Marks Electrical: A domestic appliance retailer with a lot to like, but not quite enough to buy.
Sometimes I spend several weeks researching a company and come to the conclusion that I don’t want to buy it. Given that this is likely to happen at least as much, if not more, than me finding companies that I am keen to invest in, I have decided that I will publish by thesis (or lack thereof) on these companies as well.
The reason for this is two-fold. Firstly, I am trying to write a blog as well as make investments and if I were to only publish the really good ideas the blog would be pretty sparse. The other reason is that you may disagree with me. Where possible I will try to write without too much bias, although it is inevitable that this will come through. This leaves you free to develop your own opinions as to whether the company is a good investment or not.
Of all of the companies I have researched, this was one of the most difficult to come to a decision on. I think part of the reason for this was the meeting I had with a member of the senior management team. Given he was generous enough to spend a significant amount of time explaining their business model to me and answering my questions, I felt some pressure to come to a favourable conclusion on the company (not least because he asked me to send him a link to it when finished). I now understand why some investors prefer not to meet with management, believing that it affects their ability to remain impartial.
The other reason is that there is a lot to like about the company. It is founder led, has an easy-to-understand business model and operates in a large, growing end market. I have however, made the decision not to invest in Mark’s Electrical. A summary of my thesis points, including explanations as to why I don’t see them as sufficient, are summarised below.
Summary
· Shift to online purchases – There is a growing trend towards consumers purchasing MDAs online. Given the propensity for younger consumers to be more comfortable making purchases online, this is a trend that should only continue. However, whilst I believe that a rising tide lifts all ships, there are a number of large competitors operating in the same space.
· A vertically integrated delivery model – The MDA market can be split into manufacturers and retailers. Within retailers, there are only four companies that operate their own vertically integrated, two-man delivery teams: Currys, Argos, AO World and Marks Electrical. Of these four, AO and Marks Electrical (ME) offer the best delivery terms and serve the more premium segment of the market.
· How Marks Electrical differs from AO World - Marks Electrical and AO are similar in nearly every way, except for their logistics model. ME operates from a single warehouse site in the midlands whereas AO operates a more conventional ‘hub and spoke’ model. This reduces the need for overnight trunking to satellite warehouses and significantly reduces lease expenses for ME. The offsetting factor is that this increases the mileage delivery vans must cover and could explain the spiralling distribution costs the company is experiencing.
· Focus on premium products – Marks Electrical’s focus is on the premium end of the MDA market. The unit economics of operating in this segment of the market are compelling, given the relatively fixed cost of delivery. The issue here is that the demand for premium white goods has softened with the cost of living crisis, eroding the companies average order values and profits as a result.
· Leaving the Euronics buying group – The decision to leave the Euronics buying group will give the company greater flexibility to manage their inventory through direct relationships with manufacturers. It is unlikely, however, to achieve more favourable terms in terms of price than the group had previously, and I therefore don’t see its effect as being significant for the company.
· Importance of service for MDA retailing – The company aims to differentiate itself from other retailers by the level of service that it provides. Whilst this is a factor that is likely to be more important to consumers in this space, given the essential nature of the items and the challenges involved in delivering and installing, I do not see it as a sufficient source of competitive advantage.
Business Overview
Marks Electrical (ME) is an online retailer of major domestic appliances, consumer electronics and smaller electrical appliances. It operates a vertically integrated delivery service from a single warehouse site in the midlands, allowing it to offer next day delivery to 90% of England’s population. Its focus is on selling and delivering what it refers to as ‘unfriendly freight’, which requires the use of two-man delivery teams and specialised vehicles. It aims to differentiate itself on the level of service that it can provide by operating its own delivery fleet.
Consumers shift to online purchases
UK consumers are increasingly likely to purchase major domestic appliances (MDAs) online. This trend, whilst developing for some time, was accelerated by the COVID pandemic. The percentage of purchases made online increased from 37% in 2015 (the latest pre-pandemic year I could find) to 58% in 2020 and 68% in 2021. This was driven by the closure of brick-and-mortar retail locations and consumers’ high levels of disposable income at the time. This trend has proven to be sticky post lockdown, with 70% of MDA purchases made online in 2022.
The trend towards online purchases of MDAs is increasingly prevalent compared to other industries because of the nature of the goods being sold. Firstly, these items are large and difficult to transport, meaning that consumers are unlikely to purchase them from a high street retailer and take them home the same day. Many of these consumers also want their appliances to be installed, a service that is offered by most online retailers.
The research cycles are also longer than small electrical appliances given they represent much larger investments and are expected to last a significant period of time. There is also less focus on aesthetics and more on performance than in other areas of the electrical appliance market. Reading reviews, looking at product specifications and comparing different models are all important aspects of the purchase journey and are more easily carried out online than in store.
According to research by McKinsey, the two most important factors for consumers when deciding where to purchase MDAs are price and speed of delivery. Online retailers are able to compete far more effectively on price than their brick-and-mortar counterparts given their significantly lower cost structures. The rise of online price comparison tools also facilitates easy comparison between retailers, ensuring that consumers get the best value for money.
Delivery is the second most important factor for consumers when choosing where to purchase MDAs. We will look at delivery in greater detail in relation to ME’s operating model, but those retailers who offer the best delivery service are those that operate online only business models.
The difference between MDA retailing and the rest of the electrical appliance market can be seen in the graph below. As we can see there was a spike in the number of purchases made online during the pandemic for the entire electrical appliance market. Since then, the trend has reverted and whilst still above pre-pandemic levels, it is significantly lower than the 70% online share for the MDA market specifically.
Percentage of electrical appliance purchases made online.
This trend towards the increased percentage of MDA purchases made online is likely to continue given that younger consumers are more comfortable making MDA purchases online. The graph below shows consumer’s preferences for in-store purchases based on age group. 25-34 year olds are the least likely to purchase a major domestic appliance at a physical retail store, with the preference increasing as respondents age does.
Preference for in-store MDA purchases by age group.
There are three primary drivers for buying a major domestic appliance. One is when consumers purchase a new home, the next is when they wish to trade up, and the final reason is when their current model breaks. The final two reasons are likely to be focused on the older segment of the market, i.e. those consumers who have owned their current model for a reasonable period of time.
Those consumers who purchase a major domestic appliance when buying a new home are likely to be skewed towards the younger segment of the market. The average age of a first-time buyer in the UK is now 34 years old, making up just over half of all property purchases made annually. Research by Aviva suggests that homebuyers spend an average of £10,000 on renovating their homes after purchase, with at least part of this allocated to a domestic appliance of some kind. This driver of MDA purchases amongst younger consumers should further push sales online.
A vertically integrated delivery model
As a side note before we get into ME’s delivery model, this discussion is particularly focused on the MDA market. Whilst the group does sell smaller appliances and consumer electronics, it uses a third-party delivery service for these items and therefore their vertically integrated delivery model is not relevant in this area.
For the purposes of this discussion, I have split the MDA market into three different types of operator. The first is the manufacturers themselves, most of whom operate their own DTC offerings. Manufacturers have the advantage of greater control over their stock levels and access to their latest models. Research by McKinsey shows that 32% of consumers will visit the manufacturer’s website during the purchase journey to read product information or reviews, but just 1.6% will purchase a product from them. Part of the reason for this is that manufacturers offer a more streamlined product range than retailers and don’t allow consumers to compare models from other brands.
Manufacturers also generally do not compete on price in the same way that retailers do. This is caused by the fact that they often sell the latest models and therefore do so at full retail price. Retailers on the other hand generally sell a much wider range of models and often at discounted rates.
The other important factor where manufacturers differ from retailers is in the delivery service they offer. Manufacturers won’t generally manage their own two-man delivery teams but will outsource the work to specialised providers. This means that their delivery terms are significantly behind those that offer their own integrated service. There is little incentive for them to address these concerns given their focus is on market share gains over competitors, not retailers.
The next operator in the market is the retailers who sell major domestic appliances, but do not operate their own two-man delivery teams. This includes the likes of John Lewis who have made the decision to move away from these types of deliveries over time. This function is either outsourced to specialist providers such as Arrow Logistics, or sold in a ‘drop shipping’ style arrangement through the retailers themselves.
ME says that these retailers have actively moved away from this segment of the market because it is such a challenging area to operate. Firstly, there is the need for significant fixed cost investments in vehicles and equipment (e.g. tail lifts etc). Then there is the need to train employees in the safe handling of ‘unfriendly freight’ and the installation of a wide variety of different appliances.
The final segment of the market is made up of those retailers who, like ME, also operate their own 2-man delivery teams. These include the likes of Currys, Argos (who do outsource some of these deliveries), AO world and of course ME. I have spent a lot of time adding washing machines and fridges to baskets and checking the available delivery times for each retailer. From my (limited) research Argos generally offers the worst delivery terms, usually averaging over 3 days. Curry’s is slightly better at 2 days on average and ME and AO World are the best, usually offering a next-day delivery option including installation.
What further separates these retailers is the segment of the market they are focused on. Both Argos and Curry’s are focused on serving the more affordable segment of the MDA market whereas ME and AO World offer more premium appliances. Based on this we can see that ME’s most direct competitor is AO.
How Marks Electrical differs from AO
AO and ME are similar in nearly every way. Both operate in the more premium segment of the MDA market, offer next day delivery on most items, compete closely on price, and differentiate themselves on the level of service that they provide.
The only point of differentiation between them is their logistics model, in particular warehousing and distribution. AO World follows the conventional ‘hub and spoke’ model for a retailer of this type, with 5 large central warehouses and a network of 16 satellite warehouses, or ‘outbases’. Goods are shipped from the large central warehouses to the smaller satellite warehouses via overnight trunking. The goods are then shipped from these smaller ‘outbases’ to the customer via AO’s fleet of delivery vehicles.
ME’s logistics model, on the other hand, relies on the use of one, very large, central warehouse. This negates the need for overnight trunking of goods between warehouses and the subsequent loading and unloading of heavy goods. The result is significantly lower warehousing costs compared to AO world and higher ROIC as a result (with the exception of last year).
Return on invested capital for Marks Electrical and AO World.
If we break down the ROIC for each of the two companies, we see the difference between the two operating models more clearly. I have only looked at 3 years of data from AO, but it is sufficient to understand the difference between the two companies.
Breakdown of return on invested capital for Marks Electrical.
Breakdown of return on invested capital for AO World.
Excluding the effects of changes in accounting policy, distribution expenses split out from cost of sales in 2023 and the separate recognition of right of use assets from 2021 onwards, we see some interesting trends.
Focusing on invested capital turnover to begin with (the bottom section of the tables) we can see some clear differences between AO and ME. The first is that ME has consistently increased their invested capital turnover over the past 6 years, mainly through tighter working capital management (lower inventory days), but also by reducing their net PPE balance. One of the ways they have achieved this is by selling their warehouse to the founder prior to the IPO. As we can see, net PPE as a percent of revenue went from over 17% pre-IPO, to under 10% after and has continued to trend down. AO’s invested capital turnover on the other hand has decreased over the past 3 years, primarily driven by an increased level of contract assets within long-term trade receivables.
Invested capital turnover for Marks Electrical.
There are two significant differences within invested capital turnover. The first is that AO has negative working capital, something its scale allows it to achieve through favourable credit terms with suppliers and quick cash collection from customers. The next, and most interesting difference, is between the two companies’ right of use assets (as a percent of revenue). These are predominantly made up of leased buildings and vehicles and are significantly lower for ME than AO.
There are three factors that allow ME to achieve such a low right of use asset balance compared to AO. The first and most significant is related to their warehouse model discussed above. Their one large warehouse compared to AO’s network of 21 gives them a significant cost advantage over their competitor. To illustrate this, total lease expense as a percentage of revenue is over twice as high for AO, 2.1% vs 0.9% in FY24 (1.9% vs 1.1% in FY23).
The next factor is that the company is able to achieve very good rates on their warehouse lease, given it is owned by the founder. I spoke to a friend of mine who works in commercial property and he tells me the lease terms and costs are very good. The current lease, renegotiated in Sept 24 is £640,000, putting it at a below inflation increase over the previous lease. This also makes the cost per sq. foot £2.97 and significantly below the roughly £10 average for England. Given that Mark Smithson is the majority shareholder of the business by some margin, I do not see this transaction as carrying significant risk.
The third factor that is that because the building is owned by the founder and CEO, the company has the flexibility to negotiate short-term leases. Usually this would carry significant risk to the business because it leaves the company vulnerable to increased lease expenses, and the potential loss of access to a site that they have invested significant capital in improving. In this case these risks are mitigated, allowing the company to operate under short-term leases and remove a significant portion of the assets from the balance sheet. In doing so this significantly reduces the asset base and boosts return on capital and asset ratios.
The operating model for each of these companies is also reflected in the NOPAT margin. This has been far from stable for either company, but ME has historically been able to maintain a higher margin than AO. Like for like comparison is complicated by the fact that AO’s distribution costs are included in cost of sales and ME’s are separated.
If we add back distribution costs to cost of sales for ME this changes cost of sales as a percentage of revenue to 80.1% and 84.3% for FY23 & FY24 respectively. This is above the 79.1% and 76.6% recorded by AO for each of these fiscal years. It also means that ME has significantly lower administrative expenses than AO after adjustment, 13.3% vs 19.9% for FY23 and 15.3% vs 20% for FY24. A large reason for this is significantly lower depreciation of right of use assets, related to the factors discussed above.
The concerning factor, however, is the decline in gross margin for ME. The most obvious reason for this is rising distribution costs relative to sales which was something that was mentioned in a meeting with management. The decline is even more stark given that the company removed its free next-day delivery during this period, now charging £29.99 for next-day deliveries. I think the company’s operating model is contributing to this, to explain why we need to look at the way the company makes long distance deliveries.
Graph showing the adjusted gross margin (distribution costs added back to cost of sales) for Marks Electrical and AO World.
For most operators, such as AO, goods are shipped from large central warehouses to smaller ‘outbases’. From there they are delivered on smaller vans to the customer. For ME, the single large warehouse model means that delivery drivers will drive significantly longer distances than competitors, sometimes staying overnight. This obviously means far higher fuel costs compared, which ME hopes to offset with lower warehousing costs. Whilst this model may have been effective 5 years ago, the rise in fuel prices appears to have had a significant impact on the company’s distribution costs.
Graph showing weekly diesel and petrol fuel prices. Source: UK Gov.
The other factor here is that the company’s delivery vehicles are technically classified as HGVs and therefore require class C licences to drive. Average salaries for class C drivers are around £32k, whereas for class B drivers they are closer to £25k. The current shortage of class C drivers has also fuelled further wage rises in this area. ME drivers share the driving on longer journeys, so both must hold class C licences. This means that they are paying two sets of above average wages per vehicle on delivery.
The other reason for the decline in gross margin, particularly in the last couple of years, is the decline in average order values for the company which we will look at below.
Focus on premium products
One of the most enticing aspects of the business model when I first began researching the company was the focus on the premium segment of the market. The unit economics of MDA retailing make this really compelling. If you imagine selling a Miele washing machine for £1000, and you have a relatively fixed cost of delivery of £50, this makes up 5% of the product. If instead the customer chooses a Bosch at £500, the fixed cost of delivery now makes up 10% of the product value.
This aspect of the business was made even more compelling by the trend towards premiumisation that took place within the MDA market. Driven by COVID, those MDA brands with a price index of over 150 grew by 26% in 2021, whereas those with a price index of 75 grew by 16% (Nielson IQ). Driven by higher levels of disposable income consumers were choosing to trade up, opting for more energy efficient and advanced models. This trend has somewhat faltered however, with most consumers now looking to trade down amidst the cost of living crisis and the economic uncertainty that this has created.
ME have, by their own admission, lent into this trend slightly too much. Average order values for the most recent period (H125) are down 9%. Management admits they have chased market share gains at the expense of profitability. The other concerning factor is the loss of a point of differentiation between them and their competitors. Whilst this is a trend that I would expect to soften somewhat, we are unlikely to see a return to the levels seen during the pandemic given the artificially high levels of disposable income at the time.
Leaving the Euronics buying group
The company has made the decision to leave the Euronics CIH buying group, Europe’s biggest electrical buying group. The decision was made primarily on the basis of supply rather than price.
According to discussions with management, commercial terms were the same for every member of the group. This is despite the fact that by the time they left, ME was the largest member by a factor of 4. What this would mean is that if a manufacturer put inventory into the Euronics central stock and there was significant demand for that model, it would have to go on allocation. This means that each member would get the same quantity, regardless of company size.
This became a significant impediment to the business, limiting the effectiveness of the buying team, who were unable to have direct relationships with the manufacturers. The company has now re-negotiated terms with every one of its suppliers and in all cases has either secured the same terms as previously or better.
Whilst I therefore don’t expect this to be particularly margin accretive to the company, given the significant buying power that the Euronics buying group would have had, it will be interesting to see how greater transparency and control over supply affects the business.
Importance of customer service for MDA retailing
Good customer service is an important aspect of MDA retailing, more so than would be the case for smaller electrical appliances. The essential nature of these items, combined with the fact that the majority are forced purchases, can make the purchase and delivery a stressful experience. Anyone who has been without their fridge for several days is likely to be less focused on delivery cost, and more on who can deliver and install it with minimal interruption.
Whilst service covers a wide range of interactions that the company has with a customer, it is particularly evident during delivery and installation because of the challenges involved. Trained delivery teams with specialist equipment are required to complete these deliveries. ME have their own on-site training centre, which allows them to train their employees by simulating challenging delivery environments (e.g. delivering a two-door range through the smallest possible UK door). Given that a large percentage of customers will choose installation and recycling as part of the delivery process, delivery drivers must also be trained to install a wide range of different appliances.
As discussed previously, most other retailers have already outsourced their delivery function, and in doing so have lost control over the level of customer experience that they are able to provide. ME takes pride in offering a superior level of service, with incentives offered to delivery drivers who receive good customer feedback.
ME’s focus on customer service is also evident in other areas of the business. They have invested significantly in their website, developing their own proprietary pricing tool to ensure they are competitive with the rest of the market. They also have a sales team that you can talk to over the phone and a range of different finance options.
Given the competitive nature of MDA retailing, high level customer service is one of the few areas where retailers can differentiate themselves from competitors. That said, service is still likely to come after price and delivery, so these two factors remain the primary concern. The issue for me with differentiating on customer service is that everyone can do it. If we use Trustpilot scores as a rough proxy for the quality of customer service that customers receive, ME and AO are nearly identical.
ME argues that they are not ‘competing’ directly with AO, with such a large addressable market to go after, they are able to take market share from other retailers. The problem with online retailing however is that they are competing directly with AO, as well as a number of other online MDA retailers.
Valuation
As I have decided not to invest in ME, I have not completed the valuation for this business.