Value in UK Retail?

When I began running various value oriented stock screens only a few months back, one could not but notice the cluster of UK retail stocks that appeared across various screens. Many UK non food retailers apppear to trade on incredibly low valuation multiples (whether they be sales, earnings, asset value or cashflow). With seemingly an entire sector out of favour, I had to investigate. I want to invest, so these are precisely the type of oppportunities that I am looking for as a contrarian value investor – or are they?

A simple lesson that I have learned is that all of my big winners have had strong balance sheets, and all of my losers in the markets had ticking timebombs planted in those balance sheets. If I am to learn anything from my success and failures then it is pretty obvious that successful value investing cannot be divorced from rigorous balance sheet analysis. On the surface many UK non food retailers trade with net cash on the balance sheets, but these do not reflect the reality of off balance sheet committments in the form of lease agreements. I have analysed three companies, namely Home Retail Group, Kesa Electricals, Game Group.

Home Retail Group

 The retail format owns the suceesful Argos retail brand as well as the somewhat less successful Homebase. Operations are spread across the UK and Ireland predominantly. My interest was piqued by the valuation as well as the familiarity. I have been in Argos many times (usually to purchase toys for my kids). It is the valuation that really stands out.

Home Retail trades on a PE of 5.5x trailing earnings as well as a P/S of 0.18 and a P/B of 0.39. The balance sheet has net cash. The FCF yield is 12% with a dividend of 11.5%.

The stock has taken a hammering over the past number of years. Sales have not grown since 2008, while at the interim stage sales were 5% lower than the prior year. Revenue is falling and a reasonable amount of stores are underperfoming and require closure. Yet closure could be expensive given lease committments.

 Profitability has also been under pressure with gross margins 2% to 3% lower than the figure from 2006 thru 2009). Gross margins are presently 32.1%. Operating margins at 4.4% are over 1% lower than recent history.

The balance sheet although optically sound, the notes to the accounts reveal that the company has been providing for the exit from onerous operating leases. If rent on operating leases is capitalised at a norm of 8 times, then the Net Debt/EBITDAR rises to 3.6 times. EBITDAR Fixed Charge cover is a bare 2 times having fallen in each of the past 6 years. Using a simple ‘back of the envelope’ type calculation, an 8% fall in sales with COGS of £3900m and operating costs of £1620m would see Fixed charge cover fall to less the 1.

This is not particularly fanciful given a 5% fall in sales at the interim stage. Put it this way, two further years of deteriorating revenue would more than likely put the company into severe difficulty from a balance sheet point of view. I guess thats why the valuation is so low!!

The crazy thing about Home Retail Group is that the strategy is one that in my opinion that undermines the balance sheet not bolsters it. The Argos format is winning an increasing amount of its sales via the online channel. Online sales are increasing at a time when many stores are underperforming. Yet the management persist in opening new stores (which presumably involve signing new lease committments). Now for anyone that is not familiar with the UK, Argos is a pretty ubiqiutous reatail brand. Consequently, it is questionable what the ROCE for new store openings is?

This company has the characteristics of what a former colleague described as a ‘smelly stock.’ For now the operating metrics and strategy are poor enough that the balance sheet is not as strong as it seems. Whilst the valuation is uber appealing, I cannot bring myself to purchase the stock presently. As a value investor, one has to be prepared to admit that much of what enables a stock to derate to such an extent whereby the valuation is attractive, is not eniterly pleasing. So what would it take for me to add Home Retail as an investment. Well forstly I would like to see a committment to cease new store openings for the present – I simply do not see what they add in the present retail environment in the UK. Secondly, I would like some news on a store closure programme for underperforming stores in areas what high store footprint. Importantly I would like an understanding as to what such a store closure programme might cost. The dividend should be cut in my opinion, and I wouldnt be surprised if it was. Valuation is so low, that maybe it is the case that a cost of lease exit is somewhat embedded in the valuation. Am I hoping for too much?

Home Retail Group plc is due to issue a trading update on September 8th.

Kesa Electricals

 Kesa is one of the largest electrical retailing groups operating in Europe. The principal formats are Darty in France and Comet in the UK and elsewhere. It should be pointed out that Darty is significantly more profitable than Comet. Activist investor Knight Vinke has amassed almost a 19% stake in the group and has been agitating for a change in strategy and some asset sales.

Kea trades on a P/S of 0.1, with a 6.4% dividend yield and a 10% FCF yield.

Annual rental expense stemming from operating leases are €2223.5m, which when capitalised at 8x given a Fixed Charge cover of 1.9x. To put into context, a simple static scenario involving a 5% reduction in revenue would leave fixed charge cover of less than 1.

Despite the existance of an activist investor, I am not so sure how a reasonable exit from the underperforming Comet franchise can be achieved in the present UK retail environment. I will pass on Kesa.

The Game Group plc

Many years ago I was an avid gamer, and owned many of the various iteration of Playstation cponsoles. During that period of my life, I shopped regularly at outlets of the Game Group. Since then I have grown up (only slightly) and the world has moved on. An increasing amount of console and PC gaming is now being sold and distributed online. As with HMV, this presents quite a challenge for the Game Group. The stock has fallen on hard times and is down 90% since 2008.

Could this be simply a case that a shift in the way purchaes are made have condemned The Game Group to a slow death? If the company has a future that is profitable then the valuation is does not agree. This business is priced for extinction.

The Graham & Dodd PE is 2.6, off a P/S of 0.05. The P/B is 0.26 and trailing P/E is 4. On the flipside, FCF has been erratic over the past decade. The fixed charge cover on the last balance sheet date is 1.6. By my reckoning a 4% fall in sales cet par would leave fixed charge cover below 1.

This is a poor company that is caught up in a shift in how its consumers actually purchase products. The lease committments are significant relative to earnings. Cashflow is inconsistent as is working capital movements. Sales have fallen 17.5% in two years. Gross margins have fallen from 30% a decade ago to 26.5% now. Operating margins have tended to vary between 4.5-5.5%, but fell to 1.8% in the last year. 

I should run a mile. This seems to be HMV all over again. However the valuation is pricing capitualtion – but what if the company actually survives? This is a dangerous situation. But I am going to delve a little deeper. Is this a case that some stocks priced to go out of business sometimes do that or is there a puff left in this cigar butt?

So for the moment, despite valuation seeming to be attractive, I am not prepared to part with hard cash to buy any UK retailer. The search continues. I will keep an eye on Home Retail and Game for any hnt of omprovements (or where I might be wrong on my analysis). For now I plan on taking some time to see has the market carnage left anything in the European banking sector that is investible in any way.

I will be looking at Barclays and Lloyds in the UK, as well as the main French and Italian Banks. Hopefully if I get an opportunity I will check out a few gambling stocks (Ladbrokes & OPAP) as well as some more construction oriented stocks (Persimmon, Morgan Sindall).

I would welcome any thoughts, feedback or critiques from other investors on how they deal with valuing a company with significant lease committments on top of what is optically a strong balance sheet.

8 Responses to “Value in UK Retail?”

  1. 1 Lewis August 18, 2011 at 9:26 pm

    Hi John,

    Philip O’Sullivan pointed me to your blog, I hadn’t seen it before, so thanks to him for that.

    Agree with you on all three counts – and I have the same greedy eyes when it comes to screens. Home Retail popped up on almost every function of ‘cheap’ I could throw at it, Dixons sits in a lot of them, Game is everywhere.. the list goes on really.

    Like you, I just couldn’t find the stomach to invest in any of them. They all have such obvious routes to demise, particularly the operating leases you talked about, which in a background of declining sales is like a ticking time bomb.

    Exposure to the UK consumer is pretty toxic at the moment – I chose my poison with Howden Joinery, which is looking particularly cheap given the state of the market. While not quite as obvious as these guys, I like the fact they seem to be holding up well given the state of the economy and so consider them to offer decently protected downside with a big positive if things pick up before the market’s expecting – article on my blog if you’re curious!


  2. 2 John @ UK Value Investor August 22, 2011 at 7:38 pm

    Hi John. Of those you mention I find Game quite enticing because of the dividend yield, but what exactly will get paid out next year is anybody’s guess.

    They have a mediocre history and are not consistent enough for me now. Perhaps a year ago I would have invested but I’ve become picky about the quality of companies I invest in.

    I own JD Sport, which is quite similar, but has been much stronger and isn’t having the kind of issues that Game has had through the recession. So I would say that to get around the retail lease issue only look at companies that are highly likely to be able to keep paying the rent. Generally for me that means avoiding companies that are having significant problems earning a good profit.

    Of course even M&S has had its fair share of troubles, but I think playing around with struggling retailers is dangerous and often speculative.

    Saying that, I can still feel Game’s 20% ‘hypothetical’ dividend yield pulling me in like a moth towards the flame.

    • 3 jmcelligott August 22, 2011 at 10:36 pm

      Hello. Thanks for taking time to comment. Personally I never trust double digit yields – I used to run a dividend fund. I know of very very few examples where you see that yield honoured. Game is very lowly priced _ I am going to keep an eye on both it, Home Retail and M&S. I am not sure if you have heard of Andrew Lapthorne – he is part of the strategy and quants team at Societe Generale. Anyway, he does some great work on valuation and income. Many years back he did some work on dividend yield – as a signal of value it performs very poorly. The conclusion was that to be a successful income investor, then yield is actually the last thing to look at. You forst look at book value, cashflow, earning history etc etc. Once you satisfy yourself that value exists then run an income overlay to pick out the higher yielding securities. As you say, its hypothetical. I guess one way to look at stocks like Game, JJB, JD Sports etc is as a call option or warrant. If they survive and begin earning their cost of capital again then maybe they are worth significantly more. If not, yoou just lose your option premium?

  3. 4 Mark Carter August 25, 2011 at 9:40 pm

    Currently GMG has a market cap of £80m, and net cash of £120m, making it a rare case of a company of having negative Enterprise Value. Christopher Waller over at SeekingAlpha argues: “Game Group has been falling heavily recently largely due to the belief that it is in structural decline. However, the numbers show that this is purely cyclical, with rises and falls coinciding with the relases [sic] of next generation consoles.”

    No position.

    • 5 jmcelligott August 25, 2011 at 11:41 pm

      Hi. Thanks for the comment. It was the cash value versus mkt cap that was part of the attraction for GMG. However I don’t think you can ignore the off balance sheet liabillities. The cash can only be realised if you could close the company and not incur a cost inexcess of the cash balance. That is not the case at present. Now despite that it is ludicrously cheap. I think the malaise is secular & cyclical. More gamers are buying online, but cyclically there has been a reported slowdown in blockbuster game release. That part is cyclical and will improve at some stage. I keep an eye on it, but a net net screen will also throw up several construction stocks that do not have similar off B/S liabilities.

  4. 6 memyselfandi007 August 29, 2011 at 8:22 pm

    Hi John,
    congratulation to your blog, great quality posts.

    I kind of discovered Home Retail when I ran a “Magic Sixes” Screener (Peter Cundill).

    I am not a retail expert but the operating leases seem to be a problem, especially in markets with declining rents.

    Did you ever try to quantify the value of the outstanding lease commitments vs. their “fair value” ? This could be interesting in order to determine some kind of liquidation or replacement value.

    I find it very strange that companies are not required to provide more information about operating leases, e.g. if rents are inflation indexed which seems to be the case quit often with retail leases.


    P.S. I run a german language value blog with a focus on “continental europe” value stocks and special situations. In case you need some infos, just let me know.

  1. 1 Home Retail Group – UK Blogpost | valueandopportunity Trackback on August 29, 2011 at 8:14 pm
  2. 2 Ugly Ducklings . . . or Baby Swans? « valuestockinquisition Trackback on November 22, 2011 at 6:06 pm

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