Leon’s Furniture (TSE: LNF) is a well-known retailer in Canada that operates efficiently and creates value for shareholders. Therefore, investors who want exposure to the retail sector may want to consider its stock.
LNF’s Efficiency Has Remained Steady
Leon’s Furniture needs to hold onto a lot of inventory in order to keep its business running. Therefore, the speed at which LNF can move inventory and convert it into cash is critical in predicting its success. To measure its efficiency, I will use the cash conversion cycle, which shows how many days it takes to convert inventory into cash. It is calculated as follows:
CCC = Days Inventory Outstanding + Days Sales Outstanding – Days Payables Outstanding
Leon’s Furniture’s cash conversion cycle is 74 days, meaning it takes the company 74 days for it to convert its inventory into cash. In the past several years, this number has trended upwards, as it was just 58 days in Fiscal 2016, potentially indicating that the company’s efficiency has deteriorated. However, that is not really the case.
Indeed, days inventory outstanding (how long the company holds inventory), which is the most important metric in the equation when it comes to efficiency, has remained relatively flat since 2015. The same can be said for days sales outstanding.
Therefore, the culprit for the increasing CCC metric is days payable outstanding, which measures how long the company takes to pay back its suppliers. This number has decreased, meaning that Leon’s has been paying suppliers back faster. As a result, efficiency has not actually deteriorated.
In addition to the cash conversion cycle, let’s also analyze Leon’s Furniture’s gross margin trend. Ideally, I would like to see a company’s margin expand each year. This is, of course, unless its gross margin is already very high, in which case it is acceptable if it remains flat.
In Leon’s Furniture’s case, its gross margin has expanded very slightly in the past several years, going from 42.7% in Fiscal 2016 to 43.9% in the past 12 months. This is ideal because it allows the company the opportunity to increase its free cash flow or reinvest a larger percentage of revenue into growth initiatives.
Leon’s Furniture Creates Value for Shareholders
Great companies often have great management teams that can effectively allocate capital to profitable projects.
To get a good picture of management’s effectiveness, let’s take a look at the numbers. A metric I like to look at is the economic spread, which is defined as follows:
Economic Spread = Return on Invested Capital – Weighted Average Cost of Capital
The idea is very simple; if a company’s return on invested capital is greater than the cost of that same capital, then the company is creating value for its shareholders through well-thought-out projects. Otherwise, the company is destroying value and would be better off simply investing money into risk-free bonds.
For Leon’s Furniture, I will use its five-year average return on invested capital in order to smooth out the increase it saw in 2021. Its economic spread is as follows:
Economic Spread = 11.5% – 8.8%
Economic Spread = 2.7%
Analyst Sees Ample Upside Potential
In the past three months, only one analyst has issued a price target for Leon’s Furniture, which stands at C$20 per share. This implies 29% upside potential from its current price. The analyst is Stephen Macleod from BMO Capital, who nearly has a five-star rating, and he assigned a Hold to LNF stock.
Final Thoughts: A Solid Stock for Retail Exposure
Leon’s Furniture is a solid business with a solid track record of efficiency. Its efficiency has not been impacted by competitors as its gross margin has expanded and days inventory outstanding has remained constant.
In addition, the company generates value for its shareholders by earning a return on capital that is greater than its cost of capital. As a result, investors may want to consider taking a deeper look into the company.
