Have I changed my view of Myer’s float?

Have I changed my view of Myer’s float?

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