Competitive advantages are often easily identifiable in large global corporations but can be less obvious to recognize in smaller companies. While my prior experience focused on the large cap space, my first year working with the QV small cap team has emphasized the unique and sometimes overlooked competitive advantages of certain companies within the Canadian small cap universe. Long time QV small cap holding Leon’s Furniture provides a strong case study for competitive advantages that have resulted in excellent long-term compounding opportunities for our clients.
On the surface, Leon’s is a small Canadian furniture company facing intense competition from global giants such as IKEA and Wayfair in addition to local players like Structube. Despite this challenging landscape, the company has consistently expanded same-store sales growth. The company’s timely adoption of online sales channels during the pandemic furthered these trends, rapidly increasing market share. Even prior to COVID, Leon’s expanded sales by acquiring one of its largest peers (The Brick), while international competitors like Sears struggled to operate efficiently and were eventually forced to exit the market.
Over the past decade, Leon’s has achieved outstanding earnings per share growth of 14.7% per year, coupled with annual sales growth of 4%. The company has consistently delivered a return on equity (ROE) above 10%, a feat achieved by only a limited number of companies in the Canadian small cap universe.
Source: Capital IQ
In our assessment, the key to this success lies in Leon’s efficient, coast-to-coast distribution channel. Canada’s vast topographically complex landscape, combined with a relatively small population, poses significant challenges for establishing an economically efficient, scalable, and timely distribution network, especially for large and high-ticket items like furniture and home appliances. This challenge partly explains why major American players such as Target, Sears, Zellers and, most recently, Nordstrom, failed to penetrate the Canadian market. When Sears Canada exited in 2017, its operating margins were close to -12%. In that same year, Leon’s operating margins stood at 6.6%, before nearly doubling to over 10% by 2022. Even Wayfair, which has been shipping products to Canada since 2008, continues to struggle to establish a profitable distribution network.
Leon’s is not our only Canadian small cap holding that capitalizes on this distinctive value proposition. Andlauer Healthcare Group, the leading provider of third-party logistics and transportation for the healthcare industry in Canada, and Cargojet, the leading provider of overnight domestic air cargo services in Canada with 90% market share, also leverage well-established nationwide distribution networks. Cargojet, in particular, has achieved remarkable success, to the extent that major couriers like UPS, FedEx, DHL, and Amazon Logistics utilize its services despite having their own fleets with excess capacity.
ONE-STOP SHOP MODEL
In addition to retail stores, Leon’s has other attractive business segments that complement one another. These include a commercial retail banner serving the largest developers/builders in Canada, an after-sales service business, and insurance and warranty businesses. Leon’s also maintains better quality control and a diverse portfolio of products stemming from more direct relationships with suppliers, and a pricing strategy based on more than a century of consumer spending data through different economic cycles. In aggregate, these factors make Leon’s a more attractive option for the average Canadian retail and commercial consumer.
HIDDEN VALUE OF REAL ESTATE
Significant value lies within Leon’s more than 5.2 million square feet of real estate property. Held on its balance sheet at historical cost, these assets represent roughly 20% of Leon’s current market cap. At market value, this real estate could be worth considerably more, perhaps multiples of its original cost. The company has recently announced a potential real estate investment trust (REIT) spin-off to unlock this value and leverage a potentially lower cost of capital.
The success of Leon’s reflects its ability to establish local economies of scale and tailor services to the Canadian consumer. These factors coupled with strong free cash flow and a solid balance sheet have propelled Leon’s to grow sales organically and inorganically, capture market share and maintain its position as the number one player in the Canadian furniture and home appliances industry. Success stories like Leon’s challenge the assumptions that size equates to scale and that small cap enterprises are inherently limited in competing with larger players.