Saturday, May 14, 2011

Retailers and rent - and JD Sports

One thorny issue that comes up with retailers is off-balance sheet finance due to rental obligations under leases, which tends to skew the figures. Richard Beddard of Interactive Investor is cautious on this matter; and with companies like Woolworths and HMV, he has a right to be. Richard recently wrote about JD Sports Fashion, a company in which I own shares.

The question is how to size up a retailer when there is a big rental component. If anyone has some good ideas, then please let me know. One way I thought of approaching the matter is to recompute a return on capital adjusted for rent.

Let me examine JD.L (JD Sports Fashion) to obtain its ROCE (Return on Capital Employed), and RAROCE (Rent-adjusted ROCE); the latter being a fictitious number devised by me. I will look at y/e Jan 2010 accounts to make my computations. Although y/e Jan 2011 has passed, I don't have access to a full set of accounts to make my adjustments.

I define ROCE as:
where CE is Capital Employed.
CE = TA - CL
where TA is Total Assets, and CL = Current Liabilities
We could have many debates here about whether CE should include only tangible assets, and whether an average capital should be used. I prefer to include intangible assets in with my ROCE. I shall use y/e Jan 2009 balance sheet to to calculate ROCE, rather than average 2009 and 2010.

According to my calculations, EBIT for 2009 (i.e. for y/e 30/1/2010) was £61.4m, and CE at the beginning was £129.2m (= TA 220.6m - CL 91.4). This gives a ROCE of 47.5% (=61.4/129.2) - a suspiciously high figure.

Let me now adjust for rental obligations under leases. According tot he accounts, JD. had obligations under plant and equipment too, but they do not appear material, so I am ignoring them. According to note 3 of the accounts, rent for the period was £75.8m. According to note 28, total commitments under leases at the beginning of 2009 (actually 20/1/2009) was £537.4m, of which £68.5, was due within a year. This means that leases due outside of 1 year amounted to £468.9m (= 537.4-68.5).

This means that our revised earnings are £137.2 (= 61.4 + 75.8), and our revised capital employed is £598.1 (= 129.2 + 468.9), implying a RAROCE of 22.9% (= 137.2/598.1).

So we have revised our return on capital from 47.5% down to 22.9% (rent-adjusted); which is still a high return. At the current price of 893.8p, JD. does seem quite underpriced, having a PER of 7.8. The market is attaching a lot of doom and gloom to the high street at the moment, and its fear is not necessarily groundless. I should point out, though, that the share price plummeted in 2008 to a low point of about 200p, and traded at a low PER (less than 6). During that period, though, adjusted EPS grew by nearly 30%. So investor fears were completely unfounded.

A statement by management last month expressed "extreme" caution in outlook, noting that VAT increases will have an adverse rebasing effect, as well as "adverse fiscal changes in addition to the multiple current economic pressures". In their christmas trading statement, the board also expressed concerns about increased raw material prices.

It should be noted, however, that JD. has net cash of £86m. Also, JD. seems to have a knack of surprising on the upside, which is the kind of knack that I like to see! This is why I continue to hold, and I am not anxiously edging towards the exist. I think one point that is overlooked about JD. is that it is good at acquisitions. If conditions worsen, then it will likely be able to pick up struggling competitors at bargain prices. Having a good cash position is a definite help here. Also, as noted on 14 April, JD. has a agreed £75m funding with the banks to refinance existing debts and "provide additional growth funding". A statement by one of the bankers involved in the deal seems particularly bullish:
By continuing to provide the finance to support their ongoing strategic plans, I'm confident JD will take full advantage of the growth opportunities in the markets they operate in.

I see JD. as being a bigger company five years down the line than they are now.

Investors interested in retailers might also want to check out ALY.L (Laura Ashley) at 20.5p/£149m, which showed record profit to y/e 29 January 2011, but they did warn that "Since the beginning of February, we have seen a decline in our performance which we attribute to a general weakening in the consumer economy."

A retailer that has been getting much more interest lately is FCCN.L (French Connection), at 102.7p. It is on a PER of 13.8, but it has a net cash position of £34m against a market cap of £98m. Share performance has been strong, having risen nearly 20% in year-to-date. In a statement of preliminary results, the company announced significant growth in profit, although it also noted: "The current economic environment is clearly difficult and it appears likely that it will remain so in the coming year."


Richard Beddard said...

Very interesting post Mark and I must confess I haven't gone as far down the road as you in adjusting for operating leases. I may have a bash at adjusting for operating leases when I look at Sports Direct, but only if I can think of something sensible!

John said...

Hi Mark. I think "good at acquisitions" may be a key part to JD's success. Since turning First Direct around they seem to have learned some key lessons and have a great track record of buying up the weaker competition as you say. Leases are important but given that JD just rode through the great recession without blinking I wouldn't worry about them too much (famous last words).