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With owner earnings we are trying to obtain the earnings that, in future, would be left for shareholders after the managers’ use of the cash generated to pay for items of expenditure to maintain the strength of the economic franchise (e.g. additional capital items, additional working capital, marketing spend, R&D and staff training) and to maintain unit volume and to invest in all value-generating projects available.
Depending on circumstances, the owner earnings figure may be the same for every future year or on a steadily rising (or falling) trend. Naturally, owner earnings are impossible to obtain with any degree of precision because many of the input numbers are merely educated guesses about the future. Despite this imprecision it remains an important method for thinking through valuations. Using the past to guess the future Owner earnings analysis is about future cash available for shareholders to take out of the business. But the only evidence we have available is past data. We start with that, and then use qualitative analysis to judge whether to simply project forward the past pattern or modify the previous trend for future orientated thinking. In the following we use what the company actually invested in new working capital items and in new fixed capital items, and what they spent on marketing, R&D and staff training etc. already deducted from the P&L. What the analysis really requires is the amount necessary to maintain the quality of the economic franchise, unit volume and invest in value generating projects. To start with we make the bold assumption that what was spent by the managers was also the necessary amount. When we move to forward-looking analysis to value the firm we need to make another bold assumption on the real amount needed to invest in new WC, fixed capital items, etc., in the future. The historical analysis helps us make that judgment. “Owner earnings” in the past... ... P“Owner earnings” in the past £m YEAR 2022 2021 2020 2019 2018 2017 Profit after interest and tax deduction 77.7 53.2 17.5 41.9 54.7 56.4 Add back non-cash items such as depreciation, goodwill and other amortisation 36.1 36.7 41.1 36.0 34.9 31.6 Totals to: Amount available for distribution to shareholders before considering the need to spend on fixed capital items to maintain the company’s economic franchise, unit volume and invest in value generating projects. 113.8 89.9 58.6 77.9 89.6 88.0 Deduct fixed capital expenditure other than property. And deduct cash invested in working capital. (The figures shown are actual expenditures and are therefore a rough proxy for the ‘needed’ expenditures to maintain franchise, etc.). A positive number indicates cash being released from WC changes greater than cash used in capex. -113.4 +22.0 +7.3 -30.5 -42.5 -44.6 Owner earnings 0.4 111.9 65.9 47.4 57.1 43.4 Past years have produced a surplus after paying for working capital additions/reductions and capex items which have been volatile. The large variation is mostly due to jumps up and down in inventory levels during the Covid period. Because of that volatility from one year to the next and the volatility of profit after tax we need to obtain a longer run estimate of past “owner earnings” by taking an average. This turns out to be £54.4m pa over the six year period. If we took this number as our estimate for each future year, i.e. no growth, then we can discount (at 8%) all those future owner earnings to obtain an estimate of intrinsic value: £54.4m/0.08 = £680m or £3.11 per share. This compares well with the current share price of around £1.70. Will the future be like the past? Now, more than ever, we are uncertain, but we can think in terms of reasonable scenarios. Scenario 1: Recession and recovery Owner earnings fall to zero for two years. All years after that generate £54.4m in owner earnings (I see no reason to believe that Halford’s reputation will be destroyed nor for the market for bicycles and car parts & services disappear). What is the discounted value of those owner earnings, i.e. our estimate of intrinsic value? Value of a perpetuity: £54.4m/0.08 =£680m This needs to be discounted by two years: Intrinsic value estimate is £680m/(1.08 x 1.08) = £583m or £2.66 per share. Under this scenario the shares offer a good margin of safety. Scenario 2: Depression The depression lasts for 5 years and Halfords’s annual profits average zero over those five years. In the sixth year they bounce back to the average of the six years 2017 – 2022: Intrinsic value estimate: Perpetuity value = £680m Discounted over five years at 8% pa: £463m, or 211p per share There is still some margin of safety on the current market price. Scenario 3: Recession and growth Two years of zero profits followed by a year at £54.4m which then grows each subsequent year by 3%. £54.4m/(0.08 – 0.03) = £1,088m Then discount by two years: £1,088m/(1.08 x 1.08) = £933m or £4.26 per share. All in all, intrinsic value estimates based on owner earnings suggest that Halfords’ shares are cheap on the stock market.
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With a market capitalisation of 218.9 shares x £1.62 = £355m Halfords is trading at a cyclically adjusted price earnings ratio of only 162p/27.3p = 5.9. That seems cheap. But it’s often the case that companies on very low CAPEs are high risk because they have dangerous financial structures making them vulnerable to distress.
The coming recession will test any company that has borrowed too much or that has a tendency to fall into losses in hard times. On the later point, we can note that Halfords has not made losses in any year in the last decade, not even during the depths of the Covid crisis. And looking at the profits in the Great Recession we find that it rode through with good profits every year (after tax profits: 2007: £57m, 2008: £64m, 2009: £56m, 2010: £77m). Having been satisfied on limited vulnerability of the operating business, this section will focus on the balance sheet, cash flow history and Piotroski factor analysis to explore if the company is vulnerable to financial structure stress. Balance sheet data (Ignoring IFRS16 on leases) Yearend April, £m....... ....Observations on balance sheet:
The car servicing strategic business unit, SBU, includes Halfords Autocentres as well various tyre-focused garages and its fleet of vans to service cars, change tyres and service fleets of cars and trucks....
...Halfords already claims to be the largest vehicle 'Service, Maintenance and Repair' (SMR) business in the UK, with approximately 604 garages, 234 consumer vans, 190 commercial van and 8 warehouses. It has even greater ambitions with current targets set at 800 garages, 300 consumer vans and 500 commercial vans. The B2B offering was mostly created by the combining of McConechy’s and Universal. These have a different operating model of lower gross margin but strong margin per worked hour. They also have more resilient revenues. Halfords is aiming for national coverage, allowing the winning of larger contracts to support businesses seeking a single service provider across the UK – it wants to have “full and unrivalled UK coverage in the commercial tyre market” (Prelims 2022) (Also included in B2B discussion in Halfords annual reports is the completely different type of business of the Cycle to Work scheme) Halfords' strategy to grow its Motoring Services business is not only focussed on scaling the physical estate; other key initiatives to drive trade into Autocentres include Project Fusion, Motoring Loyalty Club and Ayaler: Project Fusion. A few towns were selected to develop a joined up way to retailing the range of products/service Halfords now has to offer. In a “Fusion town” you will find a retail store plus an Autocentre garage and an extended Halfords Mobile Expert van offer. These are all linked with the online and home delivery service. Thus a customer goes to one website and sees the full range. Most importantly, the stores, garages and vans ....... Halfords is the market leader in the retail sale of motoring and cycling products. And it does some servicing of cars and bicycles at its retail stores.
Its motoring servicing business has grown from virtually nothing 12 years ago to become one of the biggest, if not the biggest, player in a very fractured market. Being the biggest means you only have 2% of the market. Halfords has hundreds of fixed and mobile locations in UK and Ireland, bestowing economies of scale and widespread brand recognition for Halfords itself (but the car service places are less well known).... .... Most of the revenue growth has come from half-a-dozen acquisitions in the motor service business over the last 12 years which cost around £160m to buy, and from inflation. The directors’ medium term plan is for over half of the Group’s business to be service related. Over £400m of current revenue already comes from the car servicing segment. They aim to be “the super-specialists in motoring and cycling, trusted by the nation… [offering] motoring services in a retail store, a garage, at home or at work.” The directors claim that the combination of 400 stores, 606 garages (tyres, batteries, MOTs, exhausts, etc) and a mobile van provision to service cars and commercial vehicles at home/office/roadside means they can offer unrivalled amenity. The company has 181 vans aimed at consumers called Halfords Mobile Expert vans. In addition, 68 vans are dedicated to mobile tyre fitting and another 192 vans are focused on helping businesses with their fleets (tyre fitting by the roadside, etc.). There are also four vans servicing cyclists. The complementary services offered from stores, garages and vans are all displayed on a single landing page at Halfords.com, offering the company potential opportunities to sell additional products and services from across the Group: “Online has played a pivotal role in our success over the last two years. Our website re-platform at the end of FY20 brought together three individual websites, enabling customers to see the full breadth and scope of our offer in one place. This has provided powerful synergies that have included increasing Halfords Retail customers’ awareness of Autocentres [garages] and facilitating cross shop through the ability to bundle cross-Group products and services into one basket. "The new web platform has also delivered tactical improvements to the customer shopping experience. Since launch, we have invested in [making it]….simpler to navigate for our customers. Whether this has been to support new customers into staycation products through guided selling, or finding a bike through our dynamic stock finder.” (2022 Prelims) The RETAIL Strategic Business Unit, SBU Retail accounts for about three-quarters of overall turnover, with very roughly half of that from selling cycling related goods and services and the other half from selling motoring stuff and fitting wiper blades in Halfords car parks, etc. Retail SBU statistics..... Halfords (LSE:HFD), best known for bicycle and car part sales, also has a very large service business (tyres, exhausts, batteries, MOTs, etc.). With its recent acquisition of National Tyres and Autocare managing 239 garages and Universal (20 sites) adding to its existing Autocentres, Halfords is now the largest or second largest along with KwikFit, both with slightly over 600 garages in UK and Ireland. It’s shares have fallen from over £5 in 2016 to £1.70 (MCap = £1.70 x 218.9 shares = £372m) on fears of a major retail recession and because Halfords has not raised it’s EPS in ten years. The current year’s earnings are expected to be 26p, slightly less than in 2013. The question is: even with an assumption of no growth in earnings in the future would I be happy to hold Halford’s shares through the next decade and more? In other words, once the current recession has been withstood, is there assurity that Halfords will come through with earnings in future at least the same as its average for past years, i.e. 27.3p per share? If so, that would put the shares on a PER of 170p/27.3p = 6.2. If there is no growth in revenue presumably these earnings will flow through to shareholders (there is no need for incremental capex and WC investment), giving a 16% yield on investment. And then there is the possibility of earnings rising given the strategic strengths of the business, or merely because of inflation. In which case, the valuation estimate rises considerably. Earnings and dividends..... ....A new team of directors took over in 2018. Since then there has been significant divergence between the statutory reported EPS and the one the directors prefer you to look at, the “underlying”. Guess which metric is used to trigger their bonuses. I’ve looked at some of the costs they exclude to calculate “underlying” EPS – most do not seem exceptional to me. So we’ll ignore the directors’ measure. With the average statutory EPS over ten years at 27.3p the cyclically adjusted price earnings ratio, CAPE, based on a ten year record is 170p/27.3p = 6.2, less than half that for UK shares generally. Dividends paid are around half of what they used to be at 9p per share. Even at this reduced level the dividend yield is 9p/170p = 5.8%. If they were push dividends back to say 17p, yield rises to 10%. Are they likely to maintain or increase the dividend? This company carries no bank debt and had £46.1m in cash i......... Following a strict caution-first value investing approach I sold a lot of shares before and during the first Covid wave. The pile of cash was very useful later in 2020 and 2021. The shares bought in those years have generally risen nicely – see first table. Since the start of 2022 I’ve sold out of a number of companies so as to have about 40% of the portfolio in cash – a comfort in these troubled times with potential for inflation-induced or war-induced recessions. Some of the cash is now invested in property abroad to give our family more options in a Putin-crazed world, but a goodly proportion will be looking for a home in deep value shares in a period of extreme flux after the market capitulation. A list of all the shares I bought in the Covid-19 crisis (Newsletters published at the time of each purchase set out my rationale for buying) Company Purchase date Purchase price Divs to 30 June 2022 Price 30 June 2022 Return to 30 June 2022 Smiths News (Connect Group) 18.3.20 £0.151 1.15p £0.336 130% Character 5.6.20 £2.52 20p £4.90 102% McCarthy & Stone 1.10.20 £0.718 0 Sold 7 Dec 2020 £1.185 65% Capital & Counties Properties 6.11.20 £1.032 0 Sold 19 Aug 2021 £1.743 69% Dewhurst “A” 11.11.20 £5.94 23.25p £5.10 -10% MS International 16.12.20 £1.292 10p Sold 20th Sept 2021 – 7th June 2022. £2.488 100% Wynnstay 29.12.20 £3.405 15p Sold 24Mar 2021 – 3 Feb 2022 £5.58 68% Lloyds Bank 12.3.21 £0.4169 2.57p £0.4237 8% J Smart 18.3.21 & 24.3.21 £1.253 3.22p Sold 7 Feb 2022 £1.575 28% Fletcher King Feb 2020 – May 2021 £0.3265 0.5p Sold Sept 2021 – Feb 2022 £0.40 24% Orchard Funding 7.6.21 £0.568 4p £0.53 0% Caffyns 22.6.21 £4.65 7.5p £5.00 9% Highcroft 22.7.21 £8.75 55p £10.30 24% Town Centre Sec 10.8.21 £1.426 1.75p Sold 2 Feb 2022 £1.581 12% bp 26.1.22 £4.006 8.5151p £3.87 -1% AVERAGE 42% Longer run performance Nine years ago that I left a tenured professorship to concentrate on investment. Back then the FTSE 100 was around 6,600. It is now 7,150 – a slow rise. In addition, there have been dividends of around 3% per year. I believe the numbers in the tables below show that I have outperformed, which is quite a relief given the salary and security sacrifice I made nine years ago. The tables display the results (so far) of all the purchases I’ve been writing about in my newsletters. The comments I made at the time explaining the rationale for each investment are available for you to read in older newsletters - there is nowhere for me to hide from my appraisals I made three, four or seven years ago – all the errors of omission and commission are there in broad daylight. I present the returns after taking the hit on broker costs, stamp duty and bid/offer spread. (Some of you have joined us recently so, in case you are not familiar with them, I briefly describe the criteria for my portfolios following the portfolio performance tables.) The 2013 Net Current Asset Value, NCAV, portfolio Company Purchase date Purchase price Divs to 30 June 2022 Price 30 June 2022 Return to 30 June 2022 French Con. 25.7.13 £0.3047 zero Sold July 2015 £0.4378 44% Caledonian T 25.7.13 £0.70 zero Sold April 2020 for £1.391 99% Fletcher King 6.8.13 £0.30 14.25p Sold June 2016 for 46p 101% Northamber 22.8.13 £0.287 1.6p Sold Oct 2016 £0.303 11% Titon 5.9.13 £0.379 6.5p Sold May 2016 £1.06 197% Mallett 12.11.13 £0.7682 12.7p Sold Nov 2014 £0.60 -5% AVERAGE 75% The 2014 NCAV portfolio Company Purchase date Purchase price Divs to 30 June 2022 Price 30 June 2022 Return to 30 June 2022 Holders Tech 10.10.14 & 3.11.14 £0.47 1p Sold March 2017 £0.33 -28% Airea 4.11.14 £0.1195 0.9p Sold Sept 2016 £0.309 166% Northamber 17.11.14 £0.4265 0.7p Sold Oct 2016 £0.303 -27% Caledonian T 30.12.14 £1.39 zero Sold April 2020 £1.391 0 AVERAGE 28% The 2015 NCAV portfolio Company Purchase date Purchase price Divs to 30 June 2022 Price 30 June 2022 Return to 30 June 2022 PV Crystalox 15.1.15 £0.122 zero Sold Dec 2016 £0.237 94% Arden Partners 1.9.15 £0.422 1p Sold May 2018 £0.364 -11% Northamber 4.9.15 £0.443 0.4p Sold Dec 2016 £0.303 -31% AVERAGE 17% The Buffett-style portfolio This type of share is rarer than the others, and so I combine all years. Company Purchase date Purchase price Divs to 30 June 2022 Price 30 June 2022 Return to 30 June 2022 Dewhurst 9.4.14 £3.18 70.5p Sold February 2020 £7.217 149% MS International 9.10.19 £1.723 13.50p Sold 20th Sept 2021 – 7th June 2022. £2.488 52% Character 20.1.20 & 5.6.20 £2.811 28p £4.90 84% Dewhurst 11.11.20 £5.94 23.25p £5.10 -10% MS International 16.12.20 £1.292 10p Sold 20th Sept 2021 – 7th June 2022. £2.488 100% AVERAGE 75% (I bought some more of Dewhurst in June 2014 at £3.11, December 2014 at £3.75, November 2017 at £5.46, February 2019 at £5.54 and April 2019 at £5.64. These were sold Feb 2020). Modified price earnings ratio portfolio 2015/16 Company Purchase date Purchase price Divs to 30 June 2022 Price 30 June 2022 Return to 30 June 2022 Haynes 11.2.15 £1.159 33.5p Sold 2.10.19 £2.9175 181% AGA 11.3.15 £1.002 zero Taken over June 2015 £1.456 45% Hogg Robinson 10.4.15 £0.4709 2.37p Sold June 2016 £0.656 44% MS International 3.7.15 £1.86 46p Sold 20th Sept 2021 – 7th June 2022. £2.488 58% BHP Billiton 24.9.15 £10.43 127p Sold May 2018 £16.90 74% TClarke 5.11.15 £0.7916 13.61p Sold Feb 2020 £1.1215 59% Premier Farnell 8.4.16 £1.222 3.6p Taken over 20.6.16 £1.632 36% AVERAGE 71% The AGA holding was doubled 30 April 2015 at a price of £0.9466. Modified price earnings ratio portfolio 2017 Company Purchase date Purchase price Divs to 30 June 2022 Price 30 June 2022 Return to 30 June 2022 Braemar 28.6.17 £2.848 20p Sold June 2018 £2.639 0% Caffyns 10.8.17 £5.012 52.5p Sold July 2020 £2.389 -42% Connect/Smiths News 27.9.17 £1.046 11.95p £0.336 -56% MS International 14.11.17 £1.84 30p Sold 20th Sept 2021 – 7th June 2022. £2.488 52% AVERAGE -12% The 2017/18/19 NCAV portfolio Purchase date Purchase price Divs to 30 June 2022 Price 30 June 2022 Return to 30 June 2022 Caledonian Trust 7.11.17 £1.23 zero Sold April 2020 £1.391 13% J Smart 30.1.19 £1.13 4.14p Sold Mar/Apr 2020 £1.101 1% Northamber 6.12.19 £0.504 0.3p Sold Mar 2020 £0.5717 14% AVERAGE 9% More Caledonian Trust shares bought in February 2019 at £2.29. More J Smart bought 30.4.19 at £1.16 The 2018/2019 modified price-earnings ratio portfolio Purchase date Purchase price Divs to 30 June 2022 Price 30 June 2022 Return to 30 June 2022 Connect/Smiths News 14.6.18 £0.285 5.25p £0.336 36% N Brown 17.8.18 £1.42 9.93p Sold Sept 2021 £0.557 -54% Spaceandpeople 31.10.18 £0.224 0.5p Sold Dec 2020 £0.128 -43% Tandem 2.4.19 £1.59 9.49p Sold Aug 2020 £3.707 139% MS International 6.6.19 £2.22 20p Sold 20th Sept 2021 – 7th June 2022. £2.488 21% Character 25.10.19 £3.506 33p £4.90 49% AVERAGE 25% More Connect Group shares bought in February 2019 at 40.86p, March 2019 at 38.29p and May 2019 at 39p. More N Brown bought May 2019 at £1.30. The 2020/21/22 modified price-earnings ratio portfolio Purchase date Purchase price Divs to 30 June 2022 Price 30 June 2022 Return to 30 June 2022 Wynnstay 7.1.20 & 29.12.20 £3.33 29p Sold 24Mar 2021 – 3 Feb 2022 £5.58 76% Daejan 5.2.20 £52.90 zero Sold 21 Feb 2020 £79.41 50% Connect/Smiths News 18.3.20 £0.151 1.15p £0.336 130% Lloyds Bank 12.3.21 £0.4169 2.57p £0.4237 8% bp 26.1.22 £4.006 8.5151p £3.87 -1% AVERAGE 53% The 2020/21 NCAV portfolio Purchase date Purchase price Divs to 30 June 2022 Price 30 June 2022 Return to 30 June 2022 McCarthy & Stone 1.10.20 £0.718 0 Sold Dec 2020 118.5p 65% Capital & Counties Properties 6.11.20 £1.032 0 Sold 19 Aug 2021 £1.743 69% J Smart 18.3.21 & 24.3.21 £1.253 3.22p Sold 7 Feb 2022 £1.575 28% Fletcher King Feb 20 – May 2021 £0.3265 0.5p Sold Sept 2021 – Feb 2022 £0.40 24% Orchard Funding 7.6.21 £0.568 4p £0.53 0% Caffyns 22.6.21 £4.65 7.5p £5.00 9% Highcroft 22.7.21 £8.75 55p £10.30 24% Town Centre Securities 10.8.21 £1.426 1.75p Sold 2 Feb 2022 £1.581 12% AVERAGE 29% The return reversal portfolio Purchase date Purchase price Divs to 30 June 2022 Price 30 June 2022 Return to 30 June 2022 Havelock Europa 20.5.15 £0.14609 zero Sold Dec 2016 £0.0915 -37% AVERAGE -37% Brief description of criteria for the portfolios Shares are allocated to portfolios designed around ideas flowing from research conducted when my PhD students and I asked the question “what works in investment?” These investigations were often inspired by the ideas of great investors such as Benjamin Graham. More detail on these ideas is presented in earlier posts (if you put key words into the search box those Newsletters will appear). Net current asset value, NCAV, criteria
Return reversal
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Glen ArnoldI'm a full-time investor running my portfolio. I invest other people's money into the same shares I hold under the Managed Portfolio Service at Henry Spain. Each of my client's individual accounts is invested in roughly the same proportions as my "Model Portfolio" for which we charge 1.2% + VAT per year. If you would like to join us contact [email protected] investing is about making the right decisions, not many decisions.
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