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Is now the time to buy Kogan (ASX: KGN) shares?
It’s been a painful 2022 for the e-commerce sector, particularly former market darling Kogan (ASX: KGN). The pandemic induced retail spending surge of 2020 and 2021 is gone. Instead, households now face the scary economic reality of rising interest rates and inflation. Add in a sharp market sell-off in technology shares in addition to ongoing internal issues over inventory and it’s little surprise the Kogan share price has sunk 59% so far this year.
It’s not the only online retailer feeling the pinch, with the share price of Cettire (ASX: CTT) plummeting 86%, Redbubble (ASX: RBL) falling 68%, Temple & Webster (ASX: TPW) down 61% and Adore Beauty (ASX: ABY) off 66%. If you didn’t know the date, you’d think it was Boxing Day!
Fortunately, it’s not all bad for the e-commerce sector, or at least e-commerce investors. The sharp drawdown in their share prices has meant valuations have become much more attractive relative to the past. There is clearly interest out there, evidenced by Woolworths Group (ASX: WOW) snapping up 80% of MyDeal.com (ASX: MYD) on Friday just above its IPO price 18 months ago. So then what is Kogan worth? The business is currently loss-making so a traditional profit metric like the price-to-earnings (P/E) ratio isn’t useful. Most of its peers are in a similar bucket, so there isn’t any competitor to base long-term margins off. As a result, investors need to think more abstractly.
Consulting firm McKinsey estimates the average earnings before tax, interest and amortisation (EBITA) margin for retail companies is around 10%. For simplicity, assume interest, tax and amortisation amounts for 5% of sales, so the earnings margin falls to 5%. As you can see in the chart above, the P/E looks attractive given that online penetration should continue to increase over time.
The big question is if Kogan and the broader e-commerce sector can achieve such margins? While online websites don’t pay for rent for physical retail stores, each spends buckets of cash for digital space across Facebook and Google. As traditional physical-only stores move towards omnichannel and privacy changes reduce the effectiveness of targeted promotions, competition for ad space has only accelerated.
Spending infinite amounts chasing the big tech search algorithms is an unsustainable strategy. The winners will be sites that generate organic traffic via high brand awareness and customer loyalty. Kogan has taken steps towards this, such as launching Kogan First, its equivalent of Amazon Prime.
Arguably Kogan’s biggest issue is not external but internal. It’s still dealing with inventory issues stemming from over-ordering a year ago. Management failed to fully capitalise on the pandemic tailwind, with the core kogan.com website increasing gross profit by just 13% over the past two years. Earnings have reversed, while the business moves into non-core offerings like insurance and mobile. The business continues to trip on its own shoelaces, leaving investors uncertain it can achieve its potential.
Before investors regain confidence in Kogan – and its flailing share price – two things need to happen. First, it needs to demonstrate disciplined cost control and therefore improve its EBITA margin to be in line with the retail average. Second, it must do a better job of explaining its growth ambitions. Set ambitious but achievable targets and communicate them to the market. Growth isn’t always linear, but the volatility in the Kogan share price is partly a function of its failure to execute on past expectations.
If Kogan can achieve these two goals, market scepticism will abate and the share price will rise. Today offers a compelling entry if it can execute. However, it’s up to Kogan to deliver on budget and on time.
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