No-moat Kogan’s (ASX: KGN) June quarter 2024 earnings were better than we expected. Gross sales of $184 million were slightly ahead of our $177 million forecast due to a sooner-than-expected return to growth in the core Australian segment. Earnings before interest, taxes, depreciation and amortisation (“EBITDA”) margins were much stronger than we anticipated, driven by operating leverage.

While operating cost control has improved, the next earnings leg-up depends on gross sales growth. We expect sales momentum to pick up in fiscal 2025 as consumers buy more online and household incomes rise. We forecast solid gross sales growth, averaging 7% per year over the next decade.

We maintain our $10.70 fair value estimate, which is underpinned by our strong long-term earnings growth assumptions. Shares in Kogan screen as materially undervalued. We believe the market is excessively focused on recent soft trading conditions. A hangover from brought-forward sales during the pandemic lockdown and consumers' diminishing discretionary buying power are crimping demand for household goods—including Kogan’s top-selling product categories.

However, we expect a solid rebound in retailing sales in fiscal 2025, supported by wage growth and tax cuts. Within the Australian retail sector, we expect the online channel to outperform brick-and-mortar sales over the next decade as consumer spending structurally shifts to online. E-commerce is already outperforming. In fiscal 2024 to March 2024, online sales are up 3% on the previous corresponding period, compared with 1% sales growth in the brick-and-mortar channel. For more details, please refer to our Retailing Industry Pulse published July 1, 2024.

Kogan’s fourth-quarter underlying EBITDA of AUD 10 million beat our estimate by 30%. A key driver for the earnings beat was a solid increase in Kogan First members and fee income. Despite a material bump of subscription fees to $129 in April 2024, from $99, members grew by 6% to some 500,000 compared with the March quarter of 2024.

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 June 2024, Kogan First had over 500,000 members.

Moat rating

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 AUD 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 502,000 subscribers as of June 2024. 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.

Terms used in this article

Star Rating: Our one- to five-star ratings are guideposts to a broad audience and individuals must consider their own specific investment goals, risk tolerance, and several other factors. A five-star rating means our analysts think the current market price likely represents an excessively pessimistic outlook and that beyond fair risk-adjusted returns are likely over a long timeframe. A one-star rating means our analysts think the market is pricing in an excessively optimistic outlook, limiting upside potential and leaving the investor exposed to capital loss.

Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company's future cash flows, resulting from our analysts' independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.

Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn about finding different sources of moat, read this article by Mark LaMonica.

Uncertainty Rating: Morningstar’s Uncertainty Rating is designed to capture the range of potential outcomes for a company. An investor can think of this as the underlying risk of the business. For higher risk businesses with wider ranges of potential outcomes an investor should consider a larger margin of safety or difference between the estimate of what a share is worth and how much an investor pays. This rating is used to assign the margin of safety required before investing, which in turn explicitly drives our stock star rating system. The Uncertainty Rating is aimed at identifying the confidence we should have in assigning a fair value estimate for a stock. Read more about business risk and margin of safety here.

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