Thursday, June 21, 2012

Report on Home Retail Group (HOME)

Yesterday & today I have been further researching Home Retail Group (HOME) as this has now become one of my larger positions - I've been very encouraged by the recent IMS which indicated trading had bottomed out at Argos, and was only negative at Homebase due to the unseasonal weather - a credible excuse this year. Therefore I've bought more shares at 81p and 89p, in my view this is a very favourable price, but as always it is NOT a recommendation or advice at all, and please Do Your Own Research!


Here is the link to the IMS dated 19 June 2012;
http://www.homeretailgroup.com/media/136666/2012_june_19_q1_ims.pdf


A couple of comments on that IMS - the market had assumed that HOME was in structural decline, hence overwhelming "Sell" recommendations from almost every broker. However, by delivering flat (well, 0.2% down) LFL sales at Argos (the main part of the group), with virtually flat margins (25bps down), against a very poor economic backdrop of mild double-dip recession, the picture has radically altered - despite unseasonal weather. It now seems that trading has stabilised, and given that overheads should be flat against last year, since the strategy is to make cost savings which offset cost increases, then we should be looking at profits around the same level as last year. Indeed, management confirm they are comfortable with market consensus forecasts.


Given that the squeeze on household incomes is now coming to an end, with inflation falling to 2.8% most recently, and average incomes rising by almost the same amount, then in my opinion this could be the bottom of the cycle for earnings. Factor in some modest recovery, and with operational gearing inherent in retail, there is scope for HOME's earnings to begin rising again from here - which should attract a premium, rather than a discount PE rating. So potentially nice upside here as it gets re-rated. Certainly the shares bounced strongly, and were up about 25% on the week, but have softened somewhat today - making this a good entry point in my opinion at around 84p/share.


Also factor in that HOME is one of the top shorted shares in the market, at around 20% of shares out on loan & shorted, then a short squeeze is one of the reasons why I think this share could have very good upside, as all those shorters become forced buyers.


Also please note all my research is entirely independent - I have never accepted any kind of fee from companies to promote their stocks. It is something I might consider in the future, but it would only ever be for companies that I already like, and would be clearly stated at the beginning of any article. And I would NEVER write anything that I didn't 100% believe to be true. My motto is that "honesty is the best policy", and it's never worth compromising your reputation for anything.
But anyway, that's just musings. For the moment, everything is independent, although of course like everyone else, I'm talking my own book, as I hold shares in this.


That's enough disclaimers & general ramblings, let's get into the analysis.
I'm focusing today on HOME's most recent Annual Report, for the 53 weeks ending 3 March 2012, which you can download here;
http://www.homeretailgroup.com/investor-centre/reports-results-and-presentations/
Also some useful presentations on that page, worth checking out.


The market cap is £707m (based on 87p/share * 813m shares in issue)


Here's the 3-year chart


Click on the Chart to add a Cross Hair Price Indicator


HOME operates Argos and Homebase. Argos has 10% of the market in home & general merchandise. Homebase has 23% of the sheds DIY market (itself about half the total DIY market), and given the demise of Focus DIY in June-July 2011 (most of whose stores were closed) this market share is the highest recorded. There are now only 2 competitors in the DIY sheds market - B&Q and Wickes.


The reason I like Argos is because they are the last man standing in general retail on the High Street, and have successfully embraced technological changes, with internet sales now 41% (33% last year) of their total sales (with either pick-up in-store on the same day - a crucial point of difference, or home delivery).


Argos is the second largest internet retailer in the UK, which excites me given that I can buy these shares on such a cheap rating.


Mobile is now 7% of total Argos sales (3-fold increase on previous year).


Argos has 746 shops (with net closure of 10 stores planned for 2012/13), whilst Homebase has 341 stores.


Some investors are frightened by retailers' rent liabilities, but as a former FD in retailing, I can tell you that profitable shops are never a problem. The leases are only a problem if the shop is loss-making. HOME makes provisions for onerous leases, and there is a £153m provision on its balance sheet (see AR note 24) which is mainly expected to be utilised between now and 2019.


Interestingly, 300 stores (30% of the total) have lease renewals or break clauses falling due in the next 5 years, so HOME has the opportunity to easily dispose of loss-making shops, or renegotiate the lease terms on renewal at potentially much lower rents. Being large units, there are only a limited number of alternative tenants, so HOME should be in the driving seat when it comes to lease renewals - so the opportunity is there for them to gradually reduce their fixed overheads.


Incidentally, AR note 7 shows rents as £368m, which at 6.7% of turnover is pretty low in comparison with other retailers. Therefore in my opinion lease obligations seem less of a problem for HOME than with other struggling retailers.


Bear in mind also that inflation gradually erodes problem leases, since rents are fixed for 5-yearly periods, whilst over time turnover will rise, especially once the economy begins to recover, which it will at some point (even though when in recession, nobody can see the way out at the time). As investors we should be thinking ahead to recovery, when cyclical, operationally geared companies will see profits rise strongly again.


The 5-year P&L performance for HOME has been poor, with a steady decline in benchmark operating profit from £398m in 2007/8 to £251m in 2010/11, not unexpected considering the effects of the credit crunch on household spending. But HOME has a particularly bad 2011/12, with profit plunging to £98m on the back of a dreadful LFL sales decline of 8.9% at Argos, and a much smaller LFL decline of 2% at Homebase.


The AR states that 80% of the decline in sales at Argos was due to a 20% fall in sales of consumer electronics, partially offset by growth in laptops & tablets. So it seems a concentrated issue, rather than an ebbing away of sales across the board, which would be more worrisome.


Given that mgt have this week confirmed they're comfortable with consensus forecasts, that means we're looking at around 6p EPS this year. So why do I think the shares are cheap at 83p (a PER of 13.8) then?


It's all about Balance Sheet strength. HOME is debt-free, and indeed had £194m in net cash at the most recent reported date, 2 March 2012. Better than that, they had an average net cash balance of £320m throughout the year (see AR page 25, first column), or about 45% of the mkt cap. There is a huge £700m unused overdraft facility available, so this business clearly has surplus cash that could be removed by an acquirer. Facilities are due for renewal in June 2013, so I would expect a smaller overdraft facility from then. 


However, better than all that net cash, is that HOME finances its own store card operations internally, with no associated borrowings!
This is a major bull factor for the shares, because they own outright a net customer loan book of £457m (stated after bad debt provisions) at 3 March 2012. As stated on page 29 of the AR (middle column, top);


"The Group has the ability to monetise this loan book, for example by securitising it, should it wish to do so".


Arguably therefore HOME is a deal waiting to happen. Someone could come along and launch a takeover bid for the group, at say 120p (which would cost them £975m), and then strip out all the average net cash balance of £320m, sell off the loan book for £457m by e.g. getting in HSBC to buy their store card operations (much like HSBC operates M&S Bank for them), which would recoup £777m of the £975m takeover bid. Add in £200m of debt (bear in mind we're only at a cash/debt neutral position after stripping out £777m of cash & debtor book) and you've bought a £5bn+ turnover, profitable retail group, the second largest internet retailer in the UK, for nothing! Bear in mind those figures also include a 45% takeover premium above the current share price.


It's a deal waiting to happen in my view, and I'd be amazed if venture capitalists were not salivating over this potential. Indeed I note there are a number of US investors on the books with disclosable stakes, which can sometimes be a precursor to bid activity.


So it's very much the combination of the Balance Sheet stuffed full of surplus capital, which is actually more than the entire mkt cap, and the fact that trading now seems to have stabilised at the same level of profitability as last year.


There is a pension fund deficit. It was roughly in balance, but as with other pension schemes, the recent fall in discount rate has sharply enlarged the present value of scheme liabilities. Although the £115m pension deficit (up from  only £7.5m last year) is covered almost 3 times by average cash balances throughout the year, and should probably be taken into account when thinking about a takeover deal - as the pension fund trustees might be able to block a deal unless it recouped the deficit first? I'm not sure of the exact rules, so if anyone is expert in this area, please feel free to add a comment after this article - would be good to ascertain the position of the Pensions Regulator, etc.
But I seem to recall reading somewhere that they can block takeover bids, or at least insist on the pension deficit being made good first, etc.?


I note there is also £107m of freehold property, so arguably that just offsets the pension fund deficit, since the figures are about the same.


Dividends/Buybacks - HOME did an ill-timed share buyback scheme, which wasted about £100m by buying back shares at more than double the current price. But that has stopped now, and the dividend was slashed by about two thirds to 4.7p last year. There must be a risk that the divi might be passed altogether this year, but given the strong cash position, and stable trading, I hope that they maintain it. But no guarantees. Although on page 26 of the AR, they state that the Board recognises the importance of dividends to shareholders, and that future dividends will be set at a level which is sustainable & reflects the trading prospects and financial position.



If 4.7p is maintained, which looks reasonable, then the yield will be just over 5%, not to be sniffed at.


Other points;


Directors Remuneration - I was somewhat surprised to see that the CEO & FD both received bonuses of £217k and £124k respectively in 2011/12, which seems bizarre given that it was an extremely poor trading result. The bonuses seem to have been based on hitting cashflow targets, despite lousy profitability & a slashing of the dividend. This does not pass the common sense test in my opinion, and I would suggest that the Board should be a little more careful to not fall foul of the shareholder spring by continuing perceived rewards for failure. It also raises the question whether they managed cashflow in such a way to boost it in the short-term, in order to hit bonus target? If so then that could be an example of targets incentivising behaviour that is not in the long-term best interests of the company or shareholders.


Personally I feel we need to ditch the ludicrous bonus culture, and just pay executives a fair salary & expect them to do a good job to the best of their ability.


The CEO received £1.1m in total, and the FD £612k. Those figures are just too high in my opinion, taking into account the reality that this is a bread & butter retailer, and this type of business is run by an army of middle managers, and doesn't really require that much input from its main board.


£250k for a Chairman too! Really? Someone who essentially just turns up for a board meeting once a month & fills in a lot of forms. It's far too much.


One other point I forgot to mention. When I began this review, I was only really interested in Argos, and thought Homebase was probably a bit of a liability. However, on going through the figures I'm encouraged that Homebase has value. Partly because Focus DIY going bust has thinned the competition down to just B&Q and Wickes in the sheds market, but also because Homebase has a £43m depreciation charge annually. So when you look at its cashflow, it's not too bad.


Profit has ranged from £15m to £48m in the last 5 years, but it's not a declining trend, it's erratic but no trend is visible. When you add back the depreciation charge (non-cash) then cashflow in the good years is knocking on the door of £100m.


Although LFL sales were down 8% this year to date (weather-driven), the gross margin being 225bps up recoups about half of that gross profit fall, by my calculations.


Conclusion


Key points;



  • Balance Sheet contains excess assets (cash and storecard debtor book) equal to the entire mkt cap, so profitable business is in for free.
  • IMS this week confirmed that sales at Argos have stabilised, compared with sharp falls last year - turning point?
  • IMS also confirmed management comfortable with consensus forecasts for this year.
  • Takeover potential due to opportunity from leveraging Bal Sheet.
  • Dividend yield still over 5% despite reduction.
  • Squeeze on consumer real incomes now ending.
  • Strong internet & mobile growth - 2nd largest internet retailer in the UK.
  • Pension deficit recent & manageable size.
  • 30% of stores lease renewals or break clause in next 5 years - mitigates risk of problems. Onerous leases already provided for.
  • £107m of freehold property.
  • Cashflows still strong (add back £126m depreciation & amortisation charge to profit)
  • Operationally geared to economic recovery.
  • Valuation very cheap once surplus assets on Balance Sheet taken into account.

Please remember this Blog is purely for information only, and is just expressing my personal opinions. Nothing written here should ever be misconstrued as being advice. Please therefore always Do Your Own Research. Sensible cmments are welcomed after the article, whether you agree or disagree with me, and especially if you have spotted an error in the article. This is a completely independent Blog, and no fees are received by me from any companies covered, although readers should note that I sometimes own shares in companies that I write about, but will make this clear from the article. Thank you for reading this. Oh, I do receive a tiny amount of money from ad revenues, but thought why not, since ads are pretty invisible to most people, and they do seem relevant & there are only 2 or 3 on a page.




3 comments:

  1. Management have announced the closure of the final salary pension scheme from Jan 31 2013 in order to reduce liabilities.

    ReplyDelete
  2. Hey great report. Was wondering on the reason of the 20% shorts... Seems a lot for me. What are these investors thinking? I am sure they are not stupid..

    ReplyDelete
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