Exciting future for REH, page-5

"The thing I like about REH is how little thinking/analysing that I have to do when it releases their reports. After updating a few numbers in my excel file and reading one page paragraph of the report, I can close the file until the next report comes in 6 months time."

Widjayay,

Gee, it's funny you should put it that way because that is precisely the observation I have made in relation to the user-friendly and consistent nature, as well as the quality, of REH's financial results.

I have found over time that, there is often a link between the ease with which I am able to reconcile my spreadsheet financial model with the reported results of any given company, and the quality of that company and its share price performance over time.

Not just that, but when REH reports its results, I always find the results to be very close to my forecasts on a line-by-line basis. And that's not because I am any great forecaster or Excel modeler; instead it's because of the company's reliable and predictable financial performance.

And like you, I find that I usually only look at the model I have for REH only about twice a year, that being on result announcement days. Its such a stable, consistently growing business that it requires zero continuous-calibration.

And it seems that I am competing with people like you to buy shares whenever the REH share price stumbles for whatever reason (ha ha).

Like the past few weeks, which saw some decent weakness in the share price on surprisingly high volumes.

At bit of trawling around the internet taught me me that one of REH's long-standing institutional holders, a domestic small cap manager whose investment performance had been poor over the past 12 months, appeared to be suffering from investors redeeming their money from the fund. I concluded that because REH was significant holding for that fund, that it would be a forced seller of REH in order to maintain portfolio construction.


I can't say for sure that was indeed the case, but that's was I inferred.

So I was dutifully buying while the share price appeared to me to be under pressure due to this apparent technicality.

In terms of your being "quite excited about what they will be to achieve in the next few years", I have very simple way of viewing REH's earnings potential based on the company's current capital base.

Essentially, REH today has a little over $1.0b in Employed Capital.

And my studied opinion is that that Capital Employed is, on average, quite "immature".

And about 40% of that Capital was employed in just the past three years, and about one-third of it in the past two years alone (including the Actrol and Metaflex acquisitions, and the investment in more than 40 new stores and two regional distribution centers, in the past two years).

Given the time it takes for new stores to reach steady state foot traffic, for distribution infrastructure to reach full capacity utilisation, and for synergies from acquisitions to be realised, this means that there is a lead time before this collective incremental capital is able to generate optimal returns.

That, combined with the cyclical improvement in ROCE on the "mature capital" during the upswing in the residential construction cycle, means that once the cycle reaches a peak and as the capital base matures (as described above), REH should generate ROCE similar to the levels it generated during the last peak in the cycle (2004/2005), namely around 27%/28%.

This compares to REH's ROCE today, impacted by the drag of immature capital as well as the cyclical position (being somewhere in the upswing phase of the construction cycle), of ~15%.

Applying a peak cycle ROCE (i.e., 27%) on the ~$1.0bn of Capital Employed, translates into NPAT of around $270m, which is some $45% higher than the current level of NPAT.

I have no idea whether that level will be reached in one, two or three years, but whatever the time frame is, this (admittedly crude, but simple) analysis demonstrates to me that REH is currently under-earning by a significant degree, and that as this situation normalises, the earnings growth momentum will be strong.

In my view, FY2015 clearly demonstrated the start of this ROCE normalisation process.

I fully expect this to accelerate in coming financial reporting periods.


PS. For context, here is a history of my calculation of REH's ROCE:

FY2002: 27.4%
FY2003: 25.5%
FY2004: 27.2%
FY2005: 28.3%
FY2006: 28.1%
FY2007: 25.9%
FY2008: 24.7%
FY2009: 18.8%
FY2010: 23.2%
FY2011: 22.5% [*]
FY2012: 21.1% [*]
FY2013: 18.3% [*]
FY2014: 16.6% [*]
FY2015: 15.4%

[*] Between FY2010 and FY2014, NPAT was barely changed (NPAT in FY2010 NPAT was $114m, in FY2014 it was $123m), yet Capital Employed (not even including the impact of the Actrol acquisition) rose by 37%.