow, margins are likely to move in the same direction in a manner that is reflexive.

In this context, I see countless similarities between dusk and See's Candy, the Californian based chocolate maker with an enviable operating record that is a darling of the Berkshire Hathaway portfolio. When queried as to what made See's Candy such a remarkable business, Buffett was once quoted as saying:

"...Can you imagine going home on Valentine’s Day—our See’s Candy is now $11 a pound thanks to my brilliance. And let’s say there is candy available at $6 a pound. Do you really want to walk in on Valentine’s Day and hand—she has all these positive images of See’s Candy over the years—and say, ‘Honey, this year I took the low bid.’ And hand her a box of candy. It just isn’t going to work. So in a sense, there is untapped pricing power—it is not price dependent."

In many respects, dusk has cultivated a similar image in the minds of its consumers as Buffett had envisioned for See's Candy, especially during key gifting periods. After all, would your sweetheart prefer a run-of-the mill candle from Kmart on Valentine's Day or an immaculately designed and packaged candle emblazoned with dusk's logo? The answer to that question is self-evident, and therein lies the power of the dusk brand.

Fortunately for dusk, many consumers in the home fragrance market are brand sensitive, meaning that new entrants are confronted by an obvious barrier to entry, as the marketing spend and store presence required to build brand awareness is considerable. Notwithstanding, dusk has managed to enhance its brand image despite only allocating 2% of revenue to marketing spend. This is predominantly because the majority of its marketing activities are targeted at its own loyalty rewards members and the company otherwise focuses its efforts on 'unpaid' marketing channels to reduce customer acquisition costs.

Customer captivity

There is no better advocate for the stickiness of dusk customers than the success of the company's rewards program, which had grown to 550,000 members by FY20 (at a CAGR of 16% between FY18 and FY20). The rewards program is a paid loyalty program ($10 membership over 24 months) which demonstrates the extent to which customers are actively engaged with the brand and its products.

Source: Dusk Group Limited Prospectus dated 2 October 2020

What is striking is that the contribution of dusk rewards members to the company's overall revenue is substantial and growing. The average transaction value of a dusk rewards member is 1.4x higher than a non-dusk rewards member. Moreover, dusk rewards members accounted for 56% of total sales in FY20.

Source: Dusk Group Limited Prospectus dated 2 October 2020

As the dusk rewards membership base continues to expand and its rewards members continue to represent a greater proportion of total revenue, the company's revenue profile begins to resemble more of a SaaS company with annual recurring revenues rather than a traditional brick and mortar retailer. Given this dynamic and the company's ability to captivate and retain its customers, dusk is likely to benefit from exceedingly attractive unit economics in the future.

Vertical retail model

Central to the dusk value proposition for its customers is the company's ability to range high quality, innovative and widely differentiated products at competitive prices, which represents a meaningful value-add for its customers. One of the reasons the company is able to deliver on this promise is its vertical retail model, which unlike many of its competitors, enables it to exercise greater end to end control to ensure product quality. Additionally, exclusive distribution through dusk stores and via its online channel allows dusk to take full responsibility for pricing and marketing strategies.

The company's omni-channel offering also provides a key competitive advantage, given the tactile nature of the product range. Shopping for home fragrance products requires a sensory in-store shopping experience. Once a dusk customer has developed an affinity for a particular dusk product or fragrance, the likelihood of the initial in-store sale being complimented by future online sales is high, given dusk products are not available through third party distributors or retailers and can only be purchased in dusk stores or via the dusk website.

Fortunately for dusk, many of their home fragrance products (including candles and refills) have a consumable quality to them, in the sense that they need to be replaced relatively quickly after use, further amplifying the demand for repeat purchasing.

Industry dynamics

The home fragrance market in Australia is estimated to have generated sales of circa $461.5 million in FY20, having grown at a CAGR of 9.1% between FY17 and FY20. The market is forecast to grow by a CAGR of 5.8% in FY21.

As is evident from the table below, the diffusers and other home fragrance product category is the fastest growing segment within the broader home fragrance market, growing by roughly 11.5% in FY20 and forecast to grow by 17.6% in FY21.

Source: Dusk Group Limited Prospectus dated 2 October 2020

The domestic home fragrance market comprises both brick and mortar retailers and online retailers. Comparatively, dusk is uniquely positioned given its vertical operating model, exclusive distribution and omni-channel approach.

The company's competitors include department stores, other specialty homewares retailers and online only retailers. dusk also competes indirectly in the broader gifting market which includes names such as T2, Body Shop, Lush, Mecca etc. This market is more relevant during seasonal and key gifting periods (i.e. Christmas, Easter and Mother's Day).

Source: Dusk Group Limited Prospectus dated 2 October 2020

With the advancement of the internet, it is not surprising that most retail businesses that operate physical stores also have an online presence. Moreover, there are a number of online only retailers that compete with dusk by offering home fragrance products, including, Amazon, and Adore Beauty.

Interestingly, the market penetration of online sales in the home fragrance market (8.2% of total sales in FY20) is lower than penetration levels observed for the broader retail market (circa 10%). This can be explained due to the sensory nature of home fragrance products which favors in-store purchases, therefore making it challenging for pure-online players to actively compete against dusk in the absence of an in-store presence.

Market leadership

dusk is the clear market leader in the Australian home fragrances market and is the largest specialty home fragrance retailer in Australia, enjoying an estimated market share of 22% in FY20.

The company has also benefited from the explosion in customer demand across the fast-growing diffusers and other home fragrance product segment of the broader home fragrance market, where it established a dominant 38% market share in FY20.

From FY17 to FY20, sales growth in the home fragrance market (which grew by a CAGR of 9.1%) was outpaced by the growth of dusk's own revenues (which grew by a CAGR of 15.9% over the same period).

Market thematics

There are a number of market themes that may also impact on the growth of the home fragrances market in Australia moving forward. These drivers can be summarized as follows:

  • dusk management have observed a sustained interest in home improvement and styling in Australia which, when combined with the Covid-19 pandemic, has resulted in more consumers spending time at home, leading to a 'nesting effect'. Consumers that had historically been focused on meeting expenditures related to travel, out-of-home entertainment, cafes and restaurants have, due to restrictive Covid-19 measures and a propensity to avoid public places, been pursuing home decoration and comfort related opportunities. Naturally, this reallocation of household spending is likely to benefit dusk in the short to medium-term;

  • technological advancements are driving consumer demand for home fragrance products, especially in the diffusers and other home fragrance product category. Products such as ultrasonic diffusers are higher-value products that have attracted the attention of customers due to the controllable nature of the fragrance emission and the fact that a flame is absent, meaning they are perfectly suitable for environments such as homes, office use, children's bedrooms etc;

  • Australian consumers are increasingly associating home fragrance products with wellness. In fact, certain home fragrance products are designed and marketed to assist consumers seeking support or relief for common ailments such as diminished sleep quality and anxiety; and

  • the rapid growth of payment innovations such as 'buy now pay later' products offer payment flexibility that supports increased consumer spending.

3. Able to generate very high rates of return on equity, whilst employing little to no debt

One of dusk's compelling features is its ability to generate very high rates of return on equity (and similarly high incremental returns on equity), without relying on leverage.

With no debt to speak of and a robust balance sheet, dusk managed to deliver returns on shareholders' equity of circa 45% in FY20, which is a credit to the operating efficiency of its business model and its structural economic advantages. The result was an impressive feat. However, what is vastly more revealing about the business was the 101% incremental return on shareholders' equity generated by the company in the period between FY18 and FY20.

Put simply, the return on incremental shareholders equity represents the rate of return that dusk had earned on its most recently invested capital. In this context, dusk was able to deliver more than a dollar of after-tax earnings for every dollar that was reinvested in the business between FY18 and FY20 (all this whilst rolling-out 16 new stores). This is a truly remarkable effort and reflects a return that was considerably higher than rates of return generally available in the market .

Given the company's ambitious store roll-out initiative (targeting an additional 45 new store openings by 2024) and its record of delivering LFL same store growth at high margins, history suggests that dusk will have no trouble continuing to reinvest a decent portion of its future earnings at incrementally high rates of return.

Crucially, earnings invested internally at high rates of return tend to have a compounding effect on a company's business value over time, and by extension, can be expected to have a similarly positive effect on share price over the same period.

4. Free cash flow generative

dusk is a company that benefits from favorable underlying economics, in the sense that it is able to convert a reasonable portion of its revenues into operating cash flows, with minimal capital investment required to maintain its competitive position. Naturally, this leaves the the balance of its unrestricted earnings to be allocated to pursue attractive growth opportunities or otherwise be returned to shareholders.

As can be observed above, the company is increasingly converting a greater proportion of its revenues into operating cash flows, which is significant given total revenues have grown by a CAGR of circa 16% between FY17 and FY20.

When combined with the gradual decrease in its capital expenditure needs (noting capital expenditures have reduced as a percentage of revenues from 5.2% in FY18 to 4.4% in FY20), the net effect is that dusk is beginning to deliver a strong and steady stream of growing free cash flows, which grew by a CAGR of 108% between FY17 and FY20.

In my view, this is a dynamic that is likely to persist for three primary reasons: (1) dusk will likely continue to capture more market share, especially in higher-margin product segments such as diffusers and other home fragrance products; (2) revenues attributable to dusk rewards members will likely continue to make up a greater proportion of total sales over time; and (3) online sales will likely continue to make up a greater proportion of total sales over time. Under these scenarios, the recurring revenue growth from rewards members will be complimented by strong margin improvement driven by online sales and limited capital expenditure needs, which should feed through to the free cash flow level.

Interestingly, the company's ability to generate free cash flows has been aided by a relatively sedated demand for capital expenditures. This suggests to me that the durability of dusk's competitive position lies not with its investment in property, plant and equipment but rather its efforts to build and maintain brand recognition and the associated stickiness of its customer base, which requires minimal marketing spend.

5. Excellent management who understand capital allocation

One thing that any shareholder likes to see in a portfolio company is high levels of insider ownership. In the case of dusk, insiders hold roughly 42% of the company, with management holding circa 10% and Catalyst and BBRC holding 32% between them.

Peter King was appointed dusk's CEO in 2014 and has remained in that role until this day. He is a skilled operator with strong retail experience, including from Levi Strauss, where he was marketing director. Whilst there is minimal information on management available given the company's recent listing, the key players in this equation, being Catalyst and BBRC, come with considerable retail pedigree.

BBRC in particular is a name that is worth remembering. It is the private investment vehicle of Australian retail magnate and billionaire, Brett Blundy. BBRC have been involved with many success stories in the Australian retail landscape and common themes among BBRC's past and current investments include a winning strategy, strong growth, efficient business models and prudent allocation of capital. Some of BBRC's most recognized holdings include Lovisa (ASX:LOV), Adairs (ASX:ADH), Sanity and Bras N Things.

6. Is available at a fair or reasonable price

Having conducted what I considered to be a reasonably high-level due diligence exercise on dusk, I was stunned to see that the company was trading at such a depressed valuation relative to its peers.

The company recently provided forward guidance for 1H21, indicating that it expected revenue to be in the range of $90 million to $90.5 million and EBIT in the range of $26 million to $27 million. Assuming even a very conservative estimate for 2H21 of say $8 million in EBIT (resulting in a total of $35 million in EBIT for the full FY21), the company would still only be trading at a forward EV/EBIT multiple of 4x.

This desktop valuation suggests that dusk offers extraordinary value for a business with such attractive underlying economics, both in the context of its future growth opportunities and the prevailing low-rate environment.

Fund manager, Emanuel Datt of Datt Capital recently wrote an insightful article for Livewire titled, "Why is the market valuing this stock so cheaply?". The article, alongside his recent interview with AFL footballer turned podcaster, Chris Judd, on the investment merits of dusk was the catalyst that encouraged me to research the company.

In the article, Datt provides an extremely helpful chart (refer below) setting out the stark valuation differential between dusk and its universe of listed peers in the Australian discretionary retail sector:

Source: Livewire

For a company that: (1) benefits from an economic moat; (2) is growing revenue and earnings at a healthy pace; (3) has attractive unit economics, a healthy balance sheet and no debt; (4) is a market leader in its industry; and (5) has a reasonable runway for growth with an opportunity to reinvest at incrementally high rates of return, the sheer level of market neglect towards dusk is quite frankly stunning.

In some respects, whilst one can never fully understand or appreciate the vagaries of Mr.Market, it is reasonable to suggest that perhaps the mispricing of the stock is partly attributable to recency bias, given dusk only completed its IPO in November 2020. The market's expectation could be that much of the consumer stimulus related buying trends that were prevalent in FY20 are likely to subside moving forward, which would imply that dusk's revenue growth is largely unsustainable.

Whilst valid to some degree, it is important to note that dusk was already demonstrating strong growth prior to the pandemic. Arguably, the flow-on effects on consumer sentiment due to COVID-19 related shutdowns and a post-pandemic environment, where consumers are more amenable to staying indoors and to reallocating travel spend, is a potential tailwind for the home fragrance industry, and by extension for dusk.

7. Conclusion

In summary, dusk is an extremely high quality business that is currently trading at a deep discount to its peers (whether on a relative or absolute basis). In light of the above and at current market prices, I think dusk presents investors with a compelling risk/reward opportunity with an asymmetry that is skewed heavily to right tail returns over the long term.

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