HOME is Mr Market being too pessimistic?

25th Nov '15 by kalkanite

43 comments 22335 reads

HOME
Mkt Cap – 866m
Enterprise Value – 673m
Share price today – 102.6p
Dividend Yield – 3.5%
Price to net tangible assets – 1

HOME, the owner of Home Base and Argos has had a real torrid time of it lately, with its share price dropping from a high of 218p in January of this year to todays valuation of 103p per share. There is no doubt that Mr Market is quite depressed about this company so let’s take a peep at what’s happening.

THE FIVE YEAR TRANSFORMATION PLAN

“In October 2012 Argos outlined a five-year Transformation Plan to reinvent itself as a digital retail leader, transforming from a catalogue-led business to a digitally-led business. The Plan is designed to address competitive challenges, exploit emerging market opportunities and restore sustainable growth.

Fast Track Collection enables customers to choose from c.20,000 products, pay online and collect their products from their local store on the same day, from a dedicated Fast Track counter, in as little as 60 seconds. The service is free of charge.

Fast Track Delivery offers customers the same c.20,000 products for same day home delivery, with the choice of four time slots per day. Orders can be placed until 6pm for same day delivery by 10pm, 7 days per week, at a standard cost of £3.95. To make this offer available to customers throughout the UK, Argos has recruited and trained c.2,300 new colleagues as customer fulfilment drivers for its dedicated fleet of c.800 vans, and expects to increase this to c.3,300 drivers over its peak Christmas period.”

That is a very impressive and ambitious plan, if they can execute it and do so profitably the quality and perspective and financial dynamics of the business will improve enormously.

SO WHY IS IT ALL GOING WRONG

On the 21st of October, HOME issued its interim results....

http://www.stockopedia.com/share-prices/home-retail-LON:HOME/news/rns/151021home8921c.htm/?title=half-year-results-part-1

John Walden CEO made the following remarks...

"We look forward to an improved sales performance for both Argos and the Group in the second half. However, as I have previously stated, trading at Argos during this year's important Christmas season seems less predictable than usual, as both retailers and customers determine whether to repeat last year's unusual Black Friday patterns. The combination…

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jjis

17th Dec '15

Hi I think you may be too optimistic on the value of the debtor book. Based on what they said in their October 2015 investor pack on their IR website see - http://www.homeretailgroup.com/media/283004/octobe...

On page 91 they point out that the Home Retail Group revolving loan book @ 29 August 2015 was £321m & that Financial services historic norm – debt to equity ratio is 85% / 15%. Thus the Equity component at 15% ratio = £48m.

Including Odey mentioned in other replies there are shorts totalling 8.53%, awaiting the next profits warning presumably.

Hope this helps, no position either way for me. Scores poorly on my Compound Income Scores at 23.

Regards

Jamie

CompoundIncome.org

imranawan

Hi Jamie thanks for the reply.

Do you know what the Financial Services loan book valued at £550m relates to on the balance sheet (on page 12).

Regards,
Imran.

It looks like the net of gross receivable of £611.6m less £62m of provisions.

roddy10

1. I have been long HOME in the past but not currently
2. It always struck me that they picked up Habitat for a song
3. I think the market does not appreciate that quite a significant part of the product range is common between Argos and Homebase (and also throw in that Hygena, Schreiber, Odina, Qualcast, Habitat etc are sold in both). So disaggregate Homebase and Argos is harder than it looks.
4. My local Homebase now has a Habitat, an Argos and a Laura Ashley - as well as display areas for Odina, Habitat / Schreiber etc . I have often wondered if they ought to go the whole way and actually buy Laura Ashley. I think the different brands appeal to some extent to different customers - but is become a bit of a destination for furniture but they never quite have enough of the right stuff on display.
5. I think the loan book historically was overprovisioned
6. If I was an activist this would be a company whose board I would think of joining. I think that there are a number of own goals that have hurt it:
--- lack of clarity on its own strategy and differentiation
--- misinvestment / underinvestment in IT
--- lack of focus on product quality
--- looking at the customer journey in store - especially in Homebase and fitting it in with the customer's needs
7. Frankly I think a cross between a Next Home and a Ikea could do wonders for the Homebase stores - but using the Laura Ashley, Habitat and Odina brands. (They ought to also add in a coffee shop). [Our local Homebase also has a sad looking carpet area (?Carpetright) - that needs to be worked on.]
8. The working capital in this business is crazy. They claim by direct sourcing in Asia they get better margin but I suspect that internally someone forgot to add the cost of capital to the margin calculations. I think they should be able to alter their terms of trade. Note that a surprising amount of their sales are electronic / electrical and many of the major suppliers will be supplying out of the UK. I know that they have lots of own brands (it is worth digging into this - there are lots) - but I do fear that they do not have differentiated brands in all segments and they tend to build to a price; rather than price to a quality build. I think a bit of clean up on branding / sourcing / quality improvement could impact both branding, working capital and margins.
9. Services - it is all about services. I know that everyone talks about Polish builders etc. However I think that this business misses a beat. I think it could make its Homebase stores 'hubs' for approved contractors - offering services from cutting the grass, repainting, electricals, plumbing etc - ie simple DIY onwards. Also link it to kitchen design (which they do do), and interior design. Obviously it depends on catchment area but I think that this company could potentially build a very interesting business model. (It is worth considering the changes Matthew Brownett put in place at Dixons before leaving to go to Apple).
10. The issue with capitalising leases is that this business is that the outstanding lease liabilities are actually relatively short so I would be tempted to capitalise them at least than 7 years (I need to check the current profile).

Happy to discuss further.

kalkanite

18th Dec '15

The link provided by Herbie did make me chuckle. Whilst I note his intended point about declining DIY sales it was another case of immigrant bashing, they rarely get good press. Now it seems the immigrant's are responsible for Travis Perkins decline in profits! Look out for the next article from a clothe retailer "African immigrants bring warm weather with them causing lower spending in cold weather wear".

@ Jamie, if you look at page 8 of the same report it clearly states the following

"Loan book increased by £33m to £550m since H1 last year
Loan book asset fully funded from internal cash generation with no third
party financing"

However your observation of the notes on page 91 does appear somewhat to contradict this. I have emailed the FD Richard Ashton to try to clarify this confusion. It remains my opinion that the loan book is indeed £550m, however I can't be 100% sure now, I will post his comments should I get a reply as this is a very important part of my valuation of Home.

@ Roddy - You make a good case as to the problems and possible solutions to Homebase. Personally I would like to see it sold off for someone else to make a go of it.

On the loan book I guess if you are trying to ascribe value to it the question is what would it be worth if they were to sell the credit business to a bank say. I think probably not the value of the debt outstanding. Hard to get figures on this as I saw that Santander sold their Store card business for £472m back in 2013. This had 7 million customers and ran the store cards for Arcadia, which includes Top Shop and Top Man, House of Fraser, Debenhams and Laura Ashley, although they declined to comment on the size of the loan book or provide further details.

Not sure how many customers Argos have on their credit books but I suspect it is not as many as the above transaction and presumably the balances in that transaction would have been considerably larger?

Argos themselves talk about the industry standard 85/15% debt equity split and an assumed ROE of 15% on that basis based on the assumed £48m in their presentation. Banks and finance companies tend to be valued on a price to book which tends to also be driven by the ROE. Taking their 15% and £48m equity might suggest a price to book of say 1.5x to me which might mean the Financial services bit could be worth say £72m to a buyer not £550m.

I could be wrong on that of course if there is some price per customer or price per £ of debt metric that is used in these transactions that I'm not aware of. Guess you we would need a banking analyst or corporate financier to help on that.

Rusty2

Does seem a bit odd as Travis Perkins is not a DIY store, so they should be benefiting from less DIY, maybe immigrants don't use Travis Perkins? I don't know why anyone does uses them, my experience has not been good. IMHO there are better alternatives.

Hi Jamie

Thank you for your reply. I must admit that this is way out of my area of competence. However, assuming that Home were not in a hurry to monetize their loan books they could close future lending and wait for the debt to be paid. There will of course be some default but I would assume that this would be covered by interest on the good debt.

I guess it may be an academic debate in any case as they say in the presentation that: "This offering was developed, operated and funded in-house to ensure that the financial services products fully supported the retail offering."

So it seems integral to the business, so I guess they wouldn't sell it or wind it down. So probably just need to assess how much capital they have tied up in it and what return they are getting on it as part of an overall assessment of their profitability and risks involved (bad debts etc.)

janebolacha

This comment from today's Friday Blog on "ToyWorld" must be extremely worrying for Home Retail, not only because of this being the critical time of the year in their sales cycle but also because of the ever-growing move to online shopping, besides their ambitions to match Amazon's same-day delivery service.

"Elsewhere, I hear that Argos’ now legendary systems issues continue unabated: I understand that a percentage of their sales didn’t register on NPD data for several weeks, which will surely skew the figures, given the volumes that can be achieved at this time of year. Perhaps worse – as far as Argos and its suppliers are concerned – I gather that as some items were not registering as being sold, Argos wasn’t reordering and lines were going out of stock. I genuinely feel for them: in many respects they are the engine room of the toy market, and they make an invaluable contribution to the industry. But it’s precisely because of their stature and position in the toy firmament that these tribulations are viewed with such concern, and I am sure the toy industry is united in hoping they can rectify these problems sooner rather than later."

http://toyworldmag.co.uk/blog/alibaba-and-the-40-thousand-thieves-its-the-friday-blog/

gus 1065

There are several different ways of valuing a loan book and I am afraid I am not that familiar with this aspect of the Home Retail (LON:HOME) buiness. I set out below a methodology that a financial buyer might apply - perhaps someone with a better understanding of the Home Retail (LON:HOME) portfolio could fill in the gaps!

Assuming the business is essentially unsecured, short to medium term interest bearing product purchase finance, the emebedded value in the loan book will be the present value of the loan margin for the outstanding term of the loans after the cost of funds of carrying the assets plus any additional income from e,g, payment protection insurance etc. (if applicable) less an assumption for prospective bad loans, costs for collections and recoveries and ultimately write downs of any bad debts.

For example, if the loan book face value is £500m with a cost of funding of say 7% (15% equity at 10%, 85% debt at 6.5%) and a margin/APR to the customer of 17%, then the annual gross margin income would be £50m (500 x (17 - 7%)). If we assume there is no additional income, that loans have an average life to maturity of say 2 years and that we expect net losses/costs of debt recovery of 2% per annum (calculated on the £500m face value) then the net annual income would be £40m (£50m - 2% x 500m) for 2 years. The PV of this at say a 10% discount rate (a reasonable return to an investor buying a reasonably good quality asset book in a non distressed situation) would be approximately £69m depending an assumptions made about when payments etc.. are made.

If this were, e.g. a credit card type portfolio with high APR's of say 30% there could be considerable embedded value. However, if it is being run more as a loss leader as a sales finance product rather than a profit centre in its own right the value would be considerably less. Unlike the store card business mentioned above, I presume there is limited ongoing business from this loan book if it is stripped away from Home Retail (LON:HOME) (i.e. no new loans being created from the acquired customers) so I would doubt there is any real value to a purchaser in the acquisition of a new customer base so probably only a very limited, if any premium, for this element.

Hope this helps a bit.

Gus.

(Just to be clear, the £69m in the above example is the "profit" to book value on the loans. The purchaser would pay the nominal face value of the loans and Home Retail (LON:HOME) would presumably repay the 85% debt (assuming it is third party debt funded) and be able to free up the 15% equity otherwise tied up as risk capital in the loan book).

cig

But is it debt funded at all? Maybe they just recycled some incoming cash flow. Can't see much debt anywhere on the balance sheet. Have I missed it or is it accounted for as a net number somewhere?

Hi Kalkanite

If you do get a response from Richard Ashton, I'd be grateful if you could update this article re: the loan book.

Best wishes,
Imran.

Hi Cig.

If it is indeed funded out of retained earnings i.e. No use of debt, then the sale of the loan book would theoretically release the whole £500m of equity capital plus any premium represented by the £69m in the example above. Clearly this would have a significant impact on the overall valuation/analysis of the implied value of the Argos and DIY businesses as a going concern.

Gus.

Hi Imran

I have just looked at my email and have found the response as follows....

Dear Mr xxxxx,

Thank you for your email.

The statement that you refer to in the Groups investor pack "Loan book increased by £33m to £550m since H1 last year. Loan book asset fully funded from internal cash generation with no third

party financing" was a statement about the growth in the loan book since the same period last year i.e. over the previous 12 months. The loan book comprised 2 elements, a revolving loan book of £321m and a promotional credit loan book of £229m. There was no external funding required to fund the loan-book with it being funded out of the Group’s cash generation over several years as the loan book has grown. On a half-year basis, since the end of FY15, the loan-book had declined by £29.9m, a number which can be followed through the cash flow statement within cash flows from other operating items.

Given that there is no third party debt associated with the loan book, without an interest charge it would report an artificially high profit number as, obviously, one of the costs of lending money is that of having to borrow it. Therefore, page 91 illustrates the mechanic that we use to calculate the reported annual profit of the financial services business (FY15 £7m) using an “artificial”, but financial services industry norm, capital structure. This is, in effect an internal capital structure with any profit that Financial Services generates over and above this calculation accruing to the retail businesses, where the transactions and customer relationships originate. Page 91 sets out the calculation that is performed in order to provide investors detail of how we determine this calculation. The table illustrates the historic industry norms for pre-tax return on equity of c.15%, and a debt to equity ratio of 85:15%. This ratio is applied only to the revolving element of the loan-book, which at 29 August 2015 was £321m. Therefore the calculation of the “internal equity” component is: £321m x 15% = £48m, which at an industry norm of a c.15% return on equity results in the reported profit of £7m. For the avoidance of doubt, there is no external debt associated with the loan-book and we use these ratios only to calculate the reported profit based on industry norms. Finally, the “internally” calculated interest cost to Financial Services is then shown as an offsetting credit within the Group’s interest line. This is depicted in the interest note 7 on page 27 of our half year announcement.

I appreciate that this is a fairly technical area, but it is an approach that we have consistently applied, with agreement with our auditors, for about 15 years. I hope this answers your questions.

Regards

Richard Ashton

Group Finance Director

Hi Kalkanite

So just to check my understanding is the loan book value of £550m as from the response its not entirely clear?

Best wishes,
Imran.

I think the main thing that we can take away from the reply is....

"For the avoidance of doubt, there is no external debt associated with the loan-book and we use these ratios only to calculate the reported profit based on industry norms."

So yes, there is a £550m loan book which is completely financed in house.

Agreed. Unless the loan book is a complete can of worms, if you stopped writing any further sales on cash it would convert to cash over the remaining life of the assets. There may be some upside if the loans are profitable in their own right, but in the scheme of things this would be a rounding error. Coupled with the net cash in the business of about £200m, the loan book and cash combined are about equivalent to the market cap of c.£750m, so the Argos and Homebase businesses are valued at zero. Clearly risks and investment required to maximise their value but not a bad starting point for making some shareholder value. Apologies if I seem to have gone round the houses and reached the same conclusion as the original article!

Gus.

5th Jan '16

HOME is up 31% today due to an RNS from Sainsbury that it made an offer for the company in November and they are evaluating their options.....
http://www.londonstockexchange.com/exchange/news/market-news/market-news-detail/SBRY/12646495.html

HOME is Mr Market being too pessimistic?

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Kalkanite

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