Consumer discretionary

“Roger, would you buy Nick Scali (NCK) over the likes of TRS, ORL and JBH?” This last week, its been a frequently asked question.

Let me start by saying that I consider Nick Scali to be a high quality business. While the business listed in May 2004, I have run my ruler over the business financials since the year 2001. In every single year its been an A-Class company and an A1 in most. This is impressive. Few businesses have such an excellent track record, which speaks highly of management.

Indeed, given my tough quality and performance criteria, NCK would be in the top 5% of all companies listed on the ASX.

But are high quality financials and a good track record of performance enough to justify buying a business?

Let’s consider the businesses of NCK and The Reject Shop – another high quality retailer.

NCK is engaged in sourcing and retailing of household furniture and related accessories. The Company’s product portfolio includes chairs, lounges, outdoor, dining, entertainment  – what are called ‘big-ticket’ items as well as and furniture care products. It has 28 showrooms located in New South Wales, Victoria, Queensland and South Australia under the Nick Scali brand, and additional showrooms in Adelaide under the Scali Living and Scali Leather brand.

TRS on the other hand is engaged in discount variety retailing. Its footprint of around 187 ‘convenience’ stores is focused on low price points, offering a wide variety of merchandise. Stores are spread throughout Australia.

TRS has an exceptional history of quality and performance, and in that respect is not dissimilar to NCK.

While NCK and TRS both have top tier fundamentals, there is one major difference; their business models. And this is the important difference that puts TRS far ahead of NCK in my mind from an investor’s perspective.

Consider the economic cycle and the impact it could have on each business; NCK is a retailer of ‘big ticket’ items and TRS is a retailer of ‘low price point items’. Cast your mind back just a few years to when the stock market was crashing, and depression talk filled the media. Do you think spending on big-ticket items like a sofa or a $2 tube of parallel imported toothpaste selling at a cheaper price than a major supermarket, would have been reined in first? This is where TRS offers arguably a more stable and slow-changing revenue stream. TRS of course has its own issues and risks, just as any business has, but the stability of earnings is perhaps superior to that offered by NCK.

TRS has positioned itself as providing ‘low price points’ on everyday goods. Things you always need – daily essentials. I’m guessing you wouldn’t stop brushing your teeth, even during a credit crunch, but you may defer the purchase of that new sofa or outdoor furniture. TRS gets you in by offering really low prices on the daily essentials and then tempts you to fill your basket with other cheap items that have a higher margin for the retailer.

The problem for investors deciding between TRS and NCK is therefore not the quality of each business – they are both very high quality and have excellent management teams – it lies in the cyclical nature of NCK’s earnings.

After determining the quality and risks for a business, the next step is determining its intrinsic values. If you don’t complete this step, you are not investing, you are speculating.

Now to me, investing in a business like TRS is a fairly straight-forward decision. An investment decision in NCK on the other hand requires much more thought about consumer sentiment toward big-ticket discretionary purchases and how susceptible leveraged households are to increases in interest rates. Buffett once said find the one-foot hurdles that you can step over.

I’m not saying I would never buy shares in NCK. There is always a time and a price at which even a cyclical business is cheap, provided its of the highest quality of course.  I just prefer to stick to the one-foot hurdles rather than trying to jump over seven footers.

I’m off to brush my teeth. Don’t forget to leave your thoughts.

Posted by Roger Montgomery, 5 June 2010.

by Roger Montgomery Posted in Companies, Consumer discretionary.

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Fifteen months ago I was shouting it from the rooftops; “we will look back on this time as one of rare opportunity”.  Since then, and as the All Ordinaries Accumulation Index rallied 61 per cent, there has been a fall in my enthusiasm for the acquisition of stocks.

Now, let me make it very clear that I have no idea where the market is going, nor the economy. I have always said you should never forego the opportunity to buy great businesses because of short-term concerns about those things. Even my posts earlier this year about concerns of a property bubble in China need to be read in conjunction with more recent reports by the IMF that there is no bubble in China. Take your pick!

My reluctance to buy shares today in any serious volume comes not from concerns about the market falling, or that China will cause an almighty slump in the values (and prices) of our mining giants. It comes from the fact that there is simply not that many great A1 businesses left that are cheap.

So here’s a quick list of companies that do make the grade for you to go and research, seek advice on, and on which to obtain 2^nd, 3^rd and 7^th opinions.

* Note: Valuations shown are those based on analyst forecasts and a continuation of the average performance of the past.

In addition to these companies, investors keen to have a look at some lesser-known businesses, that on first blush present some attractive numbers, could research the list below. I have not conducted any in-depth analysis of these companies, but my initial searches and scans are suggesting at least a second look (I have put any warnings or special considerations in parentheses).

• CogState (never made a profit until 2009)
• Cash Convertors (declining ROE forecast)
• Slater&Gordon (lumpy earnings profile)
• ITX (trying to identify the competitive advantage)
• Forge (Clough got a bargain now 31% owner and a blocking stake)
• Decmil (only made a profit in last 2 years and price up 10-fold)
• United Overseas Australia (property developer).

What are some of the things to look at and questions to ask?

• Is there an identifiable competitive advantage?
• Can the businesses be a lot bigger in five, ten, twenty years from now?
• Is present performance likely to continue?
• What could emerge from an external force, or from within the company, to see current high rates of return on equity drop? For example, could a competitor or customer have an effect or are there any weak links in the balance sheets of these companies?

Of course I invite you again – as I did in last week’s post entitled “What do you know?” – to offer any insights (good, bad or in-between) that you have about these or any other company you know something about, or even about the industry you work in.

Posted by Roger Montgomery, 4 May 2010

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Heading into Easter, I received an enormous pile of valuation requests and while many were little mining explorers burning through $500,000 of cash per month and with just $3 million in the bank, quite a few were solid companies that hadn’t been covered before.

And to confess, some of the requests were quite rightly keeping me accountable and making sure I post the company valuations I said I would, when I have appeared on Sky Business with either Nina May, Ricardo Goncalves and Peter Switzer.

What are they, I hear you ask? Forge Group (FGE), Grange Resources (GRR), Arrow Energy (AOE), Cabcharge (CAB), Coca Cola (CCL), Data 3 (DTL), Hutchison (HTA), Incitec Pivot (IPL), Metcash (MTS), Sedgeman (SDM) and UXC (UXC)

I am really impressed by the frequency with which I am now receiving emails containing insights I didn’t know about companies that I have covered.

As a fund manager it was not unusual for me to adopt Phil Fisher’s ‘scuttlebutt’ approach to investing. By way of background, Warren Buffett has previously described his approach to investing as 85 per cent Ben Graham and 15 per cent Phil Fisher. Fisher advocated scuttlebutt – talking to staff, to customers and to competitors.  I did the same and would often end my interview of a company’s CEO or CFO with I’d learned from reading Lynch; “if I handed you a gun with one silver bullet, which one of your competitors would you get rid of?” The answers were always revealing. Sometimes I would get; “there’s noone worth wasting a silver bullet on”, but most of the time, I would find out a lot more about the competitive landscape than I had bargained for. Occasionally, I would learn that there was another company I really should be researching.

Back to your insights, they are amazing. Now you know why I enjoy sharing my own insights and valuations with you as much as I enjoy the process of investing.

One thought for you; Many of you are sending your best work via email. I would really like to see everyone benefit from the knowledge and experiences you all have so hit reply and if you have some insights (as opposed to an opinion), just click on ‘REPLY’ at the bottom of this post and leave as much information as you would like.

So here are a few more valuations to ponder over Easter. I hope they add another dimension to your research. And before you go calling me about coal seam gas hopeful Arrow Energy, note that the valuation is a 2009 valuation based on actual results. The forecasts for Arrow for the next two years are for losses, and using my model, a company earning nothing is worth nothing. Of course Royal Dutch Shell and Petro China think its worth more and perhaps to them it is, but as a going concern its worth a lot less for some time to a passive investor.

I hope you are enjoying the Easter break and look forward to reading and replying to your insights.

Posted by Roger Montgomery, 1 April 2010

by Roger Montgomery Posted in Companies, Consumer discretionary, Health Care, Insightful Insights.

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Woolworths reported its first half 2010 results in recent weeks and the 17 per cent decline in the share price ahead of the result suggested investors may have been betting that the company was giving up ground to a revitalised Coles story. The price of Wesfarmers shares – being almost double their intrinsic value – certainly suggests enthusiasm for the latter company’s story.

Studying the results and the company however suggests any pessimism is unfounded and premature.

When I study JBH’s results there’s evidence of a classic profit loop. Cut prices to the customer, generate more sales, invest in systems and take advantage of greater buying power, invest savings in lower prices and do it again. Entrench the competitive advantage.

It would be obvious to expect Woolworths, with its history of management ties to Wal-Mart (who also engages the profit-loop) to be producing the same story, however WOW is flagging an arguably stronger position.

Where JBH’s gross profit margin keeps declining and net profit margin rising, Woolworths’ gross margin has increased every year since 2005. Revenues were 4.2% higher and gross profits rose by 6.5% in the latest half year result. Like JBH, WOW’s EBIT growth was stronger at 11%. As analysts we are mystified as to what is driving the increase in gross profit margins but standing back, you realise its a really good thing; if analysts cannot work it out then perhaps neither can the competitors and that’s good for maintaining a competitive advantage.  Competitors cannot replicate something if they don’t know how its produced.

Woolworths competitive advantage – an important driver of sustainably high rates of return on equity (I expect them to average 27% for the next three years – subject to change of course at any time and without warning or notification afterwards) – is its scale and its total dominance, ownership of and class leadership in supply-chain management.  The result is that a small increase in revenue even if due to inflation, results in a leveraged impact on profits.

From a cash flow perspective the other fascinating thing is the negative working capital. To those new to investing, working capital is typically an investment for a company; a business orders its products from a supplier, pays on 30 days terms and then spends the next few months selling the product it sells. If its takes a long time to sell the product and the customer takes time to pay, then there is an adverse impact on cash flow because the business is forking out cash today and not getting paid for some weeks or months.

In Woolworths case, as you might expect, the company is so strong and its buying power so dominant that it can dictate terms to its suppliers, making sure they deliver the right quantities at the right time. It can pay them when it likes and perhaps even pay them AFTER it sells the goods to consumers who buy with a debit, cash or credit card, which means Woolworths gets its money from its sales activity immediately. The difference of course can be invested.This virtuous cycle is highlighted by a negative number for working capital (WC = Inventory – Trade Payables + receivables – other creditors) which in Woolworth’s case, got even more negative! Don’t go rushing out and buying the shares because of this fact – its well known to the market and suppliers (who no doubt resent the company’s powerful market position). In the latest result, it was also attributable to timing differences in creditor payments.

The steep decline in the share price ahead of the company’s first half results suggests that many investors and analysts may have considered the company “ex-growth” and favoured Wesfarmers. Given the relative performances and valuations, this is likely to prove to be a mistake (more about that in a moment).

The company still has a lot of room to substantially increase sales and profits and the disbelief in this regard reminds me of the decade after decade in which analysts said Coca-Cola couldn’t grow anymore.

It would take a very almost illegally-informed and dedicated analyst to reach the conclusion that the company cannot continue to enlarge its coffers from further improvements to its overseas buying capability, its private label sales (both admittedly to the detriment of many smaller local owners of branded products) or its supply chain management. There’s also growth from acquisitions (speculative and don’t ever base a purchase on it), the Everyday Rewards loyalty card program and the hardware rollout (it will interesting to find out what they think their USP is).

While it will be interesting to find out what has been driving the competitor Wesfarmers sales numbers (basket size of more customers), the fact remains that it is premature to write off Woolworths. Many analysts will also be concerned about retailers cycling (comparing sales and profits to previous results) the fiscal stimulus, this is simply a short-term distraction and does not have anything to do with the long-term value of the company.

On that front, my calculated intrinsic value for Woolworths has risen every year for the last decade. When Buffett says he’s looking for companies with a “demonstrated track record of earnings power”, its because it translates to rising valuations. Woolworths was worth $2.39 in 2000. Intrinsic value rose to $14.84 in 2005 and $25.70 in 2009. Today’s value of $25.80 is expected to rise to $28.00 in 2011 and almost $30 in 2012.

The current price of $28.05 is therefore now equivalent to the valuation 15 months out and the February low prices are perhaps a better reflection of the current valuation that I have.

I have rarely been able to buy Woolworths at any significant discount to intrinsic value in the last decade and while I don’t know what the price will do next, I do know that irrespective of whether Woolworths offers lower prices in the supermarket or the share market, you would be ill advised to ignore them.

Please be reminded that my valuations for the future are based on analyst expectations, which can change at any time.

Posted by Roger Montgomery, 8 March 2010.

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I have just completed a phone interview with Ross Greenwood on his Money News program at radio station 2GB.  He was interviewing me and Patrick Elliott, the Chairman of JB Hi-Fi following todays result.  As you have all probably noticed, the half year result was excellent but JBH has traditionally exceed the market’s expectations for earnings and sales growth.  Today’s interim FY10 profit was up 29% on sales growth of 19%, and while it was at the upper end of expectations – it didn’t exceed those expectations.  Believe it or not, the result will be downward revisions to analysts future estimates.

The share price decline today – it was down 6.5% at one stage – to be down 5.1% at $19.07 per share, was partly the result of the ‘voting’ machine saying; “the growth is not going to be as high as we envisaged” but probably to a greater extent, it was due to the fact that Richard Uechtritz announced his retirement in “July/August”.

Having grown revenues in ten years from $145 million to $2.8 billion, the resignation of Richard is a blow to the company.  But as my restaurant owner friend says; “revenue is vanity, profit is sanity” and the new CEO will be no slouch.  Terry Smart joined JBH when Richard did, as part of the private equity funded management buy in.  They’ve all made millions and plenty of Terry’s money remains invested.

The changeover reminds me of the retirement of one of Australia’s retailing legends, Barry Saunders, from the Reject Shop.  He handed the reins over to Jerry Masters and Jerry continued to grow and expand The Reject Shop.  Jerry was an outsider and arguably not the first choice.  Terry is a JB Hi-Fi insider and remember my comments that the business boat you get into is far more important than who is rowing it.  I think you will find that with 210 identified stores and 140 likely to be rolled out by the end of 2010, there is still plenty of room for growth.  More over, Richard’s resignation is similar to The Reject Shop in one important way; neither Barry nor Richard departed to compete. Richard, like Barry will remain a consultant and Richard on the board.

But unfortunately, it is not growth that determines intrinsic value.  Its the return on equity, the payout ratio and the equity itself that determines whether the value continues to rise.  The big news on this front is that the dividend payout ratio continues to rise.  Now at 60%, the increased dividend is a classic response by the board to a business that is generating cash faster than it can use it.  But thats a shame because the company is generating 45% returns on its equity.  I would much prefer they kept the money – prepay some leases and get a discount (get the contingent liabilities down) – than hand it to me as a dividend.  The best I can do with it is perhaps 8% in a 5 year term deposit.  Not bad, but not 45%.

The result of not employing as much retained earnings at 45% is that the intrinsic value declines.  Its still going up but not as much.  The conservative intrinsic value before this result was about $20.30.  Now it is $19.30.  The intrinsic value next year falls from $24.14 to $22.50 and the year after from $29-ish to $26-ish.  So where previously we were looking at a rise to the $30 area for intrinsic value by 2012, it now seems the value will be at best $26.50.

The sole reason for the change to intrinsic value is the increase in the payout ratio. More dividends means less profits being retained in the business, earning more than 45%.  Now don’t get me wrong, this is still an amazing business – one of the best and intrinsic value is still forecast to rise by a compounded 16.3% per annum over the next 2 years or so.  To get really excited however, you now want a bigger discount to the current intrinsic value.

Posted by Roger Montgomery, 8 February 2010

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From the beginning of September last year, I warned investors about the pricing of the Myer float.  If you read The Australian newspaper, watched or listened to the ABC or read the Sydney Morning Herald or Alan Kohler’s Eureka Report you couldn’t have missed the warning.  On the 28th of September, using the valuation formula I have been explaining for some time and which I detail in the forthcoming book, I wrote:

“The current owners, including TPG and the Myer family, plan on raising $1.9b to $2.8b to exit the business. (Yes, the Myer family indicate on Page 33 that they may sell 100% of their shares).

$315 million will be used to pay down debt and $100 million odd are frictional costs associated with the float. The rest will go to Private Equity and the Myer Family.

Upon listing, the business will trade with a market capitalisation of somewhere between $2,282m and $2,768m.

What, however, is the business worth?

With all the relevant data to value the business now available and using the pro-forma accounts supplied in the prospectus, I value the company at between $2.67 and $2.78, substantially below the $3.90 to $4.90 being requested. It appears to me that the float favours existing shareholders rather than new investors.

Investing safely in the share market requires a wonderful business and a rational price. Myer is arguably now a much better business than it was, but the price being requested is even hotter than the cover.

By Roger Montgomery, 28 September 2009”

Then James Dunn  wrote an article for The Australian entitled Is the Myer Float a Dog?  (you can read the article and many others at http://rogermontgomery.com/media-room/in-the-press/ or by clicking MEDIA ROOM at the top right of this page and then selecting “IN THE PRESS”) In James’ article I was feeling a bit more generous toward Myer and gave it a valuation of $2.90.

Both institutional and private investors however willingly paid $4.10 to the vendors of Myer for their stake in the business and while this was at the lower end of the price range, the reality is that it was way above any sensible valuation of the company.  Indeed in one article I was quoted as saying that I thought the valuation would be $3.90 in five years time.  At the current price today of $3.14, shareholders have lost a total of $1.8 billion.  This was an easy loss to avoid but analysts who cover the stock don’t use a valuation model based on Equity, Return on Equity and the payout ratio.  Instead they looked at the $41.0 float price and compared the resultant P/E to that of DJ’s and concluded the lower P/E of Myer meant it was cheap.  But what if DJ’s higher P/E was too high to begin with?  What if it was the result of short term fashion or enthusiasm for something that didn’t eventuate.  What if the promoters of the Myer float were buying DJ’s shares (or borrowing stocks to take it away from short sellers) to make the P/E of DJ’s higher? Then the P/E of both would decline.

Professional analysts get paid more than us and yet, their expertise in the case of Myer has currently cost their clients $1.8 billion in aggregate.  Now, they will point to the turn down of the broader market, a change in sentiment towards retailers – things they cannot control, but Myer’s 23% decline since it listed on November 2, exceeds the All Ordinaries Index decline of 1/3rd of 1% and the 20 cent decline (less than 1%) of other (preferred by me) retailers such as JB Hi-Fi.

Investors thinking about buying Myer now, because 1) the shares have fallen so far or 2) have underperformed by so much, need to keep in mind that such reasons are purely based on price and therefore will result in financial pain and suffering.  You must think about value not price.  My earlier posts and analysis reveals that Myer’s valuation should rise to $3.90 in 5 years time.  This change is equivalent to a 4.4% compounded annual return which is not high enough – given the risk, compared to the 8% now on offer by some banks for 5 year term deposits.  In other words, Myer is still not cheap enough.

Posted by Roger Montgomery, 6 February 2010

Ps.  And don’t forget, if you have any questions or you have an experience at Myer you can share click the Leave a Comment button below.

by Roger Montgomery Posted in Consumer discretionary.

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Since early December Paul, Squigly, Steven and Darren have requested I value Westfield. WDC is also a popular stock with viewers of Nina May’s Your Money Your Call on the Sky Business Channel (you can watch highlights at my YouTube channel, just type ‘Westfield’ into the search feature), and rightly so. It’s a company run by three of the most capable men in the world and one whose shares I have owned in the past.

Today its price, according to a number of analysts and strategists, does not appear to have responded to expectations for an improvement in economic conditions in the US. The biggest gap between inventories and orders since the mid 70’s, the decline in housing inventory, the strong turnaround in cyclical indicators and the steep yield curve all suggest an acceleration in US economic growth – by the way if this doesn’t sound like me, you are right. I am just repeating what I have been reading.

I don’t subscribe to the view that it’s the job of the investor to allow macro economic forecasts to influence micro-based investment decisions.

If however the economists are right, and the US economic recovery does gain traction, then all that remains is a recovery in consumer confidence to see Westfield benefit. Of course if the US economic strength is sustained, then one suspects the US dollar will also recover, making Westfield’s profits more valuable in Australian dollar terms.

Those things aside, lets have a quick look at the valuation and take a dispassionate view about the price irrespective of whether others believe the price has or hasn’t responded to US growth expectations. continue…

by Roger Montgomery Posted in Companies, Consumer discretionary, Property.

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I had a call yesterday from one of my brokers (who also happens to have become a friend). He informed me that the restrictions have come off all the broker’s so that they are now able to write research about Myer. As you would expect so soon after its widely supported float (A float that lost money for the thousands of investors who sold out in the first weeks), the research has been predictably bullish. It is not however the views of the analysts that is interesting. What is interesting is the reference in several of the reports to a relative P/E. The argument goes that because Harvey Norman and David Jones have a higher P/E than Myer, that the gap should narrow and Myer’s P/E should rise, pulling the price up with it. See any weaknesses in the logic?

Its like saying that there’s a Ferrari and there’s a VW Combi and the VW combi will get faster because the Ferrari is too fast compared to it.  Clearly such conclusions are flawed.

The performance of management, the economics of businesses and their prospects all affect their values and the sentiment towards them, which in turn, affects prices in the short term.

Buffett has frequently said that academics where correct in observing the market was frequently efficient.  In other words, a lot of the time, the price is right and perhaps in the case of Myer it should be on a lower P/E than David Jones.  This post should be read in conjunction with my previous posts on Myer that discuss its intrinsic value.

Roger Montgomery, 10 December 2009.

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That is the question I have been asked by some investors. Putting aside the many individuals who have written to me to say they have recently had a less than encouraging shopping experience at Myer, meeting with disinterested casually employed staff, it seems there are those who are taking the current price as a signal that a $2.90 valuation is too conservative.

If ‘price’ is what you pay and ‘value’ is what you get, then your job as an investor is simply to pay a lower price than the value you receive. It is essential therefore that your valuation is completely independent of price.

When I bought JB Hi-Fi at $8.50, the valuation was much higher. When I bought Fleetwood at $3.50, the valuation was much higher. Had I taken my cue from the price of Fleetwood and JB Hi Fi, I would have been fearful that the price was correctly reflecting the possibility that the GFC would roll into something much more damaging.

The Myer valuation of $2.90 is based on the facts presented in the prospectus. The only subjective part of the valuation is the selection of the after tax Required Return. If I adopt a 12% required return I get a $2.85 valuation. At 11.5% the valuation is $2.99, at 11% is $3.19 and at 10% is $3.65. You can take your pick.

In any event, even an optimistic Required Return produces a valuation well below the current price and remember, you want to buy shares at big discounts to valuations. I adopt a policy of simply saying I want to buy the very best businesses when they are trading at substantial discounts to even the most conservative valuation. Compromising this standard in the attempt to generate more activity or valuations that are closer to the current price has the effect not of making you more money, but of making you more active!

By Roger Montgomery, 5 November 2009

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In short, the answer is no. Three years ago Myer was purchased from the Coles Myer Group by a private equity team called TPG/Newbridge. The Myer Family was also involved and together the consortium acquired Myer for $1.4 billion. The group used $400 million of their own money and borrowed the rest.

Before the first anniversary, a very long-term lease on Melbourne’s Bourke Street store was sold for about $600 million, and a clearance sale reduced inventory and netted $160 million. All this additional cash allowed the new owners to reduce debt, pay a dividend of almost $200 million and produced a capital return of $360 million. In other words, before the first year was out the owners had received all of their $400 million outlay back, and arranged a free ride on a business with $3 billion of revenue.

But as a participant in the upcoming float of Myer you are not being invited to pay $1.4 billion, which was 8.5 times the Earnings Before Interest and Tax (EBIT). You are being asked to stump up to $2.9 billion, or more than 11 times forecast EBIT. You are also being asked to replace the vendors as owners and while they know a lot about extracting maximum performance out of department stores, you don’t.

In estimating an intrinsic value for Myer, I have ignored the fact that the balance sheet includes $350 million of acquired goodwill as well as $128 million of capitalised software expenses. I will also ignore the addition of sales made by concession operators “to provide a more appropriate reference when assessing profitability measures relative to sales”, the removal of the incentive payments to retain key staff (not regarded as ongoing costs to the business), costs associated with the gifting of shares to employees and most interestingly, the reversal of a write-off (meaning it has been left in) of $21 million in capitalised interest costs; all regarded as non-recurring.

While ignoring these in my estimate of intrinsic value seems irresponsible, it merely means that whatever number is produced by the calculation, it is going to be higher than it really should be. That’s fine; I just have to ensure a larger margin of safety.

Taking a Net Profit After Tax figure for 2010 of $160 million and assuming a 75 per cent fully-franked dividend payout, I arrive at a return on equity of about 28 per cent on the stated equity of $738 million – equity that could have been higher after the float if $94 million in cash wasn’t also being taken out of retained profits. Using a 13 percent required return I get a valuation of $2.90.

Alternatively, I am buying $738 million of equity that is generating 28%. If I pay the $2.9 billion that is being asked for that equity, or 3.9 times, I have to divide the return on equity by 3.9 times, which produces a simple return on ‘my’ equity of 7.2 per cent. For ‘my’ money it’s just not high enough for the risk of being in the department store business.

And looking into the future, things don’t become dramatically more attractive either. Based on the numbers in the prospectus I estimate the value only rises by 6 per cent per year over the next five years and delivers a value in 2015 of $3.90 – the price being asked today.

In valuing Myer I am not predicting its price. Remember what Benjamin Graham said; In the short run the market is a voting machine.  Shares that are popular can go up a lot even if the value is much lower. In 1999 and 2000 Telstra’s value was less than $3.00 and yet the shares traded around $9.00 for a long time. But Ben Graham also said in the long run the market is a weighing machine. In the long run, Myer’s share price will reflect its value.

So no, I have not changed my view of Myer’s float.  I am going to pass on My piece of Myer.

By Roger Montgomery, 26 October 2009

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