Promising small cap or serial underperformer?

In the hunt for promising ASX small caps, retailer Specialty Fashion Group (ASX: SFH) emerges as an intriguing idea. Here’s a look at the bull and bear cases for this seemingly promising small company.

The bull case

Specialty Fashion Group, which operates about 900 women’s clothing stores across Australia and New Zealand, generates relatively unimpressive earnings but, in recent years, substantial free cash flow given its size. Gross margins have risen significantly, to around 60% in the last 12 months, and capex costs have been trending down for years.

Specialty Fashion Group also has a strong net cash position, with around $46 million in cash and no debt. This looks even better when weighed against the company’s market cap of $167 million — meaning it holds nearly 30% of its market cap in cash.

What’s more, the company’s plus-size clothing business, as represented in part by its Crossroads and City Chic concepts, is especially promising in the sense that it caters to an underserved section of the consumer market. (Endless blog accounts, the web over, detail how hard it is for women to find attractive outfits in larger sizes.) Some 40% of company stores serve this market.

As evidence of its popularity among plus-size shoppers and others, the company has over 7 million members in its rewards program (with members representing around 80% of sales), and a growing online business that already contributes some 4% of overall sales.

So what’s not to like? For all these reasons, the business looks to be in a strong position, and Specialty Fashion Group shares have risen about 78% in the last 12 months. Yet shares still look relatively cheap today. SFH shares are trading for around 18 times trailing earnings, but on an EV to EBITDA basis of just 3.4. They also pay a fully franked dividend in the 2.3% range.

The bear case

It’s got to be acknowledged that Specialty Fashion Group doesn’t historically have a great track record when it comes to share performance. Looking back further, over the last 10 years, SFH shares have significantly trailed the S&P/ASX 200 index (Index ^AXJO) (ASX: XJO), with the index rising 61% over this time while SFH fell 50%, not including dividends.

And while the company has that great net cash position, it’s not clear what exactly management intends to do with the money. The company’s store network is already large. There’s no guarantee that the cash will be used in a way that will earn the company substantial returns.

The bottom line for Foolish investors

Despite its longer-term history of underperformance, Specialty Fashion Group is a company worth watching. Stick this retailer on your watch list and wait for news of the ways in which the company will deploy its cash and how it plans to grow profits.

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Motley Fool writer/analyst Catherine Baab-Muguira does not own shares in any company mentioned here.

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