Spring in Lewis’s mattress

2020 could have been a disaster for Lewis: customers were under pressure, stores were closed, and raw materials from bed foam to timber were unavailable.

Yet, seemingly, it managed to do everything right.

The furniture retailer, whose shares, in the words of one analyst, were "dirt cheap", last week delivered a 77% increase in dividends, on a 175% rally in operating profit for the year ended March.

By most metrics the annual results were outstanding. But how much of Lewis’s stellar performance was due to accounting changes — putting money it had set aside for bad debt onto its income statement — and how much was real growth?

After all, when Lewis, which sells mostly on credit to the lower end of the market, was finalising its 2020 results last year, it rightly assumed the pandemic would lead to an increase in bad debt.

It set aside R210m in provisions for cash-strapped customers who wouldn’t, or couldn’t, pay their accounts. In April last year, stores had to be shut and customers couldn’t go to them to pay, as most do.

"Our worst fears were realised," says CEO Johan Enslin, as write-offs shot up by R124m to R923m. Fast-forward to 2021 and Lewis has now released R110m set aside for provisions, while a chunky R2.4bn, which it’s already stashed away for bad debt, means management probably didn’t need to put more money aside for defaulting customers.

Clearly, that R320m accounting change inflated earnings, says Gryphon analyst Casparus Treurnicht, and explains, to some degree, why Lewis — on revenue growth of 4.2% and a rise of 7% in furniture sales — saw operational profit rise as much as it did.

But Umthombo Wealth portfolio manager Matthew Zunckel says the results were actually "very good".

"The free cash flows from the operations that they generated were up to 51%, year on year, so that for me put to bed any doubt about whether it was a good result or not."

Zunckel points out that Lewis "has actually been performing quite well over the past couple of years", yet investors have largely shunned the stock — in part, perhaps, due to the company’s controversial charges for employment insurance on customer loans, which historically bumped up profits and also raised the ire of the National Credit Regulator (NCR). The regulator took Lewis to court in 2016 over its use of extended warranties as well as club fees paid by some customers. A separate court battle with Summit Partners director Dave Woollam didn’t help.

Woollam launched a number of legal actions against Lewis on behalf of clients, and argued that the long-term picture for Lewis was of a "tyre with a slow-leaking puncture".

"Every single operational measure is getting weaker," said Woollam in 2016.

He sought a court order declaring Lewis directors delinquent for destroying shareholder value, while Lewis accused him of concealing a short position in the company’s shares.

Finally, last year, the Supreme Court of Appeal ruled against the NCR, declaring that Lewis’s fees and warranties were legal.

Certainly, Lewis is only now clawing its way back onto investor radars.

The stock sank from its 2015 highs of R97 to plumb a low of just R12.51 as recently as August last year.

But since January, Lewis shares have rebounded 62.5% and are 157.9% higher over one year.

So how did the "bank that sells furniture" achieve the turnaround?

In part, Lewis managed inventory well. In April last year, when not even the national coronavirus command council knew how long lockdowns would last and stores were closed, Lewis management made a gamble not to cancel furniture orders.

Enslin says their nerve paid off: "We believed at that time it was the right decision." And he says debt-free Lewis had the cash on hand to fund its stock.

It meant that as consumers, many of them stuck at home, began splurging on their homes, Lewis had enough furniture in supply and was able to deliver 95% of all purchases on the same day in line with pre-pandemic targets.

The move also bought loyalty from suppliers who continue to struggle to meet demand amid global raw material shortages.

"Suddenly, a lot of suppliers were more than prepared to put Lewis right in front of the queue," Enslin says.

Lewis expects supply chain issues to continue due to shipping constraints and factory stoppages. Containers have been piling up at North American ports and not being returned empty to factories in Asia, for example.

Back in SA it means Lewis is facing "massive competition" for a container. Staff sometimes work 18 hours a day, says Enslin, and once they find an affordable shipping container, the next hurdle is to find a ship to transport it.

"It’s not like in the past, where you could have secured a booking three months in advance. In a lot of instances, containers and space on vessels are put up on auction daily," says Enslin.

Shortages from bed foam to timber has also forced Lewis — which owns Beares and Best Home & Electric — to increase reliance on international suppliers as local producers struggle to buy sufficient raw materials.

While Lewis still sources a big portion of its stock from abroad, the group has committed to increase its use of local suppliers.

More broadly, Lewis is tapping into the value trend that helped retailers such as Mr Price and Pepkor produce stunning results last week.

Cheaper clothing stores Pep and Ackermans have gained market share as consumers buy down and even Pick n Pay says its growth market for the next five years is the discount space with its Boxer brand.

It also means Lewis’s cash sales have spiked — up 26% during the year.

This isn’t necessarily a good thing. Lewis, which makes half its earnings selling insurance and unsecured loans to consumers, could lose as much as 50% of its revenue stream.

But Enslin says the increase in cash sales is part of a long-term plan, discussed six or seven years ago, to move away from reliance on credit.

Treurnicht points out that Lewis’s lending practices and charges have more than once caught the eye of financial regulators that didn’t like the fact that it makes "huge profits" off poor, and sometimes financially illiterate, consumers.

Enslin says Lewis "will be quite happy, five years from now, to run this business with a 50-50 cash and credit sales split".

He argues that the group can withstand the loss of insurance and interest revenue after increasing its gross profit margin from about 33% 10 years ago to 40%-42%.

Lewis is also optimistic about the growth of United Furniture Outlets (UFO), a cash-only chain catering to the more affluent, that it bought in 2017 for R320m when it had 30 branches.

With about 40 UFO stores open now, Enslin sees another 2½ years of expansion, thanks in part to how well the retailer has done in Mthatha in the Eastern Cape and Thohoyandou in Limpopo.

Says Zunckel: "[UFO is] quite a niche offering in terms of the stores that they can actually roll out. It’s going to be limited in terms of the overall contribution it can ultimately make but it’s been a stellar acquisition."

Lewis’s results have also been flattered by its purchase of 17.3-million of its own shares since 2017.

The retailer has no illusions about the weak consumer market it faces.

Enslin flagged the unrest in many small towns across SA as a risk in the coming year.

But with better debt collection and more consumers using debit orders, the group expects the level of paid-up accounts to rise from 74%, the highest it’s been in 13 years.

The R2.4bn Lewis set aside for bad debt means investors need to watch future earnings closely.

In other words, will the retailer keep on releasing provisions back into its income statement, as it did this year, or will growth be from sales of actual furniture?