Online retailer and logistics provider THG (THG) presents investors with a major conundrum at the moment.

The shares currently trade at 114p compared with their post-IPO highs of 800p, while valuations vary from 110p to 700p depending on which analyst’s research you read.

Most brokers have a ‘buy’ or ‘hold’ recommendation, yet over the last six months they have all slashed their earnings forecasts for this year and next year.

Meanwhile, results for 2021 and the first quarter of 2022, which were published last month, seem to have done little to cheer investors, and the whole investment case now appears to hang on the potential future value of the Ingenuity platform.

GREAT EXPECTATIONS

THG’s market debut in 2020 was quite an event. At £1.88 billion it was the most raised since the Worldpay initial public offering of 2015.

It valued the group at £5.4 billion, which based on 2019 EBITDA (earnings before interest, tax, depreciation and amortisation) of £111 million meant a multiple of nearly 49 times.

Yet the company now has a market cap of just £1.5 billion, meaning almost £4 billion of investors’ money has gone up in smoke.

Results for 2021 looked reasonable, with revenues climbing 35% to £2.18 billion due to gains at its Beauty and Nutrition units.

The Beauty business combines eight owned brands across skincare, haircare and cosmetics, and provides a route to market for over 1,300 third-party beauty brands through its websites, including Lookfantastic, Cult Beauty and Mankind.

Sales last year rose 49% to £1.12 billion, or more than half of group revenues, although most of the increase was due to two big acquisitions in the US.

The Nutrition unit, which includes the world’s largest online sports nutrition brand Myprotein and related brands such as Myvitamins and Myvegan, increased sales by 17% to £660 million or roughly 30% of group revenues.

With a greater proportion of consumer spending having shifted online during the pandemic, the number of active Beauty customers rose by 2.3 million to 9.2 million last year while Nutrition saw a rise of just under one million to 7.2 million customers.

The third leg of the business is the Ingenuity division, within which Ingenuity Commerce provides an end-to-end direct-to-consumer e-commerce solution for major global consumer goods brands, or as THG calls it ‘a business in a box’.

Revenue for Ingenuity jumped 41% to £194 million as the number of live customer websites doubled to 187 against 89 the previous year.

Disappointingly though, group EBITDA margins dropped to 7.4% against 9.3% in 2020 as the firm battled rising input costs – in particular whey, a key ingredient in its nutrition products – and soaring freight costs.

The firm also cut its 2022 EBITDA margin target from 8% to 6%, as it opts to absorb some of the inflationary pressure rather than passing it all on and risk losing customers, ‘with a weighting to the second half’ which is code for ‘the first half could look ugly’.

WEAK UNDERLYING GROWTH

There wasn’t much to cheer in the first quarter update either, with group revenue growth slowing to 17% against a strong first quarter last year.

Beauty sales rose nearly 20%, while Nutrition growth slipped to 12.6% despite a raft of new product launches.

Stripping out the positive contribution from acquisitions analysts at Numis estimate underlying group sales were up just 2% during the quarter with Beauty sales actually falling 7% and Nutrition sales rising 7%.

For the firm to reach its full year target of 22% to 25% growth, like-for-like sales need to grow by double digits according to Numis, which looks like a tall order.

While the effect of not passing on the full impact of price rises at the risk of losing customers and damaging the ‘brand equity’ has yet to be seen, with the cost of living crisis really kicking in this quarter we suspect sales growth will have slowed further and tighter margins will result in an even lower first half EBITDA figure than the company  has envisaged.

All of which means Ingenuity really needs to deliver. Yet, while the number of live client websites rose to 202, average recurring revenues and the average annual run-rate dropped quite considerably from the fourth quarter of last year meaning the division missed estimates.

HIDDEN POTENTIAL?

While it may not currently generate a huge amount of revenue or value for the group, THG insists Ingenuity can become a key standalone global logistics player for e-commerce retailers and global brands.

At first the market seemed to buy this argument, seeing THG’s selling its internet retail expertise as a service as similar to Ocado’s (OCDO) out-of-the-box solution for global supermarkets. In the interim however, scepticism has built.

The firm manages over three million square feet of warehousing globally, has its own warehouse management software and connections to over 200 ‘final mile’ delivery providers.

Yet for all its expertise, the market remains unconvinced of the potential for Ingenuity to become a pure e-commerce logistics solution.

An October 2021 capital markets event proved a spectacular flop, sending the shares tumbling, and reactions from analysts to the firm’s latest strategy update suggest the jury is still out.

While the firm says it is doubling its capacity to handle £14 billion of gross merchandise value ‘to facilitate Ingenuity growth in major markets’, there are questions over where the increased volumes will come from compared with the current £2.5 billion run-rate.

Also, ‘the margin structure and return on investment on the pure logistics proposition is somewhat opaque,’ notes Numis, concluding that beyond the rhetoric the first quarter trading update contained ‘little in content to meaningfully move the equity story’.

DO YOU FEEL LUCKY?

THG feels like a binary choice to us, which unless we had a gun to our head like Albert Popwell in the film Dirty Harry we wouldn’t particularly choose to take right now given the uncertainty in global markets.

The core business faces slowing sales growth and a self-imposed margin squeeze, and the noises coming from the consumer discretionary sector so far – including pure online players – are not encouraging.

To quote Numis again: ‘The core e-commerce assets look to be facing tough trading conditions, negative forecast momentum and a challenging competitive environment (as with many listed peers), and on comparable valuation wouldn’t justify the current market cap.’

The key to the firm’s current £1.5 billion valuation is Ingenuity, which if it does turn out to be a huge store of hidden value means we, and many other investors, will probably miss the boat.

There has been plenty of takeover speculation, with management confirming it has had ‘indicative proposals from numerous parties’, but the board has decided that ‘each and every proposal has been unacceptable, failing to reflect the fair value of the group’ and there is no live interest.

The shares have fallen a long way, and while it’s tempting to assume it’s the work of faceless, cold-blooded short-sellers that’s not actually the case.

Only AHL Partners, which is part of Man Group (EMG), is short THG, and then only 0.6% of the share capital alongside its similar-sized short bets in online fashion retailers ASOS (ASC) and Boohoo.com (BOO:AIM).

It’s important to say we don’t think investors are in danger of being wiped out in THG as they were in McColl’s, but the balance between risk and reward just doesn’t appeal to us here.

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