Thursday, August 4, 2011

ROE or ROIC? hhgregg...Again

At the risk of turning this blog into a site dedicated to the comings and goings of hhgregg (HGG), this is yet another post dedicated to drilling down on this company. Last week, a reader responded to the post discussing hhgregg's ROE breakdown with the statement that "I'm not sure if ROE is the right metric" and subsequently provided some calculations whereby he concluded that he believes "its clear that this company does not manage to earn its cost of capital especially if we assume a mild 12% cost of equity." My response to this reader's comment contains enough points to warrant its own post.

The reader is correct that ROE is not always the best metric; but whether it's the best metric to use depends on what is being measured. If one is trying to measure the rate of return that has been achieved on the firm's equity investments, including retained earnings, there is no better measure. On the other hand, if one would like to know whether the firm achieves a good rate of return on all of its invested capital (i.e. equity and debt combined), ROIC would be better.

Some would argue that shareholders should care mostly about ROE, since shareholders have claim on only the equity returns. But returns on equity can be risky. If a lot of debt is used to finance a business, fixed costs and obligations are high, leaving the firm vulnerable if trouble hits. For this reason, knowledge of both ROIC and ROE are necessary to understand a business.

To that end, the reader provides some rough calculations for hhgregg's most recent year's ROIC. Unfortunately, there are different formulas for this calculation, as different people have different ideas about exactly what should be considered "invested capital". While I agree with the reader that off-balance sheet leases should be included as part of capital, we disagree about whether certain liabilities should be included as invested capital (see our comments in the post for more details). These disagreements end up having a large effect on the result! Simple differences in assumptions result in ROIC discrepancies of 150 basis points (between 8.7% and 10.2%).

Armed with the results of his ROIC calculation, the reader than compares hhgregg's ROIC to a cost of equity of 12%. Unfortunately, this is not an apples to apples comparison; it is ROE that should be compared to the cost of equity, while ROIC should be compared to the cost of capital. This is because the firm generates ROIC at the cost of both debt and equity, whereas ROE is generated at just the cost of equity. Because the cost of debt is lower than the cost of equity, and because debt has a tax shield, the firm's cost of capital is much lower than its cost of equity.

My calculations show that hhgregg is adding value, because its ROIC is higher than its cost of capital. Obviously, however, different assumptions will yield different results. Readers should therefore not put too much faith in any one number.

Finally, whether using an ROIC or ROE metric, it's important to look further than just one year's worth of data. The consumer is going through a tough period right now, and recent sales of items that have some correlation with the housing market are abnormally depressed. What's important is how a company deals with changing preferences over time, not whether they were caught surprised in a given quarter that then had an effect on the most recent year.

Also in hhgregg's favour is the fact that, as a growing company, it is experiencing costs for revenues it has not yet received. As the company builds out distribution centres and trains staff for its new locations, is it spending money without yet enjoying the benefits.

So what's the conclusion? It depends. Both ROIC and ROE are useful and important. Investors should look at both and rely on neither!


Taylor said...


So would an appropriate calculation for ROIC be...

Total Assets - Cash and Intangibles - Non-Interest Bearing Liabilities + Leases(if applicable)

I've seen many different calculations

Chris said...

Does it really make sense to exclude leases though? Under the proposed change to lease accounting rules, leases would be capitalized as both a liability and an offsetting asset. The way you suggest handling them only treats them as a liability.

Saj Karsan said...

Hi Taylor. For IC, sure that could work.

Hi Chris, No I'm not suggesting treating them as a liability only. I agree that they are assets as well. But they should be treated as capital invested, as if they were debt i.e. debt used to purchase an asset that allows the company to earn

Yaniv said...

Hi Saj,

I am the one who started the ROIC discussion on the previous post, Thanks for the detailed response.

About the cost of capital: I think its good to read the discussion between Charlie Munger and one professor, as quoted here:

Most value investors would agree with Charlie. Warren Buffett has made a reference to a capitalization rate of about 10% (there is no one size fits all here). You can read a "lesson" he gave on his 1991 letter to investors Where he used a 10% cap rate.

Therefore, instead of using "WACC" as the capitalization rate or cost of capital I prefer to use 10% (with no growth assumptions) as a rough benchmark. In that case, it doesn't really matter if the company makes 8.7% or 10.5%, in whichever case it is very marginal. Moreover, in today's market its not uncommon to have retailers that trade at low multiples with ROIC in the high teens - Many of those have been discussed on this blog.

In the retail business you might want to have some margin of safety in the returns so in case there are pricing pressures the company can still earn decent returns.
Let's read what Buffett had to say about retail business:

"Retailing is a tough business. During my investment career,
I have watched a large number of retailers enjoy terrific growth
and superb returns on equity for a period, and then suddenly
nosedive, often all the way into bankruptcy. This shooting-star
phenomenon is far more common in retailing than it is in
manufacturing or service businesses. In part, this is because a retailer must stay smart, day after day. Your competitor is
always copying and then topping whatever you do. Shoppers are
meanwhile beckoned in every conceivable way to try a stream of
new merchants. In retailing, to coast is to fail."

So, my initial calculation might have been not so accurate, but I think its easy to see that this company's ROIC is not so satisfactory, especially for retailer in a tough business environment.

Consider the case of ARO that had MUCH BETTER ROIC and traded for less than X8 (without deducting the cash balance). ARO's case shows us that Buffett is very right in his perception of the retail business. Especially so when it comes to companies in highly competitive industries and no real competitive advantage or some smart business model.

In any case I hope HGG will turn out to be a better investment than ARO.

Disclosure: I hold shares of ARO.

Saj Karsan said...

Hi Yaniv,

Thanks for your note. I agree with most of what you said. As such, I would only add that investors should not pay for growth; yet they should still consider (profitable i.e. above cost of capital) growth prospects when choosing between various securities.