Comments on AFR latest article, page-12

@travelightor

I can be as stubborn as I can be stupid, so thanks for forcing me to confront some brutal facts and have a fresh look at HVN.



"As for HVN, in my personal opinion, HVN and other retailers of goods that are easily posted by mail, are vulnerable to attacks by online giants such as Amazon. Almost the whole electronics business of HVN are potential hunting grounds for Amazon.

Furniture and other bulky goods are probably less vulnerable as customers still prefer to touch and feel the goods before making the decisions to buy.

If the financial performance of HVN is negatively affected by the arrival of Amazon, then the valuation of its property portfolio will also be affected. This property portfolio, which for a long time has been HVN's source of competitive advantage, can turn into burden or source of competitive disadvantage."

I partly agree here. But remember, the bulk of HVN "electronic" business is really electrical more than electronic. So think more large(ish) items like TV's, sound systems, security systems, PVR's etc. You also have to remember that HVN is also very much about other stuff, like kitchen goods, white goods, coffee machines, indoor outdoor furniture, bedding etc. Also, remember that there is a certain synergy (there you go, I've used the ‘s’ word), as anyone walking into a store for "show-rooming", is being exposed to various other items, even if they don't buy the item they walked in for (here’s looking at you PC’s and gadgets).

The internet threat has loomed large for quite a while now, and in fact, I think, it looked a whole lot scarier a few years ago (and rightly so). A few years ago, the internet decimated retail pricing power, as it brought about price transparency. I believe this structural change was more monumental than the impact of on-line purchases per se. Was it more monumental than the threat posed by Amazon? Well, let’s not forget, that at that time, the likes of HVN were hit by a perfect storm of not just price transparency, but also on-line competitors (exacerbated by an appreciating currency), but equally importantly (if not more importantly) price-deflation (which there is good reason to believe, is now abating, if not reversing). I struggle to feel as scared by the looming Amazon threat, as by that trifecta.

But in any case, much as I suspect the consensus is getting caught up in the power of narratives, I want to avoid getting caught in narratives of my own. Any moderately articulate person can put together a convincing narrative about the future, and be completely wrong. I suspect it is why intelligent people can be some of the worst investors. So I would rather avoid prognostication, as far as possible, and focus more on hard facts.



"The current controversy relating to how HVN actually accounts for its under-performing franchisees has its origin in the very business structure of HVN. Every time I look at HVN's network of thousands of micro-franchisees, I can't help but feel that its business structure is so nineties, or even eighties! It is simply unnecessarily complicated."

It has been many years now that everyone from consumers, analysts, prominent smart bloggers to corporate-governance crusaders, have been looking for cockroaches in the HVN kitchen. But I'm not sure that they've actually found any. What they have found (and I agree with) is a lack of transparency wrt to franchisees, and a lack of adequate shareholder communication and candour. My view here is a little subtle. Wrt the franchisee structure, this stems not (I believe) from Mr Harvey’s deviousness, but rather a desire to have his cake and eat it. That is, he wants a workforce that has the incentivisation that comes from being owners of their own businesses, but he also wants the control that comes from HVN having full ownership.

I'm not saying it is right. What I am saying is that the motives are a desire for a performance culture that does not carry passengers. That is, it is reflective of an ingrained desire to add value and minimise cost and fat. It is also reflective of the fact that Gerry's personal wealth is overwhelmingly tied to the fortunes of the business. So, unpopular as it is to say, this foible actually flows from leadership attributes that I hanker for.

Is it "eighties" or "nineties"? Perhaps.



"HVN's major competitors such as JBH or NCK are able to grow rapidly without having to resort to selling franchises/territories to franchisees. As a result, their businesses are much simpler to understand."

Sure.



"As for this current controversy, I always believe that if we find a cockroach in a pantry/kitchen, chances are it's not the only one around. There is probably one big family of cockroaches hiding somewhere behind the tins of tomatoes."

Further to my comments above, much as I appreciate and respect much of the criticism, I believe that the franchise structure, and even the poor disclosure wrt analysts and shareholders, stem from attributes that I hanker for in a leader. I hanker for owner managers who have an independent mind. Yes, these attributes have here become stubborness and have caused a virtual declaration of war on those he sees as short termists and group-thinkers. I do not excuse his behaviour. What I am saying is that I can tolerate it, to a degree, because I do not believe the motives are sinister. As such, I do not believe the controversies are reflective of a dishonest or devious leadership. Far from it. I am fairly certain that Gerry, for all his foibles, and whilst being a tough task master, is a man of integrity.

As such, I am not expecting too many cockroaches.



"Sometimes, it's very hard for an investor to avoid being blinded by a big personality, especially one who has forms such as GH. When bad news arrives, it's very easy to be understanding/accommodating and ignore the bad signs as a one-off that is dwarfed by the list of boxes that are ticked."

Apart from what I have already said, all I can do is look at the numbers. I am very aware that there are many foibles here. I would much prefer a “head down bum up” leadership in the vein of ARB and REH. But then, you couldn’t exactly say that the HVN leadership is currently the toast of the town. I would suggest that the most dangerous time to be swayed by the “big personality” is when all is going well and the personality is being featured in BOSS magazine. That is likely to be the time that the personality premium is inflating the share price.



A few years ago, I had a bad experience being blinded by a big personality who I thought to be "faultless". It was Frank O'Halloran's QBE. At that time FOH spoke all the right words and "did" all the right things. In the end, it turned out that all of the acquisitions that he made were not that brilliant and QBE shareholders are still paying the price up until today.

I doubt that O’Halloran (correct me if I’m wrong) had as big of a personal stake (financial and emotional) in the business. The expansions made by HVN have been less than stellar, but I wouldn’t say they have been reckless.



The other thing that should be considered is HVN's life after GH retires. He is 77 this year. What will happen to his shares? Will the market derate HVN's valuation? Who's going to replace his role as the ultimate protector of HVN's capital

Given the anti Gerry hysteria of recent (and not so recent) years, I don’t think there is currently a Gerry premium in the price. If anything, there is probably a Gerry anti-premium. When Gerry has left the scene, I suspect the market will breathe a sigh of relief. As highly paid MBA’s, non-executive directors, governance experts, consultants and various other lemmings start marching in, if I’m still a shareholder (a big if), I will in all likelihood start marching out.



So let’s look at some cashflow numbers:

In the year ending June 2016, the business generated $438m in operating cashflow (OCF). This was boosted by about $18m thanks to reductions in working capital (WC). On a WC adjusted basis, the business generated $420m in OCF. Of this, $180m was reinvested into the business (It should be noted that tax payments, as a proportion, were fairly typical of prior years).

Of this reinvestment, $68m was payment for PP&E, $64m was purchase of investment properties, with the remaining $48m largely constituting investments in and loans for joint ventures. If we conservatively assume that all investment expenditure, except for payment for investment properties, is required just to stay in business, then we can say that $116m ($180m - $64) of the OCF was consumed by the business. This represents a cash consumption rate of 28% (cash consumed wrt OCF adjusted for changes in WC).

On this basis, we can say that the business generated free cashflow (FCF) of $438m - $116m = $322m. But as stated, $18m of this cash was released from WC. So on a WC adjusted basis, the FCF generated was $304m. Of this FCF, $267m of fully franked dividends were distributed to shareholders (a payout of 83%, wrt to FCF).

This FCF generation represents a return on average book value (in FY16) of 11.6%. It should be kept in mind that this return excludes property revaluations and any possible future rental increases (which do not require capital reinvestment). It should also be viewed in the context that it was achieved with minimal financial leverage and a large property holding. The written value of investment properties constituted 45% of total assets (76% to equity) and net debt amounted to only 24% of that property (18% to equity).

The share price currently stands at about $4.40. With 1,113m shares on issue, the business has a market cap of $4,900m. On this basis, the FCF yield, based on FY16 cashflows, is 6.2% ($304m/$4,900m). The grossed-up dividend yield is 7.8% ($267m/0.7/$4,900m). This grossed-up dividend includes $114m of imputation credits. If we add the distributed imputation credits to the FCF, then we can say that the “grossed up FCF” yield is 8.5% ([$304m+$114m]/$4,900). Once again, these yields exclude property revaluations and a degree of inflation protection provided by the property rentals.

But of course, FY16 represented fairly buoyant retail conditions, in the household goods space (though substantially less buoyant than what is currently occurring, judging by the HY results ending Dec 2016).

So here are average annualised numbers, over a variety of periods:

	Column 1	Column 2	Column 3	Column 4	Column 5	Column 6
0	​	period:​	8 years ending June 2016 ​ #​	5 years ending June 2016​ ^​	2 years​ ending June 2016​ +​	3 years​ ending June 2013​ /\​
1	a.​	OCF​	$343m​	$311m​	$389m​	$266m​
2	b.​	movement in WC​	$9m​	$31m​	-$3m​	$22m​
3	c.​	total investment​	$195m​	$158m​	$131m​	$253m​
4	d.​	inv prop purchases​	$87m​	$65m​	$40m​	$121m​
5	e.​	cash consumed by WC movement​ b/(a+b)​	2%​	9%​	-1%​	8%​
6	f.​	cash consumed to stay in business \/​ (c-d)/(a+b)​	32%​	30%​	23%​	49%​
7	g.​	FCF​ a-(c-d)​	$235m​	$219m​	$298m​	$135m​
8	h.​	dividends paid​	$165m​	$184m​	$300m​	$115m​
9	i.​	dividend payout​ h/g​	70%​	84%​	101%​	85%​
10	​	average cash return on equity <>​ FCF/equity​	10.0%​	8.8%​	11.6%​	5.9%​

Note #: A period of mainly depressed retail conditions, and also a period in which HVN was struggling to face the new reality of online sales, and trying to adjust to the unwinding of previously hugely successful PC sales.
Note ^: A period covering 3 years of very depressed retail conditions, and 2 years of relatively buoyant conditions (though nowhere near as buoyant as the conditions that existed prior to the GFC).
Note *: A period generally covering relatively buoyant retail conditions (though nowhere near as buoyant as the conditions that existed prior to the GFC).
Note +: The most buoyant retail conditions (in the household goods space), for full financial years, since the GFC. However, nowhere near as buoyant as the conditions that existed prior to the GFC, and not as buoyant as what FY17 is shaping up to be.
Note /\: The most depressed 3-year period since FY1984 (as far back as I have records in front of me). A period in which not only were volume increases anaemic (at under 3% y-o-y), price deflation detracted about 1.6% each year, thus resulting in retail sales growth of under 1% per annum.
Note \/: This is quite conservative, as it assumes that none of the capex in PP&E, or other investments made (apart from that for investment properties) is expansionary.
Note <>: This return excludes property revaluations and any rental growth (which does not require capital reinvestment). It should also be viewed in the context that it was achieved with a large, and very lightly geared, property holding.



So what do we get at current share prices?

Below are the returns that are implied at current prices ($4.40 per share), based on current book value ($2,740m = $2.46 per share), assuming different levels of cash-returns-on-equity, and assuming a dividend payout (to FCF) of 85% (about what has been delivered in the last 5 years):

	Column 1	Column 2	Column 3	Column 4
0	​	Depressed conditions​ FCF/equity = 5.5%​	Mid-range conditions​ FCF/equity = 8.5%​	Buoyant conditions​ FCF/equity = 11.5%​
1	FCF per share​	$0.14​	$0.21​	$0.28​
2	dividend per share​	$0.12​	$0.18​	$0.24​
3	Imputation credits per share​	$0.05​	$0.08​	$0.10​
4	Grossed-up dividend per share​	$0.16​	$0.25​	$0.34​
5	Grossed-up dividend yield (on price)​	3.7%​	5.8%​	7.8%​
6	FCF yield (on price)​	3.1%​	4.8%​	6.4%​
7	“Grossed-up FCF yield”# (on price)​	4.2%​	6.5%​	8.8%​

Note #: (FCF + imputation_credits_distributed)/price.

So even under todays prices, if conditions returned to those of the gloomiest days of the post-GFC, we would still be getting a yield of over 4%. That’s not too enticing, but it’s also far from disastrous, especially when you consider that it contains a considerable inflation hedge thanks to the property portfolio, and that it is a conservatively constructed yield, in that it treats all investment beyond that directed to property, as “maintenance” capex.

On the other hand, if we can expect an 8.5% cash return on equity over the cycle, then we can expect a yield going forward of about 6.5% with considerable inbuilt growth potential (once again, thanks to the property rental and to the fact that the “maintenance” capex is likely over stated). I wouldn’t call this exciting, and I personally may not be inclined to purchase at current prices (especially considering the risks), but I don’t think it’s the worst one could do.



In conclusion:

Clearly this is not a “bottom draw” stock. I don’t expect it to be able to allocate large swathes of incremental capital at superior rates of return into the distant future. I don’t expect its intrinsic value to march steadily upward, for the rest of eternity. This is discretionary retail. And what’s more, it is a mature discretionary retailer. It does not have the moat of an ARB or REH (not even close). It is hugely cyclical, and is facing the scary Amazon threat (and perhaps various other structural threats)

Funnily enough, now that everyone seems to hate the business, I think it is, arguably, more valuable than ever. More valuable than when it was a market darling and it traded at huge premiums to earnings, and naive and inexperienced investors (like myself, at the time) paid-up for blue sky.

In more recent years the business has been generating more free cashflow than ever, as the management have slowly (too slowly) come around to the realisation that they can no longer allocate incremental capital at superior rates of return. But they have come around (which is more than you can say for other “professionally” led corporations). Capex is consuming a far smaller proportion of cashflow as are investments in working capital, and what’s more the management is directing more and more of the FCF’s to shareholders via dividends.

So ultimately, it all comes down to valuation, I believe.