Tuesday, 30 November 2010

HMV: Pedigree or Prize Mongrel?

HMV Group owns the HMV (surprise, surprise!) and Watersone's retail chains on the high street, as well as a smattering of live events (Mama) and digital (7 digital) businesses, to offer an holistic retailing service (see above graphic).

The plan appears to be developing into growing areas (live events and digital) to withstand the structural pressures in the High St, whilst unlocking synergies and turning Waterstone's around.

On the face it, at a share price of 46p (as at 30 Nov 10) based on FY10 (12m/e 24 April) EPS (basic) of 11.6p, giving an implied PER of 4x, it looks as cheap as chips.

In terms of my rules:

1 - Assets - to be valued at no more than a 10% premium - The Group balance sheet shows net assets worth £100m as at 24 April 10, which compares to a market value of £195m as at 30 Nov 10. A 95% mark-up on assets doesn't seem to be a great starting point for a value-based approach! Worse still, of those assets £122m relates to intangibles, which is comprised, broadly, of £68m for the purchase of Ottaker's (2006) and £44m for MAMA (2010).

Given the nature of the business, high street and digital, I wouldn't have expected it to be asset rich. There is a lot to be said for having leases, notwithstanding the future (off balance sheet) lease commitment of £1.2 billion. On this basis, having low asset cover is not unreasonable.

Not too keen on the £39m pension deficit, but this will ebb and flow with actuarial valuations, and I've seen worse. Ask BT.

2 - Market cap - at £195m is greater than the £50m target. Hurrah.

3- Cash flow - (a) balance sheet - working cap: current assets less current liabilities = -£191m, which has worsened by £40m from the prior year, largely due to the extra debt taken on and increased stock levels. Ouch. This shows that the business is running to standstill -ie future sales (cash) are required to pay the current bills, which is not a nice position to be in.

(b) operating cash - looks healthier, with cash generated from operations of £82m. Out of this we need to deduct a tax bill of £16m and capex of £30m (actually £40m, but have assumed that 75% is replacement capex), which leaves free cash of £36m. Dividends were £31m in the year. With extra debt to service (total of £96.3m) and a negative balance sheet working capital, something is going to have to give...which will probably the dividend (as the market seems to be pricing in)

4 - Debt - (a) net debt of £66m versus equity of £100m = 66% and isn't far over my target ratio of 50%

(b) EV/Adjusted EBITDA - EV of £261m (£195m market cap + £66m net debt); Adjusted EBITDA of £82m (EBITDA of £112m less replacement capex of £30m), results in a multiple of 3.2x, which is below my ceiling of 5x. Hurrah.

5 - PER - I make the 9 year EPS (basic) to be 10.4p (source: Sharelockholmes). Based on the current market price of 46p, this represents a staggeringly low multiple of 4.4x. The market appears to be pricing in World War 3 on the High St.

6 - Yield - a DPS of 7.4p for each of the last six years, which represents a yield of 16%. The market appears to think that this is unsustainable. Interestingly, dividend cover has been less than 1.3x in only one out of the previous eight years (2007), which is a good record.

7 - ROE - Per Sharelockholmes, the average ROE for the last three years is a staggering 56%. This is to do with having a high level of profitability relative to a low value equity base on the balance sheet (due to not being an asset intensive business and having a relatively high level of dividends being paid out).

8 - Directors - the directors hold around 886,000 shares directly, in addition to various share options (most of which are under water), which only equates to £407k in value. Given total director remuneration of £2.3m in 2010, this doesn't seem like a high enough holding to me. Disappointing. There has been a trickle of director buying in October, but this was in the region of 30,000 shares, which is peanuts.

9/10 - Buy or Bye? 9 yr EPS of 10.4p and a 7 year ave PER (per Sharelockholmes again) of 10.5x, gives an implied fair market price of 109p based on L/T averages. I like the look of a 58% discount!

Other stuff ...evidence of a moat? Hmm, subjective, but in my opinion, HMV is the destination for music and Waterstone's for books on the High St. I'm less in tune (ha, ha) with live music and digital, but these appear to be sound businesses. It would be difficult to replicate the High St presence quickly or cheaply. The bigger issue is the long-term structural decline of the High St vis-a-vis online, and whether the strength of the brands can flourish on the web.

The recent acquisitions appear sensible from a diversification/finessing the business model point of view, but they have a come at a price. The hefty price, extra debt and lack of earnings, are likely to hold back the share price in the short-term, but should, hopefully, support medium term growth objectives.

On the negative sides....retail is a dirty word, discretionary expenditure is going down, World War 3 is predicted on the high street, Woolworths/Zavvi/Borders don't provide happy case studies, debt has gone up, the pension deficit has gone up, free cash will get squeezed, the dividend is under pressure...BUT

the business is diversifying, there is potential for turn-around at Waterstone's, the market is valuing the business at 4 times long-term earnings, operating cash flows are healthy, debt levels are reasonable and manageable, and even if the dividend was halved, the yield would still be over 8%, plus there is scope for a re-rating with a FTSE250 promotion.

On my scorecard approach, the biggest short-comings are on the balance sheet valuation, balance sheet working cap and lack of director ownership. All in all, whilst not the finished product, I think the investment opportunity is a pedigree one though.

For me the shares are a BUY at 46p. I will add them to my virtual portfolio (watch this space) today. Watch out for the interims on 9 December too as there could be a buying opportunity if the L-F-L's are a bit too red.

Monday, 8 November 2010

Rules is rules...

Having spent plenty of time reading around the subject and following the market, now is the time to incorporate a bit of discipline and set up my rules for investing.

I've published them on this blog as: (a) it helps me to think the rules through before I try to articulate them and (b) it's a matter of record as to whether I adhere to them or not!

My general objective is to increase my (family's) wealth through above-average stock market returns. This blog will generally focus on a value theme (ie buy low, sell high), but may cover the occasional bit of arbitrage or hedge-fund shenanigans from time to time.

My target net annual rate of return is 15%. I am expecting this to be achieved through a combination of: (i) dividends (4-5%), (ii) EPS growth (5-6%) and (iii) valuation re-ratings (5-6%). Time will tell.

I will start "proper" from 1 January 2011 to allow me time to reassess my existing portfolio and prune as required. I might even start earlier if I get my skates on...

Because the world works in decimal, I've shoe-horned my rules into 10... give or take a bit around the edges (however see Extra Considerations (a) - (c)!)

The rules (in no particular order):

1 - Assets to be no more than a 10% premium - that is...market cap to be no more than 1.1 times balance sheet assets (shareholders funds). Conventional value wisdom suggests that it should be a discount, if not a deep discount, but for the time being, I'm happy to consider valuations at a small premium to net assets;

2 - Market cap > £50m - companies, I'm focusing on UK listed ones as that's my investment universe for this purpose, need to have a certain size and stability to them. £50m is arbitrary, I did toy with £100m, but £50m feels about right for now;

3 - Cash flow - two measures here: (a) positive working cap on the balance sheet (current assets - current liabilities > 0) to show that the company can meets its short-term obligations, and (b) positive operating cash on cash flow (operating cash after working cap movements, interest and replacement capex, but before discretionary items such as dividends) to show that net surplus cash is made which can be used to grow the business and/or be returned to shareholders in dividends or buy-backs;

4 - Limited debt - a bit of debt is efficient (CAPM and all that), but I don't like too much. Positive net cash is a big plus as this gives a company lots of wriggle room. I look at (a) debt to equity (balance sheet) being no more than 0.5 - ie for every £1 of equity there is no more than 50p of debt. I appreciate a gearing ratio of 33% (50/150) may sound reasonably conservative, but c'est la vie...and (b) EV/Adjusted EBITDA should be no more than 5 times. This shows (generally) that the total worth of an entrprise is valued at not more than 5 times its cash profits (after adjusting for replacement capex). Again, the 5 is subjective, but feels about right. I probably wouldn't kick a 6 out of bed, but we'll see...;

5 - Valuation - the PE ratio should be less than 12 times, which I'm taking as a conservative proxy for where I think the market should be. If it's lower than or higher than 12, then I think that the market is being either a bit bearish or bullish than (long-term) normal. See below for entry and exit points. Earnings should be the fully diluted basic EPS average over a 10 year period (or as long as you can muster) to smooth out any cyclicality;

6 - Yield - dividend yield > 3.5%. As there are plenty of studies which show that dividends account for the vast majority of value creation over the long-term, it would be churlish to ignore them. I'm setting my bench-mark as the 10 year gilt yield, at 3.5%ish . This implies that I will get the same return (ignoring market timings) on equities as gilts, but with the upside equity growth potential thrown in. One word of warning, rather than chasing yield...there needs to be (b) at least 1.25 times dividend cover over the average of the last 3 years to get me comfortable that the dividend is sustainable;

7 - Return on Equity > 10%. This is a new one for me. To get my increase in value, I need a sensible return on equity to be satisfied that management has room to grow the business with existing resources (ie without leveraging the business to the hilt or withering away shareholder value). Therefore, I'll set a target of an average RoE of 10% pa over the last three financial years and see how this gets on;

8 - Directors have skin in the game. It's reassuring, and profitable, to see directors acting as owners rather than just managers, and there is no better way than seeing them dip their hands in their pockets and buy their own shares (legitimately). I much prefer direct share purchases to share options, but want to be convinced that the directors are there for the long-term and are incentivised to grow the company for the benefit of the shareholders. The extent of their 'skin' will be subjective in nature;

9 - Buy, buy, buy! The convention entry point will be looking at a current valuation based on (a) 10 yrs EPS (as #5 above) x (b) the lower of the 10 yrs ave PE ratio or 12x (as #5). If this is 25% below the current market price and all of the other points (#1-8) are met, then fill your boots...;

10 - Bye, bye, bye... If the market price is 25% above the same calculation in #10, then it's time to take profits, subject to hitting my 15% IRR target hurdle.

My Extra Considerations, not formal rules, are:

(a) look for evidence of a moat / sustainable franchise - a la Buffett;

(b) look for net nets and cigar butts - market value is discounted to net current assets - L/T liabilities - a la Graham and Buffett; and

(c) set Buy/Sell price targets, but only reappraise these on final results (not interims), unless the world stops turning, in which case we're all doomed anyway.

Now that I've got my rules, I will retro-screen my existing portfolio and aim to analyse at least one new stock per week. watch this space...

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