Retail – Sale on Now Big Discounts in all departments!!!

In the past week a growing proportion of retail stocks listed in Europe reported some headline figures in relation to like for like growth. Much of what was reported has disappointed Mr. Market. Tesco’s share price declined by 15% on January 12th, while Delhaize slid by over 10%. Added to this we have had the usual tales of woe from Home Retail Group – where in my view managements ability to keep running this company must be surely questioned by those that remain as shareholders. I won’t even get into Game Group, the business model is broken. There is no price at which I would be interested in buying this stock.

When I have run various stock screens, invariably they are peppered with retailers. Cheapness has not been a salvation, in that the stocks continue to de-rate as the business fundamentals show very little sign of improvement. That Tesco has now fallen so much (on the back of a 4 week lfl sales figure) has prompted me to go back to my spreadsheets, and ask are there opportunities amongst all of this gloom.

Mothercare plc (168.5p)

I have written at length about Mothercare in the past. Disclaimer: I am a shareholder in Mothercare plc.

This has been the only retailer that I have parted with hard cash to purchase shares in, whereas I am merely a customer of Argos, M&S and Tesco. While speculative, I am attracted to the large and profitable foreign franchise operation which is seriously undervalued in the present share price.

The 3rd quarter trading statement was released on Jan 12. 

Sales +3% lfl

International Sales +15% lfl

UK Sales -3% lfl (and -6.9% in total due to planned closures).

I rarely follow trading statements, as in general the mean nothing in themselves. However the piece in the interim statement relating to planned store closures stood out. To my mind there are two reasons to own Mothercare: (i) the undervaluation of the foreign operations which now make up all of the groups profitability and (ii) the company has the opportunity to exit 90 leases in the next two years or so. Unlike Home Retail, the management (Chairman) of Mothercare is not sitting idly by and praying for a cyclical recovery. They are tackling the issue of a secular change in the retail landscape, and unfortunately that means that they have (in the UK) to shrink to greatness.

The company presently trade at P/S of 0.19 and a PE10 of 12. P/B is 0.76.

Home Retail Group (84p)

I get really annoyed when I think of this company. I have shopped in Argos at many times and I can see value in the franchise. The company has gotten to grips with the rise in the internet, but like a girl on the first date, they have not gone all the way. The past 5 years has seen a store expansion programme that defies logic, in that it was unnecessary and puts the balance sheet at risk.

As most people are now aware, lfl sales at Argos and Homebase were -8.8% and -2.6% respectively. Gross margins in the Argos format declined by 0.5%, while increasing by 0.25% at Homebase. These results are particularly revealing in that the comparison period is the lead up to Christmas 2010, when much of the UK and Ireland was covered in a deep blanket of snow and ice that prevented shoppers actually getting out and about.

Home Retail management have presided over a company that has a crazy level of store density, particularly in the major cities. Furthermore, there is an astonishing amount of store overlap. In Dublin, there are two stores within 200 meters of each other. Store overlap is an issue in London, Birmingham and Manchester – I am assuming that it is a factor in many smaller cities also.

This company needs to fund an aggressive store closure programme. I am not saying that this is a trivial exercise, it is not. However, I remain of the view while there is a definite cyclical element to the downturn in sales, there is also an equally important secular shift toward online retailing. Argos needs to go all the way – close more stores and buy home delivery trucks. The company has assets, such as the £400m + loan book that could be looked at as a source of funds. Reality is that a rights issue as well as new management are likely in order to arrest the decline and change strategy. At the present rate of decline and margin attrition, I calculate that Fixed Charge Cover will fall from 2x to almost 1.6x. Free Cashflow in the period has fallen from £1115.8m last year to £20.8 recently.

Home Retail has almost £80m of dividend payments and £67million of capex in the first half of the year. The business can no longer afford the dividend and what they are spending that level of capital expenditure for is simply beyond me (and I have been in their stores).

In the next two years, Argos will have leases accounting for almost 8% of its stores than can be broken. This is unfortunate, and it will be the rock on which this ship perishes unless they look to exit leases at whatever penalty applies (probably rent foregone). 

If I saw that the company was about to embark on radical surgery (and maybe a rights issue/sale of loan book to fund this) then I would be highly tempted to add a position. Until then it stays a hope stock.

Tesco plc

On Jan 12, Tesco management surprised the markets by announcing lfl sales over the Christmas period that were well below market expectations. Group sales actually grew, by 4% (excluding petrol, at constant exchange rates). So why all of the fuss?

Well, investors and traders are less interested in actual sales and more interested in like for like sales. This measures the return on new floor space added. In the UK, lfl sales declined by 1.3%, which given that 2010 had very poor weather versus 2011 represents a poor sales outcome during the year. Like for like sales were modest in Asia (impacted by the Thai floods) and were 1% stronger in Europe.

All in all, do these figures justify a 15% fall in the share price on one day. Well by themselves no, but that is only part of the story. As many people will be aware, Tesco is a Buffett stock. This may have led to some Buffet premium building up in the stocks valuation.

Tesco 03-Jan 12-Jan
Share Price 411 320
P/S 0.55 0.43
P/E 12.5 9.8
P/E (10) 19.7 15.3
P/B 2.01 1.57

Tesco is now beginning to look more appealing in terms of valuation, and maybe worth investigating. It would appear that the stock trades on a FCF yield of 8%. 

I do think that the present price action has not played out yet. For those folks that appreciate technical analysis – the pattern of lower highs and lower lows which began in mid 2010 remains valid. The line of least resistance to my mind is down. I will wait to see if the stock begins to hit resistance (circa 310p).

Delhaize

Delhaize is a retailer listed in Belgium.

Delhaize Sales EBIT
USA 68.10% 71.20%
Belgium 23% 22.30%
Greece 7.50% 6.00%
Other 1.40% 0.50%

The company has appeared in many of my value based screens, and I have been tempted to take a closer look.

On January 12, Delhaize disappointed the market with a release of revenue figures that were below expectations. The stock closed down 10%, to leave the valuation as follows:

P/S 0.2
P/E 7.4
PE10 11.6
P/B 81%
RoCE 6%
RoE 11%

I think that Delhaize looks potentially interesting, but it has much lower returns than say Tesco or for that matter Marks and Spencer plc. However, given the eroding valuation I will do a bit more work on the stock. The cashflow profile is very interesting, with Delhaize trading on what at first glance would appear to be a very enticing 11% FCF yield (trailing 12 mth).

Marks and Spencer

I like M&S. I like the food offering. I am wearing M&S cotton socks as I type. The reason that I like their socks so much is that you can purchase socks in a 7 pack ordered by the days of the week. The stock has returned -17% in the past year, and trades at less than half of its 2007 value.

Growth has been pedestrian, but cashflow has been reasonably stable, with the company generating approximately £600m per annum over the past five years. In the past twelve months, M&S has generated £531m by my calculations. This puts the stock on a FCF yield of 10.5%. It is a fine cash yield but hardly spectacular – what is interesting is that cashflows have been reasonably stable.

G&D PE 9.3
PE 8.43
P/S 51.8%
RoCE 11.7%
RoE 22.4%

From a quality and income viewpoint, Marks and Spencer is definitely deserving of my attention. For the moment, it is where I will be concentrating my research endeavours.

Conclusion

It is unchallenging in the present market environment to find retail stocks that are trading on low valuations. There is both a cyclical and secular influence at play on retail presently. Given the valuations, it is a sector that out of pure contrarianism that I am attracted to. Yet the balance sheets of many companys are weak when the off balance sheet liabillities are included. The cashflow position of many firms are also questionable. There would seem to be some opportunities at the more boring end of the spectrum, where cashflow appears at first glance to be stable and balance sheets are not so stretched.

6 Responses to “Retail – Sale on Now Big Discounts in all departments!!!”


  1. 1 Richard Beddard January 13, 2012 at 4:16 pm

    Very good and timely round up. The other thing I find astonishing about Home Retail’s management is the buybacks. They’ve bought back shares all the way down at prices that now look very expensive.

    Marks and Spencer does look good value although profitability seems to be in steady decline. Haven’t looked into it yet. Tesco too. N Brown – one of Expecting Value’s favourites also looks good. Just going through my list now. There may be more!

    • 2 jmcelligott January 13, 2012 at 4:27 pm

      Thanks. True M&S profitability (particularly in the UK) has been seriously stressed in the past four years. I can imagine that trend will be particulalry difficult to reverse in the present climate and the shift toward online clothes retailling.
      N. Brown, is a great company. I used to own a loarge stake of the company for an equity dividend fund that I manaaged in a previous life. However I took profit in late 2005. It would have been better to hold on given the total return however. But, like its customers its pretty solid.

  2. 3 ukvalueinvestor January 13, 2012 at 8:01 pm

    You probably know where I stand on a lot of this stuff. If you can the ones that are v-e-r-y likey to be doing okay in 5 or 10 years time then current valuations are good. Tesco and M&S definitely fit that bill.

  3. 4 memyselfandi007 January 16, 2012 at 10:24 am

    John, really good summary. For a non-uk based investor it is extremely difficult to assess UK retail companies.

    I am struggeling mostly how to evaluate lease obligations.

    Do you have by chance an opnion about WH Smith, Halfords and Thorntons as well ?

    • 5 jmcelligott January 16, 2012 at 10:56 am

      I dont have an opinion on either of the three stocks that you mention. I did own shares in Thorntons several years back, but tokk profit on them – I have now lost track of the situation there.

      On evaluating lease obligations.
      (1) Firsty one needs to capitalise the value of the operating leases. The standard here is the formula of Annual Lease Expense * 8.
      (2) This figure is then included in the leverage calulation for debt/EBITDAR.
      (3) EBITDAR is EBITDA plus abbual lease expense (ie rent).
      (4) Fixed Charge Cover (as opposed to interest cover) is then calculated.
      (5) Fixed Charge Cover is (EBITDA + Rental Expense)/(Net Interestest Expense + rental expense).

      Example
      2011 Home Retail Group Accounts
      Net Debt: -£159m (net cash)
      EBITDA: £385.5m
      Debt/EBITDA: -54x (in reality not meaningful due to cash position.

      Rental Expense: £370.8m
      Capitalise this @ 8x.
      Capitalised Value of Operating Leases: £2966m

      Net Debt (plus leases)/EBITDAR: 3.7x
      Fixed Charge Cover: (385.5+370.8)/(-7m+370.8m) = 2.08x

      I hope that this clarifies how I look at lease obligations.
      I would be interested to see how other people look at leases. I find that a lot of sell side research (and some commentary from the buyside) actually ignores them completely.


  1. 1 Market Musings 14/1/2012 « Philip O'Sullivan's Market Musings Trackback on January 14, 2012 at 4:16 pm

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