No-moat Kogan (ASX: KGN) is grappling with muted consumer demand. Gross sales growth in the March quarter of 2024 missed our expectations. Operating margins, or adjusted earnings before interest, taxes, depreciation and amortisation (“EBITDA”) per gross sales, strengthened on the December 2023 quarter and on the previous corresponding period.

However, without the expected return to top-line growth, operating costs weighed on margins. We materially downgrade our earnings outlook for fiscal 2024 and 2025 by 19% and 15%, respectively.

Nevertheless, shares in Kogan screen as materially undervalued. The severe selldown following the softer-than-expected third-quarter trading update suggests the market is excessively focused on the near-term outlook. Our unchanged $10.70 fair value estimate is mostly underpinned by our long-term forecasts, which are largely intact.

Since the December quarter 2022, operating margins improved significantly to 5%, from 2%, against a backdrop of declining gross sales. Less discounting and an increasing mix shift to higher-margin sales underpinned the margin recovery. But these tailwinds are abating, and the next earnings leg-up for Kogan depends on sales growth. While the near-term outlook is more challenging than anticipated, we continue to forecast solid gross sales growth from fiscal 2025, averaging 7% per year over the next decade.

Despite a reawakening in e-commerce in fiscal 2024, Kogan’s Australian gross sales declined by 5% in the March quarter of 2024 on the PCP. Consumer demand remains sluggish for Kogan’s top product categories, such as consumer electronics, appliances, and furniture.

A hangover from brought-forward sales during the pandemic lockdown and consumers' diminishing discretionary buying power are crimping demand for household goods. The Australian Bureau of Statistics estimates that electronic goods and furniture sales are down by 2% and 4%, respectively, in the first two months of 2024 compared with the same period a year prior.

Business strategy and outlook

Kogan’s business strategy is broadly based on low-price leadership. However, as the competitive outlook intensifies from both Amazon and omnichannel retailers, Kogan is adjusting by launching a new online marketplace and building its product offerings in bulkier goods.

Compared with new entrants and most traditional retailers, while replicable we believe Kogan is far ahead on its supply chain, operational automation, IT, and sourcing capabilities. It outsources delivery and uses third-party logistics providers for warehousing, but has built a proprietary least-cost routing system that automatically calculates the best carrier depending on the article ordered.

Kogan’s strategy for its exclusive brands is largely data-driven, and seeks to identify and fulfil established demand for consumer products or categories at competitive prices. The firm analyzes Google search trends and product sales on competitor websites to identify strong consumer demand, and then manages and invites manufacturers to tender for new product contracts mostly through its Shenzhen sourcing office. Kogan is increasing private label exposure in bulkier goods including white goods, built-in kitchen appliances, and furniture with the bolt-on acquisition of Matt Blatt in fiscal 2020.

The firm also started delivering bulky goods to Brisbane, Perth, and Adelaide after expanding to 13 fulfilment centers in fiscal 2019. Although typically lower margin, we consider building a differentiated product offering around big-ticket items as a sound strategy. As fulfilment of bulky goods can be challenging to automate and usually requires dedicated handling, Kogan is competing less with Amazon’s fulfilment expertise, and in categories with generally less online competition overall.

We see great potential in Kogan’s relational business growth through its Kogan First membership model. Kogan First is a loyalty subscription service that allows users to pay less for products and delivery and gives access to exclusive offers. Kogan First has seen impressively fast user adoption since it launched in 2019. As of December 2023, Kogan First had over 466,000 members.

Moat rating

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Given low switching costs for customers to comparison shop and increasing online competition from both Amazon and omnichannel retailers, we don’t believe Kogan is differentiated enough from a product, shopping experience, or process standpoint to award an economic moat. However, we still expect Kogan to boast high returns on capital, and attribute this to structural industry tailwinds of online migration, the ramp up of its marketplace, and being a capital light business by nature.

We think Kogan benefits from traces of two moat sources, cost advantage and network effect, but don’t yet have confidence that either will prove durable over the next decade. Starting from scratch in 2006 as a pure-play online retailer, Kogan’s process and associated cost advantage of sourcing direct from manufacturers and selling online, enabled the company to undercut most rivals on price.

Since then however, comparably lean supply chains have become plentiful, direct-to-consumer efforts have increased, and traditional retailers have improved their own online presence, eroding this cost advantage. For instance in TVs, Australia’s leading consumer electronics retailer JB Hi-Fi launched an exclusive value TV brand, "FFalcon," in fiscal 2020. Highlighting the importance of price as a key differentiator, third-party brands revenue also fell 25% in first-half fiscal 2020 on the prior period, largely due to a change in GST laws forcing Kogan to charge GST on items under $1,000 shipped directly from their overseas warehouses.

As it grows its roughly 4 million active customers, Kogan group’s platforms across Australia and New Zealand are becoming more valuable to third-party brands and advertisers but they are far from achieving critical mass and a dominant network effect. Demonstrated by the sharp decline in third-party brand sales in first-half fiscal 2020, customers seek value not just range, and it remains to be seen how much value and retention a larger network would create given Kogan’s relatively low operating leverage.

Group gross sales per customer were virtually flat over the last four years despite an increasing number of brands and customers. In addition, it appears Kogan spent significantly more in marketing to acquire additional customers in fiscal 2019, contrary to a network effect. Kogan launched its membership program, "Kogan First," to improve customer retention, which achieved 466,000 subscribers as of late 2023. However, both Amazon and eBay offer cheaper membership programs for a larger range of products on their platforms. Kogan has also attempted to leverage its customer base and extend into numerous other products and services, but aside from prepaid mobile phone plans, other cross-sales have been immaterial.

The company aims to fill product gaps and offer a broader range through both its third-party business and marketplace. In third-party brands, due to new GST laws effective July 1, 2018, Kogan was forced to charge GST on items under AUD 1,000 shipped directly from their overseas warehouses, effectively raising prices substantially. As a result, global brands contributed just 33% of third-party brands revenue in first-half fiscal 2019 down from 70% in first-half fiscal 2016.

This reflects not only the sharp decline in global brands sales but also Kogan’s increased focus on domestic third-party partners. For marketplace, Kogan’s strategy is to attract more sellers with its growing customer base, which in turn may attract more customers. Kogan launched its online marketplace in fiscal 2019 and takes a 10% commission on gross sales. Like Amazon, we expect the company to eventually offer sellers a fulfilment service at a higher fee but don’t believe Kogan will build its own in-house fulfilment.

We see the outlook for Kogan’s mobile segment as being potentially challenging. A trend of postpaid plans improving their offering to consumers with shorter contracts and more peace of mind poses a longer-term headwind. With the TPG-Vodafone merger and TPG’s aggressive track record, prepaid pricing may decrease further to chase more subscribers but may not translate to an increase in Kogan’s commissions if subscribers stay relatively flat.

Aside from Kogan’s mobile segment, we forecast contributions from other business verticals to remain relatively immaterial. Given the current climate, Kogan Insurance has suspended travel and landlord insurance while a supplier of Kogan Travel also became insolvent in fiscal 2020. Through these other businesses, Kogan aims to leverage the Kogan brand and gain incremental earnings without requiring investments in working capital. There are also economies of scope on offer by fractionalizing IT costs across numerous products and services, but we expect these benefits to be small assuming limited success outside of the mobile business.

Finally, the company is investing heavily in marketing to grab land in the fast-growing online channel. Kogan pays for customer databases and advertisements, but we believe traffic from free sources will increase as sales scale. A key challenge will always be customer retention. Kogan launched its own membership program in late fiscal 2019 but faces stiff competition against both Amazon Prime and eBay Plus.

We do not anticipate environmental, social and governance, or ESG, risks to are materially impact Kogan’s moat rating or competitive position. Kogan appropriately manages these risks. Therefore, we expect them to have minimal likelihood of eroding the benefits of Kogan’s large and growing scale. Kogan is primarily exposed to ESG risks associated with its global supply chain and product quality requirements.

Kogan mitigates risk within its supply chain through its ethical sourcing policy, which requires suppliers meet minimum thresholds for working conditions, labor rights, child labor, and environmental protection. Moreover, marketplace sellers are required to comply with Australian Competition and Consumer Commission regulation. Product quality risks are managed by quality control staff and third-party inspections utilized to ensure products meet designated quality criteria. Controlling product quality assists Kogan in retaining its growing customer base and complying with Australian Consumer Law.