In today’s Money Morning…the futility of trying to pick a correction point…even in a bull market, you can’t pick stocks blind…some companies deserve to sell at a discount…and more
Before kicking off today’s Money Morning, I just want to give a shout out to all those North Queenslanders dealing with Cyclone Debbie and its aftermath. It looked like quite an ordeal. We’re all thinking of you, and hope you’re safe.
Now, this time last week there was rising angst and worry about the ‘correction we had to have’ (as one headline read). That was on the back of a one day fall of more than 1% for the ASX 200.
‘Here it comes’ was the general feeling. We’ve had a strong run, now time for a correction. The only question was, how big would it be?
Well, yesterday the market closed at its highest level in nearly two years. With Wall Street up strongly overnight, Aussie stocks look set for another decent day.
It just goes to show the futility of trying to pick correction points. Anyone who sold out of some stocks expecting a deeper correction last week would now be regretting their actions.
From here I’d expect to see the ASX 200 head towards the March/April highs of 2015, around 6,000 points. Whether we see a bigger correction play out at this point is anyone’s guess. But if we get there soon, I wouldn’t be selling, hoping to make a few bucks by taking profits and waiting for a correction.
As I wrote yesterday, ‘it’s a bull market, you know’. The best strategy is to hang on and (try to) enjoy the ride.
Not for all stocks though, which brings to mind that old adage, ‘it’s a market of stocks, not a stock market’.
And for department store retailer, Myer [ASX:MYR], it most definitely hasn’t been a bull market. Check out its dismal performance since listing in 2009:
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Prior to listing, MYR was a part of the perennially underperforming Coles Myer Group. Then private equity player TPG group took Myer private, improved its performance, and sold it back to a gullible public at $4.10 per share.
Seven years later, and the investment has been a debacle.
Now, Solomon Lew has reportedly taken a 10% stake in the company. No one really knows why at this stage. It’s either a prelude to a full takeover, or a blocking stake in case someone else makes a takeover offer.
Lew is a major supplier to Myer through various wholesale companies, and he obviously wants to try and protect these revenues in the event of a change of control for Myer.
Much of the commentary over the past few days has revolved around how ‘cheap’ Myer is at these levels, which is why it is vulnerable to a takeover attempt.
That’s an interesting claim. On the surface, it doesn’t look particularly cheap. But if you drill down, there is some value there. I’ll show you where to find it in a moment. It’s a handy tip if you do your own analysis on larger stocks like Myer.
The other alternative is that it looks cheap to a buyer who can extract significant synergies. That buyer would be the South African company, Woolworths, who bought David Jones a few years ago and is still restructuring it to improve profitability. Put the two together, the thinking goes, and you’ll be able to remove a lot of duplicate costs.
If you look at Myer’s performance since listing, it’s been a basket case. In the 2010 financial year (it’s first as a listed company) it reported earnings per share of 25 cents. The forecast for 2017 is just 9 cents per share.
Is it poor management or structural forces driving this earnings decline?
Bernie Brookes, considered by many to be a very good retail manager, was at the helm for years and couldn’t do anything to boost earnings.
And no doubt the increase in foreign retail brands establishing standalone stores over the past few years, as well as the online shopping threat, have played their part.
Whatever it is, the reality is that Myer now generates a return on equity of just 6.5%. In 2010 it was around 25%.
The reasons for this are twofold; a general decline in business conditions for department store retailers (Myer’s gross margins have declined over the years) and a big reduction in leverage. Leverage boosts profitability (as measured by returns on equity) and a fall in leverage reduces it. Since listing, Myer has reduced its debt by around $400 million.
A company with a low return on equity is not as valuable as a company with a high return on equity. And based on Myer’s accounting profits, it has a substandard return on equity of just 6.5%. Who wants to run a business and earn such a small return?
Myer has a market capitalisation of just under $1 billion. Its equity value is about $1.1 billion. Now you might think it’s a good deal to be able to buy Myer for slightly less than its equity (or book) value. But because the return on that equity is only 6.5%, it’s not as good as deal as you think.
But here’s where things get interesting. Myer’s accounting profit for 2016 was around $60 million. However, free cash flow — the actual cashflow available to shareholders for reinvestment in the business or dividend payments — was double that, at $127 million.
So when you look at Myer on a free cashflow basis, it’s not as bad as when you simply look at the accounting profit. On the cashflow numbers, Myer is twice as profitable, and buying at a slight discount to equity value looks like a good deal.
This is what Solomon Lew (or whoever is buying) sees when they look at Myer as a business investment. But there is still the structural threat to the business to think about. Those free cashflows could deteriorate in years to come if nothing changes with the business.
That’s why it makes more sense for a player like the South African Woolworths, who can extract synergies, to buy it, rather than just be a passive investor and hope something works out.
Who knows, maybe Lew does want to buy the whole business? Maybe he has a grand plan to increase profitability? Or maybe he’s just protecting his wholesale businesses, by buying a seat at the table in the event of a takeover at some point down the track.
If the latter is the case, and no takeover bid is forthcoming, expect Myer to continue to trade at a discount. Some companies are ‘good value’ for a reason.