Supreme Group PLC (#SUP on AIM) - MCap £120m @ 103p per share. Main driver is vaping business (new acquisitions announced today 9 August). Plus a mix of manufacturing and distribution within FMCG.

Founder CEO Sandy Chadha, as well as Non-Exec Chair, have bought stock this month after 3/23 guidance reset due to lighting biz inventory problem

Supreme Group PLC (#SUP on AIM) - MCap £120m @ 103p per share. Main driver is the vaping business (new vaping acquisitions announced today 9 August). Plus a mix of manufacturing and distribution within other FMCG categories - batteries, lighting, nutrition/wellness, and branded household products. Valuable distribution network of discount retailers and now increasingly distributing to supermarkets too. Led by Founder CEO Sandy Chadha, who has bought stock this month after 3/23 guidance reset due to lighting biz inventory problem. Non-Exec Chair Paul McDonald also bought £50k of stock. The biggest risk seems to be continued cost pressure /  slow recovery of margins in non-vaping businesses, but on balance we think gradual recovery there and growth of vaping business should lead to a decent outcome over a 2+ year horizon.

Insider dealing details
Insider deals as stated below - Non-exec Chair Paul McDonald and Founder Sandy Chadha both bought stock during July.

(Sandy sold just under 45m shares at 134p at the Jan 2021 AIM market IPO, generating around £60m in proceeds, so arguably the recent investment is not so significant when weighed against the scale of his IPO proceeds. This is debatable.)

More details/misc

The company’s activities and categories may seem a bit disparate at first glance - categories include batteries, lighting, nutrition/wellness products (vitamins, protein products etc) and vaping (our main focus for value here). And activities include manufacturing under their own brands, brand licensing of third party brands, and distribution via a network of retailers. However, all such cases involve FMCG (fast moving consumer goods) of some kind, and they all benefit from being sold through Supreme’s unique retailer distribution network.

 
A lot of Supreme’s value lies in its distribution setup. This is arguably less robust than having one’s value rooted mainly in brand names, as the former has a lack of pricing power that leaves you more vulnerable to factors out of your control - for instance cost-inflation factors that, as recently, may crush margins from time to time. The vaping business does have its own brands, and today’s acquisition seeks to grow that portfolio, but the bulk of Supreme’s existing vaping sales are arguably chosen by customers at least partly for their very low-price point and not just their brand-appeal. This probably makes the business more vulnerable to inflationary cost pressures than other FMCG related companies. Perhaps today’s acquisition and potential future vaping acquisitions will seek to grow out a more diversified portfolio of vaping brands including some more premium/higher price point brands than the currently dominant 88vape brand. Please see this link for the acquisition RNS

• https://www.londonstockexchange.com/news-article/SUP/acquisition-of-cuts-ice-flavour-core-trade-assets/15576481.

Following some inventory reset in the lighting division, the demand for products sold by Supreme should on average be quite robust to undulations in economic outcomes, as their product line up mostly consists of essential or everyday products that must be replaced once consumed. This should especially be true of the vaping business, where Supreme is selling an addictive product.

The way that management reports on the divisions is to give revenue and gross profit for each division, and then all the divisions share the same central admin/selling/general costs via the single distribution platform that these products are pushed through. This means that there are no divisional operating profit numbers, but you might be able to estimate them based on the reported gross margin numbers and then applying to this a typical ratio of operating margins to gross margins found at more focused businesses.

DISTRIBUTION NETWORK - The Group has over 3,300 active business accounts with retail customers who manage over 10,000 branded retail outlets. Customers include B&M, Home Bargains, Poundland, The Range, Sports Direct, Londis, SPAR, Costcutter, Asda, Halfords, Iceland and even HM Prison & Probation Service. 

 
VAPING - Vaping recently became the largest division by sales and also has the highest gross margin and thus by far the largest gross profit. It is also the fastest growing division. As such it probably comprises most of the value of the Supreme business today. In the vaping business, Supreme manufactures the products and owns its own brands, including 88Vape which is now available in major supermarkets. Today’s announced acquisition of Cuts Ice also brings the brands owned by TJuice including Red Astaire, which according to the RNS is very popular in mainland Europe.

Vaping comprised almost 60% of group gross profits in FYMar22 and will comprise around 70% of total gross profit for the current FYMar23 year.

Supreme achieved vaping revenue growth of 10% in the year to Mar22, and is guiding to grow revenue 30% in the year to Mar23, of which half will be organic and half from the M&A known to management at the time of guiding (not including today’s acquisition). The acquisition pipeline is strong - on 6 July results call the management said they were in the middle of reviewing several vaping deals which could be signed imminently. Some of these may be distressed/opportunistic deals. The company chose to cut the dividend to give maximum room to exploit such opportunities - more on this below.

Regulatory outlook for vaping in the UK seems benign for now based on latest Public Health England findings. See following two links for example

• https://www.gov.uk/government/publications/vaping-in-england-evidence-update-february-2021/vaping-in-england-2021-evidence-update-summary

• https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/962221/Vaping_in_England_evidence_update_February_2021.pdf

Vaping even looks like it is on a path to become prescribed by the NHS soon - probably in around 2 years’ time. This would further help acceptance of vaping by consumers and would also remove concerns of investors around the regulatory risk of this category, even if Supreme doesn't win or decides not to go for the NHS contract itself. 

The UK government has a smoke free 2030 objective  - a recent government report cited on the earnings call said the UK is behind schedule by about 4 years, on track to achieve smoke-free status by around 2034 rather than 2030. The report repeatedly mentions the transition to vaping as key to meeting the UK govt’s smoke-free objectives as quickly as possible. There were calls in the report to lift some of the restrictions when it comes to promoting/advertising vaping, etc. The UK Health Secretary was behind the report’s publication and in the words of Supreme mgmt on the recent earnings call, the report could not have been clearer about the favourable stance towards vaping. In 5 or 10 years time there might be bans on certain flavours of vapes more popular with non-smokers (e.g. fruit flavours), but all-out bans on vaping are extremely unlikely in the UK within any relevant investment time horizon. 

Supreme has been making huge traction with new disposable vape products - with Poundland, Iceland, Sainsburys, Asda, Core Communication and 6-7 other retailers all stocking it now. Estimated revenue from this product is £7.5m for this year, and maybe double that next year, and it is coming on as a complimentary product, rather than cannibalising Supreme’s existing vape offering. New users are buying one for the weekend, for a festival, or for a party, and then if they want to smoke habitually in the week they would go to a normal vaping setup. 

OTHER DIVISIONS

Nutrition/Wellness - This division is in earlier stages of its development but shows decent promise for the future. Nutrition and Wellness revenue growth 132% in Mar 22, from a small base. Distribution here is mostly through the same channels as the other products except in the case of one of the vitamin brands, Sealions, where they make an experiment with DTC distribution.

Vitamins progress to date is slower than protein. On the call Sandy described progress with Millions and Millions vitamin brand as “just OK”. Sealions brand - experimenting with DTC model, but with very low cost outlay - Supreme will let it grow very gradually, organically rather than gambling with big investment in DTC marketing budget. 

Inflation of input costs in protein products is a recent headwind - price of whey has more than doubled, price of creatine has tripled. Supreme will not try to pass all of it on immediately, because it might be too much for retailer customers to make an acceptable margin without large price increases to the end customer. But the inflation should be borne more evenly across consumers and members of the supply chain over time, with margins recovering in time. For now Supreme is making less margin than pre covid on both vitamins and powders.

When Supreme bought Sci-mx protein brand it gave access to both Morrisons and Tesco relationships, which can then be exploited over time for cross-selling opportunities. Now Supreme is speaking to Tesco about protein snack bars and has successfully sold its 88Vape brand into Morrissons. 

Batteries - This division is still on plan for the current year FY23 and seems to be unaffected by stocking issues for now. There are shorter lead times here and thus less scope for inventory imbalances. The battery industry itself is tracking a 10-15% decline on last year’s sales but so far Supreme is tracking according to its own plan. The battery division is a small one though, so even if sales all but disappeared it wouldn't be a huge impact at group level. About 10% cost inflation in this category right now.

Lighting  - In lighting Supreme gets exclusive regional licenses for brands like JCB/Energizer, applies these brands to products procured from China, and distributes the lighting products into its retailer distribution network. Revenue grew 4.3% yoy in Mar22, and achieved a 33% GPM. JCB license is valid until 2024. Global license with Energiser/Eveready valid until 2025, held since 2013. Retailer customers are long standing Supreme customers who have Supreme-produced store fittings in their outlets. 

Brand name licenses used by Supreme on its batteries are usually valid for 5 years at a time. When the next renewal round happens it will be the third or fourth time they have renewed most of these licenses. Sandy said on the recent earnings call that they have no fears of failure to renew key licenses. 

Concentration of customers in lighting - top 3 customers account for around 35% of lighting revenue. But these are long standing customers with permanent branded fixtures in their stores. Supreme can give them the lighting under licensed brands at the same cost as the retailers could procure a private label alternative, so this is a great deal for the retailers. 

Half of lighting division revenue is based on “FOB” order arrangement, where Supreme’s customers order via Supreme’s order system straight from Chinese factories. Orders are shipped directly into the retailers in Europe and UK (a lot of discount stores and hardware retailers), bypassing any physical involvement of Supreme, with full containers going straight to the retailer stores/distribution depots in Europe/UK - Supreme merely invoices for it. Great business in that Supreme doesn't hold the stock, doesn't use any working capital. But FOB orders are infrequent, huge orders, and there is a lack of forward visibility for Supreme’s management, hence the surprise element on FY23 order levels. 

The other half of the lighting business revenue involves Supreme importing to the UK and taking direct receipt of deliveries itself and then delivering those products to thousands of retailers around the country. 

Did the management not know about the issues in lighting business? Answers on the call to questions of this effect seemed convincing - no. Sandy even said that one of the key managers of procurement in the lighting division actually bought shares just a few weeks before the lighting-related profits warning.

What caused the inventory glut at Supreme’s lighting customers that needs to be corrected this year? Lighting business got a benefit from the transition to halogen lightbulbs in recent years, then got a covid demand boost, and then also Supreme’s retailer customers over-ordered stock following the covid-boost partly due to concerns of not having enough amidst supply chain disruption. Based on POS data Supreme just recently obtained, the end consumers are now buying 20% fewer lightbulbs so far in FY23 versus the same time last year. So now Supreme has to contend with lower end-consumer demand at a time when its retailer customers have just built up a large inventory - the only solution is a period of drastically lower sales into retailers (-50% lower sales in FY23) until the inventory glut at retailer customers clears. 

Overstocking expected to resolve within 9m. Consumer weakness is harder to say (macro), but likely to be max 2 years if we have a big/lasting recession. Currently, FY24 is expected to recover around 80-90% towards FY22 sales levels, and then FY25 onwards should be normal trading again. Expect £20-23m revenue next year FY 24, not quite fully recovered, but profitable. 

Impact on group level guidance for FY 23 - Cant reduce overheads to offset short term revenue decline, as there is nothing to reduce. The overheads are shared costs with the other product divisions. At group level Mar23 will be a solid, profitable year, but EBITDA will be lower than expectations and lower than the year to Mar22.

Could the overstocking problem happen in other categories? - on the earnings call Sandy says no, not really. It was mostly due to peculiarities of the lighting market and the particular FOB order setup described above, which gives Supreme much less visibility into potential inventory issues building up downstream in the supply chain. Processes are being put in place to improve visibility for the future to prevent such surprises recurring, including request of POS data from lighting customers periodically.

ACQUISITIONS/CAPITAL ALLOCATION

Mar 22 year end net debt stood at a negligible £4m prior to the recent vaping acquisitions, and stands at c£10-15m following the Liberty Flights purchase.

In addition to the Vaping acquisitions announced today (see RNS link above and further links below in “extra resources” paragraph), Supreme recently completed the acquisition of vaping business Liberty Flights. Supreme said they have known the company since 2014 when they approached them to manufacture for Supreme. Unlike with today’s RNS, Supreme gave some helpful numbers for the Liberty Flights acquisition - Liberty had annualised turnover around £10m. On the recent earnings call Sandy said that this is a well-functioning company and Supreme will basically let them carry on doing their thing. There is not one customer in common, so Supreme will offer Liberty’s “Dotflow” product into supermarkets and Liberty in turn can offer 88vape to its own customer base. Liberty did c£1.5m of ebitda last year, and Supreme expects to increase this with some efficiencies going forward.

Supreme is looking at a number of other acquisitions, including some in the distressed/opportunistic bucket. Despite being the largest shareholder and beneficiary of the dividend, Sandy decided to drop the dividend for this year in order to maximise room for acquisitions given the economic backdrop. This is exactly the type of dynamic capital allocation that you want to see from a founder CEO and one of several reasons that such businesses tend to outperform on average. 

Vaping is the main focus for M&A right now. Supreme aims for maximum acquisition multiples of 4-5x EV/EBITDA for established and stable, well-known companies. For opportunistic/distressed deals Supreme will aim for closer to 1.5x EV/EBITDA. Supreme has a £25m debt facility of which around £10m is remaining after the Liberty Flights acquisition. There is an additional £10m accordion facility attached. Supreme doesnt want to add more debt on top of this - as it would already amount to more than one turn of current EBITDA run-rate, which is management’s unofficial self-imposed limit. The management is risk averse to leverage in this respect. 

Valuation / upside potential

Just £4m of net debt at Mar22 year end, but this ist prior to the June 2022 acquisition of Liberty Flights which is likely to total c£12m between the £7.75m up front payment and the top up elements due over the 12m following acquisition. So with contributions from ongoing free cash flow, net debt is probably averaging around £10-15m prior to today’s acquisition.

c6x trailing adj 3/22 EBITDA seems cheap given growth potential of the vaping business. Admittedly 3/23 EBITDA could be down significantly yoy (brokers have £17.5m down from £21m in 3/22). We keep in mind that 3/23 results could be a bit worse than this broker estimate given cost inflation and being generally conservative about recovery speed in non-vaping categories, but will also depend on new contributions from vaping acquisitions which are as yet unclear. The company’s revenue guidance for the vaping segment only includes the Liberty Flights acquisition and not any subsequent acquisitions such as that announced today. We think that sales levels (confidently) and margins (mostly/probably?!) will recover over time in non-vaping categories. Furthermore, regardless of struggles in other divisions, if the vaping division continues on the current trajectory it should more than make up for disappointments elsewhere. So looking out to 3/24 and beyond the valuation is very interesting.

If one looks at other retail businesses with 45% gross margins, one might estimate that the vaping division as a standalone entity might be able to achieve a c15% operating margin and c11% net margin. On this basis the 3/23 P/E of Supreme based on the net earnings of vaping division alone (assuming other divisions’ profit goes to zero) would be around 19x.

Potential returns can come both from a resumption of double digit revenue and profit growth, and from a re-rating which would likely accompany such improvement..

Risks

Further cost inflation and inability or long delays in passing on such inflation - this is our main concern given lack of strong brand and pricing power within Supreme’s lineup.

Product safety issues in vaping or nutrition segments - eg a mistake that forces a large product recall or liability.

Loss of branding licenses in the (esp) lighting or battery products - minor concern

Minority shareholder vulnerability given Sandy’s stake is over 50% of outstanding, again only a minor concern given our impression that Sandy would like to gradually cash out from the fruits of his labours instead of pump significant capital back into the business

Extra resources

Acquisition related official RNS

• https://www.londonstockexchange.com/news-article/SUP/acquisition-of-cuts-ice-flavour-core-trade-assets/15576481

FY Mar 22 results video presentation (on 6 July 22), via Equity Development

• https://www.youtube.com/watch?v=pj-q1azpCFo

Acquisition related update from Equity Development

• https://www.equitydevelopment.co.uk/research/supreme-plc-acquisition-of-cuts-ice-ltd.-and-flavour-core-lt

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