Tuesday, July 26, 2011

hhgregg's Poor Performance

In response to last week's article discussing the investment merits of hhgregg at current prices, a number of readers have pointed out that the company appears to be suffering from competitive pressures. Return on equity has been declining steadily over the last three years, as shown below:


Undoubtedly, hhgregg operates in a highly competitive space. Not only does it have to battle with proven, conventional retailers such as Best Buy and The Home Depot, but it also has to deal with growing and constantly-improving online threats. However, before getting carried away with this negative assessment, it's important for investors to understand the source of the reduction in the company's return on equity.

Return on equity, which is net income divided by equity, can be broken down into several factors, as follows:

Income / Equity = Income/Sales * Sales/Assets * Assets/Equity

The following table depicts these factors for hhgregg over the last several years:

ROEIncome/SalesSales/AssetsAssets/Equity
200826%1.7%3.84.0
200929%2.6%4.02.8
201016%2.6%2.52.4
201115%2.3%3.81.7

Clearly, the reason for the drop in ROE is predominately due to a reduction in Assets/Equity (depicted in red in the table above), otherwise known as leverage. The company has paid down its debt, and now holds a decent-sized cash balance. As such, it is now a safer company, but otherwise performing just as well as it was a few years ago, when its P/E was much higher. This demonstrates that despite the competition and the tight consumer environment, management has continued to run the business well, as demonstrated by these performance metrics.

Disclosure: Author has a long position in shares of HGG and BBY

6 comments:

Anonymous said...

Saj,

Good analysis of ROE using dupont formula.
Do you think the slight increase in profit margin is due to less tax paid because of debt being paid down or increase in operating effeciency.

Anonymous said...

I'm not sure if ROE is the right metric to use here. I like to look at the EVA, that can be measured in part by the return on the capital employed in the business. Usually, companies with competitive advantage can earn more than their cost of capital. Other companies earn their cost of capital and create no value (most businesses around) and others earn less than the cost of capital and destroy value (K-Mart of the past)

I'm not so familiarized with the company so this is just a back of the envelope calculation. Feel free to correct me on the numbers or the adjustments needed. I will begin with the liabilities side of the balance sheet and adjust form there:

Total Liabilities: 550M
Not need to be financed: accounts payable 95M
Excess cash 30M
Capital on the balance sheet: ~425M
present value of off balance sheet leases (only 5 years, excluding thereafter): 265M

Total Capital: 690M
NOPAT (rough estimation): 60M

Return on capital: 60/690 = 8.7%

I think its clear that this company does not manage to earn its cost of capital especially if we assume a mild 12% cost of equity for a company of this kind without any competitive advantage.

[Try to do the same calculation for Walmart to see how value is created]

Based on that, I would say the returns on this business are poor and its a clear sign of a business that has not differentiation and suffers from high competitive pressures.

That's not to say the stock will perform poorly - It's just to assess the nature of this business. Some businesses that perform poorly are being sold for cheap enough prices that will still allow profits.

Saj Karsan said...

Hi Anon1,

Do you mean "interest" instead of "tax"? It has certainly helped that there is less interest to pay.

Hi Anon2,

The results really turn depending on your assumptions. I would be much more likely to use debt+equity+leases as capital, as your formula includes additional liabilities that don't need to be financed as invested capital (namely customer deposits, accrued liabilities, and other liabilities totaling almost $140M). Also, as the company has generally operated from a net debt position, one could include $70M as excess cash (which is currently the net cash position). Using these assumptions gives you a ROIC above 10% in what is a pretty tough period (from a consumer electronics point of view). Considering that half of the capital is funded by relatively low interest, tax-sheltered debt, this company would then easily beat your imposed 12% cost of equity.

I agree that Wal-Mart is a heck of a company!

Anonymous said...

Saj, so let's deduct the 140M you suggested to the capital base (I did not find enough details on each of the liabilities in the company's 10K but I saw a big portion of it is related to tenet allowance that indeed should be taken off from the capital base).

About cash: Companies in this sector always carry high balance of cash. I wouldn't deduct the whole 70M. Last time they had net-debt position it ended up diluting shareholders by more than 20% and I'm not sure they will repeat the experience anytime soon given the price-pressure that this industry experiences. Moreover, I also ignored the fact that during the last 3 years capex was twice as high as depreciation and if we will make that adjustment to NOPAT things will look even worse (even if we will deduct the whole cash balance and 140M liabilities). Also, if you will make the exact calculation for the capital lease you will get 20M more than the number I arrived at with simple calculation.

Maybe I missed something reading the report, you mentioned "half of the capital is funded by relatively low interest, tax-sheltered debt" which debt is that? The balance sheet seems to be debt free after it paid it all (and diluted the equity owners). Let me know if I'm missing something here because I'm not so familiar with this company and its history.

To sum up, even if we fix the capital base to be 550M and assume NOPAT of 60M we still get ROIC that is on the edge.
If you believe that this industry is on the verge of huge improvement in volume or pricing power then this opportunity indeed might be attractive as with some pricing power and higher volumes NOPAT/Cap can easily be 20%.
As for me, I wouldn't assume that this industry has its best days ahead and I prefer companies that can generate high returns on capital even in today's environment.

I enjoy reading you blog - Keep it up!

Saj Karsan said...

Thanks, Anon3!

I don't think that ROIC is on the edge, however. When you say that capital includes leases (and I agree with you on that), those should be considered funded by debt. So you can't compared the ROIC, which you have at near 11% now, with cost of equity. Instead, it should be compared with cost of capital, which is much less than the cost of equity, because the company's interest rate would probably be in the mid single digits.

Joseph Greiner said...

I have a few fundamental questions to the analysis that was conducted below: What was the discount rate used for the PV of off sheet leases? Are the off balance sheet activities inclusive of Advertising Committments?

For my calculation I used Debt (PV Off Balance Sheet) + Shareholder Equity (inclusive of retained earnings, additional paid, treasury stock).

PV Off-BS $345 (FY 2012 @10%
Shareholder Equity $360
Total Capital $704
2012 NOPAT $63 (@39.5% tax)

Given the latest figures released by Management I returned a ROC of 9%. This seems much lower than the proposed amounts. This increases to 11% if you utilize the firm tax expense. This does not seem like a reasonable return considering that the firm specific WACC is in excess of 10% with a size premium.

Any thoughts?

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