Is this a Thorny Investment?

18 Comments

1. 

   David King
   June 28, 2012 at 5:54 am:

   Again my thanks to Roger for Value.able and all its timely wisdom. I wrote previously to report my view that the almost constant downside risks in the market since the GFC suggested to me that not only was there great wisdom in buying good companies at below intrinsic value, but that also, constant vigilance and reassessment was in order, and that in effect what we must do is to think and behave more like traders than long term investors. Hence my gratitude to Roger that I succeeded in spotting serious revisions in value in time to book healthy profits in, among others, FGE, MCE, ORL, TGA, MIN, RKN AND Acrux, when upside no longer looked likely. .

   When I last reported, I sensed a sniff of disapproval among those who felt long-term investing was the only worthwhile goal. Fair enough, but here’s my question. How many of the above once admired shiny stocks are you keen to buy right now? I’m not buying any, and they’re all (except ACR) available at prices much lower than I sold them for.

   Roger too has clearly, judiciously bought and sold for his private fund. His retail fund is bound to do well too, because a man who can pick good ‘uns and knows when they have matured, is headed for success. As for “blue chips”? For mine, they should be re-coloured red.

   • 

     Michael
     June 28, 2012 at 5:19 pm:

     If values are having to be frequently revised, you have to ask yourself if those companies are worthy of a long term investment. All the buying and selling makes you wonder what long term investing is. Over the time periods of these investments, sentiment plays a much greater role than intrinsic values.

     • 

       Roger Montgomery
       June 28, 2012 at 8:14 pm:

       Michael Horn writes:

       WARNING
       An Amateur’s Analysis of Thorn Group Australia (TGA)
       31 May 2012

       FURTHER Warning
       This report is not a recommendation of any sort. It is for educational purposes only. You must not conduct any transaction without first satisfying yourself that you have all the facts, and independently appraise the accuracy or otherwise of the statements made in this comment by Michael. The author may own securities in the company discussed. You must first seek and take personal professional advice.
       This report is not error free, and its views and opinions are peculiar to its author, for whom it was primarily written as a thought-consolidation exercise.

       Criticism and suggestions are welcome.

       Summary
       In essence, Thorn puts up cash, substantially by investing in rental inventory, that is returned at a profit via medium-term cash collection streams, and it re-invests the continually increasing proceeds in more collection streams, relying on its collections competence to minimise profit leakages. Thorn optimises performance by having good operational facilities, and by selecting niche markets where it can assume a dominant position. Thorn’s operational facilities, outlets network, business units and product lines are substantially there to grow profitable collections streams, and each of the four business units benefits from and contributes to the business as a whole.
       Thorn pays about half its net profit as dividends – retaining the other half to expand business without resorting to debt or capital raising. Acquiring National Credit Management Ltd (NCML) in March 2011 and the related capital raising that followed was atypical, and in the medium term similar decisions are unlikely, in my opinion.
       Core Competence – Collections
        Thorn’s core competence is “collections”. This covers assessing applicants seeking to commit to leases or to repay cash loans – and then ensuring that customers honour their commitments. NCML’s relatively small business of collecting from Purchased Debt Ledgers (PDLs) replaces the credit assessment step with a debt valuation step. Additional competences and strengths are covered under the Moats subheading later in this report.
       Core Facility – Cash to invest in CAPEX
       Thorn has the balance sheet strength and the cashflow predictability to handle CAPEX that is central to its modus operandi. Most of Thorn’s CAPEX is short-to-medium term, because it is continually contra posted to the trading accounts each time a customer makes a rental payment. The cost of items that Thorn supplies via finance leases do not remain in the balance sheet after delivery, because the items have been sold, not rented.
       Core Business Philosophy
       Thorn’s management is careful and centric – making extensions to its collections-focused business in measured steps that involve much thought, research, trials and slow roll-outs. New initiatives have always been variations to existing business, or complementary to them, or they utilise competencies (mainly collection ability) and facilities (mainly collections streams and systems pertaining to them, including the outlets network) that are central to the existing business. Thorn looks for niche markets where it can occupy a dominant position, because being careful, it avoids reducing profit margins by tangling with strong companies to defend/expand market share.
       Thorn’s balance sheet is conservative, its growth pattern is conservative, it spends carefully, it lends carefully, it chooses its products carefully, it buys carefully, and it manages its receivables and rented assets diligently – all of which occasion performance metrics that few ASX-listed stocks can match for consistent quality. Acquiring NCML was an out-of-pattern decision, and it has not met management’s expectations.
       Business Profile
       Referring to Thorn Group as a “rental” business is convenient, but misleading, as is classifying it as a retail business, or a financial services business – it’s a blend of these. The annual report for YE 31/03/2012 (FY2012) describes Thorn thus:“The principal activities of the consolidated entity during the course of the financial year were the renting and sale of browngoods [small appliances], whitegoods, PCs and furniture products, the provision of unsecured cash loans, equipment finance and the provision of receivables management services [via NCML].”
       In addition to the unit-by-unit information that follows, there is more unit-by-unit information in the next section headed Easy to Understand. Information that perhaps should be in one place – and which may be so treated in a later edition of this report.
       Radio Rentals/Rentlo
       Radio Rentals/Rentlo is a rent-to-own business, rather than being a pure rental and/or retail business, although retail sales (mainly via finance leases) occur, as does rental business where lessees do not intend owning items.
       Radio Rentals/Rentlo is Thorn’s core money-making unit (it generates about 90% of the profit). The Rentlo name is used in South Australia because the Radio Rentals name is owned by another firm in SA. Radio Rentals/Rentlo supplies: audio/visual devices like TVs and entertainment units; whitegoods; browngoods; furniture; PCs and laptops; and fitness equipment (a minor line).
       In FY2013 furniture performed exceptionally well, audio equipment well and whitegoods (particularly large units) satisfactorily, whereas installations of computers and flat panel TVs declined by 4% and 10% respectively. Ultrabooks were added to counter flagging demand for PCs, and discussions to introduce Apple products in H1 of FY2013 are in progress [as in May 2012]. Although TV sales have declined, direct importation of Thorn brand TVs has partly protected profitability – reputedly, to the tune of $800K in FY2012. Thorn brand flat panel TVs are now 42% of new installs. Outdoor furniture is under trial, as are nursery lines (cots, car seats, etc.). Thorn brand refrigerators were introduced in May 2012, which will improve margins.
       Thorn announced in the May 2012 presentation that it may add used vehicles to its products in FY2013. John Hughes said that Thorn would not hurl “bucket loads of money” at this initiative, so expect the idea to unfold in measured steps. The plan is for a 12-month rental period to qualify customers who will be offered finance leases to buy vehicles they have rented. Finance lease contracts typically do not have make-good provisions, so by procuring quality ex-fleet stock, Thorn will not be much burdened by make-good obligations if each rental contract only spans a year. This initiative may be handled by a unit other than Radio Rentals/Rentlo.
       Finance leases (ownership of items passes on delivery) are declining relative to operating leases, because sales of products like PCs and TVs that Thorn deems have a useful life of about three years are declining. Thorn’s handles short-useful-life products via 36-month finance leases, and hence they are treated as sales, not rentals.
       Although short-term rental occurs, most Radio Rentals/Rentlo contracts are 36-month leases [a presumption based on the fact that the average contract is 27 months]. The operating leases’ rent-to-own provision allows ownership to pass to the customer for an agreed payment at lease expiry – often a token $1 after a 36-month term. Thorn is considering being more flexible, and introducing 24-month and 48-month alternatives to its current 36-month contract period.
       Radio Rentals/Rentlo insists on customers paying via direct debit. Many lessees are on welfare benefits, and they often pay fortnightly via Centrepay. Many customers are Aborigines, particularly in rural areas where they are a larger proportion of the population.
       Thorn’s peripheral business units (detailed below) flow from the original Radio Rentals business, in that they supply either something different (like small loans) to the same demographic, or similar things to different demographics, or in NCML’s case, it offers services externally that utilise capabilities developed to support the Radio Rentals/Rentlo and Cashfirst units.
       Cashfirst
       In recent years Thorn has branched into advancing unsecured cash loans through Cashfirst. The maximum loan is $5,000, the average being $2,400 in FY2012. The dominant qualifying criterion is the applicant’s ability to service the repayments. 80% to 85% of applications are refused. I presume that this is because Cashfirst insists on repayments being made via direct debits, and the nature of the transaction does not qualify it to be covered by Centrepay. Cashfirst offers extensions at lower interest rates when customers have established a history of meeting their payment commitments.
       After a few “investment years”, when the business model and operational facilities were being put in place with Cashfirst on a leash, the unit delivered a small profit in FY2012. Currently, it is not an offering that the outlet network pushes. A general manager is mooted to be appointed in FY2013 as part of an expansion plan that will place Cashfirst as a product in a new Financial Services division, and new lending products will be developed to tap into different demographics, plus personal loans will be promoted to leverage Radio Rentals/Rentlo’s outlet network [comment made in May 2013 presentation].
       Thorn Business Services
       This unit, which handled TAB-related business, is now part of Thorn Equipment Finance.
       Thorn Equipment Finance
       Thorn Equipment Finance (TEF) is re-entering a line of business sold by Thorn’s previous private equity owner. TEF concentrates on sub-$100K leasing to businesses customers, because it is an under-serviced niche market in which the large lenders are disinterested. Larger deals would be flicked to a bank at a commission. The long-established TAB-related business is handled by a dedicated TEF team.
       Thorn’s long-established business with the TAB involved supplying and managing PCs and other items used by TAB agencies, which are often located in major pubs and clubs. TGA has expanded the business to include supplying poker machines and other items. It is unclear how much of the following business relates to pubs and clubs, and how much comes from unrelated new business. The May 2012 presentation slides have the item-category breakdown as follows:
       IT- – – – – – – – – – – – – – – 19% – – – – Printers & copiers – — – 11%
       Telephony – – – – – – – – – 15% – – – – Security – – – – – – – – – – – 9%
       Gaming – – – – — – – – – – 15% – – – – Point of sale – – – – – – – – 7%
       Commercial kitchen – – 13% – – – – Other – – – – – – – – – – – – 11%
       If selling to TAB franchisees works well, that suggests TEF could exploit other groups of franchisees needing equipment. TEF has a new GM, Anton Laval, in place, plus the finance/underwriting specialists to drive TEF forward while substantially being able to keep the cost of this team and its enabling infrastructure static. TEF will make a major long-term contribution to Thorn’s profitability.
       NCML
       Credit Management division is comprised of the NCML business that was acquired on 23 March 2011, augmented by “collection” facilities that Thorn already had. NCML provides receivables management, debt recovery, credit information services, debt purchasing and other financial services. Accounting and administration have been assumed into head-office functions, so NCML can focus on growing the business, which is where the NCML team’s skills and aptitudes are best deployed, and which is why the founder of NCML (in 1990), Brenton Glaister, was happy to assume the role of GM of NCML recently – Brenton has a penchant for business promotion, not business administration.
       The loss of the ATO debt management service is disappointing. Put this into perspective however – the total intangible value ascribed to the value of NCML’s “Customer Relationships” was $8,797K, which amortised over five years is $1,760K a year. This write-down will be repeated for the next four years. $8,797K divided by the shares outstanding equates to 6c a share, so the loss of the ATO as a customer would only be a fraction of that, albeit a large fraction, but still no more than TGA’s SP would bounce around on a normal trading day.
       The other significant intangible pertaining to NCML is goodwill, debited as $6,672K after $7,030K was contra posted to deferred tax ($5,525K remaining as at 30/03/2012), which will help cashflow in FY2013. The $6,672K goodwill is monitored periodically, and if NCML were thought to be declining in profitability, it could be written down. For now the growth for the next five years was considered to be sufficient to leave that goodwill at $6,672K.
       The debt purchasing percentage of NCML is not large, and neither is it a must-do, so neither the dearth of PDL (Purchased Debt Ledgers) acquisitions nor the potential for them to be an unwelcome cash drain should be exaggerated. 75% of NCML’s profit comes from collections for a fee, which requires a tiny balance sheet investment, and it calls for expertise and aptitudes that are the nub of Thorn’s core competence. If NCML were to buy PDLs, the expectation is that it will require an investment of between $8M and $10M, which John Hughes referred to as “small”.
       NCML has disappointed Thorn’s management. In my opinion this will conduce management to growing Thorn organically in future (unless a bolt-on opportunity arises that is a no-brainer).
       Easy to Understand
       Thorn is easy to understand, provided one: a) reads its annual reports and presentations; b) understands the different business units, their relative size, how units complement each other; and c) one understands the rental revenue recognition and rental assets accounting for products delivered to customers pursuant to operating leases, because accounting treatment of rentals can mask the benefits of growth, or the negative impact of slowdown.
       Always understand that Thorn is fundamentally in the collections business, and that its business units exist to create income streams to be collected at a profit.
       Relative Significance of Business Units
       The following table for FY2012 gives an idea of the dominance of Radio Rentals/Rentlo (Rentals Segment) relative to NCML (Credit Management Segment) relative to Cashfirst and Thorn Equipment Finance (Other). Corporate overheads are lumped into “ Other”, which explains the disproportionate level of assets listed under “Other”.
       – – – – – – – – – Rental – – Credit Management – – Other – – Consolidated
       Revenue – 157,817 – – – – – – – 21,128 – – – – – – – 8,987 – — – 187,932
       EBIT – – – – – 45,071 – – – – – – – – 2,017 – – – – – – – 1,654 – – – – 48,742
       CAPEX – – – 56,433 – – – — – – – – – 233 – – — – – – – – – – – – – – – 56,666 (mainly rental items)
       Assets – – – 141,516 – – – – – – – 16,040 – – – – – – 27,733 – – – 185,289
       Liabilities – (42,930) – – – – – – – (2,148) – – – – – – – – – – – – – – (45,078)

       Radio Rentals/Rentlo
       The main cash/profit generating engine is the Radio Rentals/Rentlo unit. Until recently, and substantially it is still the case, understanding that unit sufficed to understand Thorn.
       Radio Rentals/Rentlo substantially supplies items via either finance leases or operating leases, and the discerning point is their deemed useful life. If the useful life is short (36 months or less), a finance lease is used. Customers and in-shop staff probably do not see much difference between the two lease types, but the accounting treatment is significant (covered later in this section).
       Some lessees do not intend owning rented items – for example: a) hiring an exercise bike for a period following knee surgery; b) companies fitting out temporary accommodation for employees; c) foreign students who might not want the inconvenience of selling items when they return home; and c) landlords hiring white goods for rental properties in order to shift the make-good responsibility to Thorn. The customer demographic is different to the one underpinning the bulk of Radio Rentals/Rentlo’s business.
       The large proportion of Radio Rentals/Rentlo business is with people on welfare benefits, and many of these pay via Centrelink’s Centrepay facility. This population tends to have no mortgages, a steady inflow of welfare benefits, low propensity to save and above average sized families, which is why large-size whitegoods are popular. Defaults by welfare recipients tends to be lower than for other customers. A country outlet contacted ventured that 80%+ of its customers paid via Centrepay, and that 70%+ were Aborigines – a profile that would be different in city-based stores, but only relatively different.
       Cashfirst
       Cashfirst makes unsecured personal loans in the $1,000 to $5,000 range. Thorn Group entered it because many customers used Thorn as a reference when applying for loans elsewhere, so it was a simple decision for Thorn to lend the money itself. Only 15% to 20% of applicants are approved, and the average loan is $2,400. Currently Cashfirst appears to occupy near-zero mind-space of outlet staff, but the May 2012 presentation mentioned that the outlet network is a growth opportunity. The appointment of a GM should see the loans business pushed more aggressively in the network, and new products created for different demographics.
       Thorn Equipment Finance (TEF)
       TEF is not too different to Thorn’s major business – except the demographic is small firms, rather than individuals. The leases are predominantly operating leases.
       NCML
       John Hughes said that 75% of NCML’s profit came from “collections” a business on which he is keen, and 25% from PDLs. Selling debtor management as a service to large organisations is easy to understand, and the skillsets and backoffice facilities were similar to what Thorn had in place to service its own business, as upgraded to handle Cashfirst. Buying PDLs and collecting the money is also easy to understand.
       Accounting Treatment
       The following accounting matters need to be understood when analysing Thorn:
        Sales metrics are misleading, so ignore them, because they do not include the bulk of Thorn’s revenue. Operating lease business is not recorded as sales, and neither are interest and collection fees. Technology products usually handled via finance leases that record as sales are in decline, and Thorn has quit the Big Brown Box retail unit, so sales have declined. Thorn’s profits have increased due to the growth of so-called rental business transacted via operating leases. Because “sales” are not as relevant to Thorn, various sales related measures and comparisons should be ignored, or read with caution – examples of which are the following ratios: a) cost of goods sold to sales; b) sales and marketing expenses to sales; c) EBIT to sales; d) profit before tax to sales; and e) profit after tax to sales.
        Capital expenditure for rental items under operating leases can be thought of as “operating” CAPEX, considering that it borders on being an expense because it is written off so quickly (usually within three years). This is significantly unlike capital expenditure for items with useful lives that can run into decades. Rental assets are capitalised at cost – much less than the NPV of their contracted collectibles, which adds to the conservatism of the balance sheet.
       In the FY2012 results presentation, John Hughes emphasised that operating leases make just as much profit as finance leases, except that the revenue recognition is delayed, and in his view this is a more honest reflection of reality. Factor this into your thinking – slower EPS growth in FY2012 in part flows from a revenue recognition convention, which shifts much of the revenue and profit into later reporting periods.
       Historical Trajectories
       Radio Rentals was started in 1937, so the business unit that generates most of the profit has been around for a long time. Annual reports that that predate the December 2006 float can be seen in Thorn’s website, but the impact of shares issued in the float was so great that they are not worth examining to relate to current per-share metrics. For the curious, the float prospectus can be found at https://www.rbsmorgans.com/download.cfm?DownloadFile=08E92ECE-0601-BE05-6B2DE782EC0D2E5B ).
       Revenue growth is not useful, because the recent rights issue to pay for acquiring NCML has diluted the shares. EPS history tells the relevant growth story, and ROE and ROCE (return on capital employed, which is EBIT/(Total Assets – Current Liabilities) tells a good profitability story. Even ROE gives the wrong impression in a capital-raising year like FY2012, because it uses the year-end equity.
       Morning Star’s metrics commence in FY2007, and analysts and black-box share valuations tend to mirror Morning Star’s EPS metrics, so I will do likewise. However, I’ll adjust shareholder numbers for 2007, which then flows to EPS, and it makes a large difference to the 5-year EPS compounded average growth (CAGR). The tedium explaining why I reject the 2007 Morning Star EPS can be found in Addendum ‘A’, which concludes that this analysis will use 5.1 cents for the diluted EPS of YE 30/03/07, and 19c for YE 30/03/2012, a CAGR of 30%.
       YE 30/3/07 – YE 30/3/08 – YE 30/3/09 – YE 30/3/10 -YE 30/3/11 – YE 30/3/12
       5.1c 8.3c 9.4c 14.9c 16.7c 19.0c
       In FY2012 $1,760K of the value of the NCML’s “Customer Relationships” was amortised, which is 1.2c of the EPS. A similar value will be amortised for another four years, because management has decided to amortise the total over five years, rather than seven years.
       If you think FY2007 was a disappointing year, and hence it inflates the CAGR, then you can use the prospectus EPS of 6.25 cents, or indeed some other EPS metric with which you are comfortable. 6.25c for 2007 gives a CAGR of 25%. All this report contends is that a diluted EPS of 11.5 cents for 2007 distorts the perception of TGA’s EPS growth since 2007, and it incorrectly suggests an erratic performance path (a retrograde FY2008 and FY2009) that does not mirror reality. This report does not postulate that EPS will grow anything like 25% or 30%, so altering FY2007’s EPS is not critical.
       As at 30/03/2012 the net debt to equity was about 6%. The ratio of long-term debt of $14 million to equity of $140.211 million was about 10%. This corrects the true but misleading debt figures that were based on the situation as at 30/03/2011, but altered soon thereafter.
       Using crude average equity, ROAE (return on average equity) for YE 30/03/2012 is about 23.68%, being $27,849,000 divided by the average of the $95,003K opening equity and the $140,211K closing equity. A weighted equity average would give a lower percentage. The Morning Star ROE calculation of 19.9% is based on closing equity, which although correct, downward distorts the perception of the ROE trend in a capital raising year like FY2012. The FY2012 annual report gives the return on capital employed (ROCE), which is EBIT/(Total Assets – Current Liabilities) in the table below:
       – – – – – – – – – – – 2007 – – – 2008 – – – 2009 – – – 2010 – – – 2011 – – – 2012
       ROCE 17.77% 17.19% 20.35% 19.02% 21.95%
       ROE 12.03% 17.49% 17.79% 23.84% 23.20% 23.68% (ROAE, not 19.9%)
       Diluted EPS 5.1c 8.3c 9.4c 14.9c 16.7c 19.0c
       Dividends .97c 4.26c 4.79c 6.32c 7.30c 8.95c

       The Future – Quality Considerations and Risks
       Before postulating what TGA’s future trajectory might be, I list some qualitative facts and opinions, followed (not immediately) by a section called Future Trajectory.
       I believe that one should consider many facts and opinions mentioned in this report, and any others that are relevant but not mentioned here. Then in reference to other listed stocks, one can invent multiples that one thinks should apply to TGA. I mean the multiples that investors use in rule-of-thumb valuation methodologies – for instance EBIT multiple or EPS multiple (PER). Underlying these multiples lurks the concept of a risk-adjusted required rate of return, which is often growth-adjusted too. More sophisticated valuation methodologies also use risk-rated required rates of return, and as these should vary from stock to stock, to set them requires knowing something about the stock.
       Profitability Erosion
       It is normal for product and service lines of business to become less profitable as they move through life cycles, but this can be countered by firms continually re-inventing themselves. Just as renting radios and radiograms become unprofitable, and Radio Rentals/Rentlo moved into TVs and later PCs, it can move into other lines as these lines become less profitable. Thorn is not wedded to products, they are merely vehicles to gain committed collectibles streams, and hence Thorn can easily switch to new vehicles. This can be done via introducing new products to the Radio Rentals/Rentlo unit, or by other styles of business like NCML, Cashfirst, and Thorn Equipment Finance. When gross margins and ROE show medium-to-long-term decline, it will be time to start worrying, and this has not happened. The ROE for FY2012 has come back a bit to 19.9%, but anything above 15% is usually considered good, and, anyhow, ROE is misleading in a capital-injection year like FY2012, and return on average equity (ROAE) is a better, but also flawed, metric. TGA’s ROAE for FY2012 was 23.68%.
       Business Cycles and Seasonality
       Thorn is a non-cyclical business, and it thrived during the GFC. TGA is a poverty stock. Most of Thorn’s revenue comes from Radio Rentals/Rentlo, many of whose customers are on welfare, and little affected by economic vicissitudes. Other customers can be affected by the economic environment, and Radio Rentals/Rentlo has responded via hardship extensions – allowing customers longer payment terms.
       The payment-stream nature of Thorn customers’ contracted commitments removes seasonality from the revenue scene, and it dampens the monthly affects of short-term and longer term factors that affect many other companies. How often have mining service companies excused bad results because it rained more than usual in Queensland, or major tenders were delayed, or they lost one or two major customers?
       Currency and other Foreign-country Risks
       Thorn does all its business in Australia. Currency movements would impact its price of imported items, but these are, on balance, a minor issue. Where Thorn imports products priced in US$, it hedges those contracts. In contrasts, stocks like CSL and QBE are to a large degree currency plays, which adds another layer of complexity to evaluating them
       Falling Prices
       Falling product prices impact TGA, and it has had to downward adjust TV and PC rental charges, but it can mitigate profit loss by bringing in new high-margin lines, and in the case of TVs and refrigerators, it has done so by direct importation at lower prices.
       Economics of Enough
       Little is written about satiation. When people stop buying, income-security fear is usually proffered as the reason, whereas the average Australian probably does not need more whatnots. How many TVs and refrigerators can one usefully own? The economics of enough applies less to the sub-prime demographic who underpin Radio Rentals/Rentlo’s business. Radio Rentals/Rentlo customers tend to have a top-up mentality, so when told the level of payment commitment that they are allowed, they tend to take up more items, because they can. Cashfirst customers often refinance (top up loans), particularly if the cost of borrowing drops as they improve their borrowing credentials.
       Repeat Revenue and Predictability
       This has substantially been covered under the subheading “Business Cycles and Seasonality”. The payment-stream nature of the business, and the predictable nature of contract extensions makes it fairly easy for investors to extrapolate performance forward. If one knows the first half year results, one effectively knows the full year results, and has a fair idea of the next few years’ EPS metrics, give or take 10%. Relative to investors, Thorn’s management have superior knowledge, and one can presume that their forward budgeting is remarkably accurate, so one can attach significance to words like “substantial” and “solid” in their rare communications concerning the future.
       Currently, Thorn is less predictable than before, because the newer business units (NCML Cashfirst and Thorn Equipment Finance) have yet to fall into a pattern – however, Radio Rentals/Rentlo’s business is still the substantial profit maker.
       Single Customer Threats
       Generally, TGA has many small customers, so it is not threatened by business loss, non-payment of debt, buyer bullying or delayed tenders to the degree that many businesses are. As the loss of the ATO business has shown, there are a few situations where the loss would be sufficient to require comment, but no single customer can significantly damage TGA via things mentioned in the previous sentence.
       Capital Drains
       Thorn’s capital expenditure is predictable and smooth, because it mainly relates to funding stock it supplies on leases. Consequently, if business slows, CAPEX self adjusts, leaving more free cash, which management could use to keep EPS, and hence dividends, increasing by diverting the free cashflow into share buy-backs (not that this is likely to happen in the medium term). This contrasts with mining companies that can have good profits, but they keep the funds for actual or potential CAPEX requirements, which can take many years to recoup.
       Increases in operating leases relative to finance leases will tend to increase CAPEX and reduce reported profits in Y1, but the CAPEX will be recouped quickly. Profitability of the two types of lease are similar, but accounting conventions make them look different.
       Expanding and restyling the outlets network requires fit-out, so this CAPEX will continual for a few years yet. Each fit-out is relatively small, so Thorn can handle them as a routine investment – dragging them out if required.
       TGA’s practice of retaining about 50% of net earnings gives it sufficient capital to fund growth in a measured way. If money is tight, Thorn can retard the pace of new initiatives e.g., hold back on expanding or refurbishing the outlet network by a few months, and similarly for internally-developed bolt-ons like Rent Drive Buy, which can be held back anywhere along the chain until network roll-out is completed, and even then, it can limit business take-up by increasing margin, or being more stringent in qualifying customers.
       CAPEX Declines
       Accounting treatment of Thorn’s so-called rental business, which includes rent-to-buy, masks the onset of long-term decline, because EPS can hold up for a few years. In my opinion, CAPEX declining for the want of opportunity to invest in rental stock or network enhancement is more serious than capital drains occasioned by good opportunities. A middle-path is optimal.
       Government and Trade Union Mischief
       Thorn group is unlikely to attract the sort of mischief that government and trade unions can visit on companies like BHP, RIO, Telstra, QANTAS, Leighton and others.
       Cashfirst is not a pay-day lender, and government interference will not occur, because the repayment that Cashfirst sets is below the 4% per month level on which the mooted legislation is intended to focus. Thorn reported in its 24 May 2011 ASX Announcement that “There are no adverse effects expected relative to Phase 2 of the National Consumer Credit Protection (NCCP) legislation, which we expect to be implemented in the next 12 months.” [I do not I think this will happen]. Tightening NCCP legislation will benefit Thorn Group, because its business style strives for the moral highground.
       Online Threat and Competition
       The hands-on nature of rental business makes it impossible not to have people on the ground. Thorn already uses online marketing and processes to reduce time that customers spend in outlets and to uplift the ratio of floor traffic to business; and to reduce business processing costs and speed up approvals, so it could respond if it could with advantage go down the same online route as a competitor. A potential online competitor could outsource logistics and credit management, but would this work in rural areas where TGA is particularly successful? Probably not. In the field of competing with retailers, online or not, Thorn prefers products that have not become commodities, which is why it exited the Big Brown Box unit in 2011.
       There are rental-company competitors – the Mr Rental franchise business springs to mind. There are 90+ franchised Mr Rental stores in Australia and New Zealand. Radio Rentals SA, which may be larger than Rentlo, competes with Rentlo in South Australia. A quick internet search raise Home Appliance Rentals in Sydney. How these competitors threaten or impact Thorn Group, I do not know. I do not want to underrate this threat – I simply do not know enough to write more.
       Shareholder-friendly Management
       Management has since the December 2006 proven to be competent, and shareholder friendly. John Hughes was involved with the then-called Radio Rentals business has a great deal of relevant experience, and he is liked by staff. As at 30/03/2012 Mr Hughes owns 3,586,113 shares in TGA or about 2.5% of Thorn, and he has rights in another 380,044 shares, so his interests should be aligned with shareholders.
       Risk of Bankruptcy or Capital Loss
       Thorn has a strong balance sheet and a good cashflow. This and its freedom from the other risks mentioned make it an incredible risk-free business. Apart from the NCML acquisition, Thorn has always expanded organically, and there is no evidence to suggest things will change, and that management will pursue the dangerous game of acquiring bolt-on businesses, which in other companies has destroyed a great deal of investors’ wealth in recent years. In my opinion, acquiring NCML has destroyed some shareholder value, but in failing to live up to the matrix and metrics that Thorn’s management expected, it may at least lessen any enthusiasm to indulge in similar adventures in future.
       Moats
       Thorn Group does not have a single stop-’em-all moat, but it has a number of lesser moats that retard would-be competitors. I admit to being surprised that a 75-year-old firm does so well in a business that is hardly rocket science.
       a) Boring and Grubby
       Targeting Thorn Group’s major demographic, pushing them to pay their commitments and skip tracing them when they “vanish”, is not the sort of business that appeals to upwardly mobile yuppies. “Collections” is not what one would call a “cool” business.
       b) Skills in short supply
       For the same reasons advanced in point a), TGA has a set of skills that are difficult to replicate quickly, and in the units that focuses on leasing items to small businesses, experienced staff (e.g., those with underwriting ability) are difficult to acquire, because big lenders have absorbed the small institutions that used to finance small firms, and those people who had the skills have drifted from the market place with the flow of time.
       c) Asset and cashflow rich
       A would-be competitor would have to have deep pockets and good cashflow, because the nature of Thorn’s business is to pay now, and collect later – much later than a typical retailer expects. Woolworths probably collects most of its sales revenue before it pays suppliers for the products sold.
       d) Procurement dynamic
       Although Thorn is not huge, the narrow range of items it supplies gives it a negotiation advantage in item-by-item procurements. Thorn now imports Thorn brand flat panel TVs at good prices relative to its competitors, and this contributes to profitability. Thorn brand refrigerators were introduced in May 2012.
       e) Australian Credit Licence
       Thorn Group operates in a highly regulated market. Documentation, marketing and sales activities (written and verbal) must comply with rules provided in the National Consumer Credit Protection Act and other legislation such as the Fair Trading legislation. The National Consumer Credit Protection Act 2009 (Commonwealth) requires those who engage in a credit activity to have an Australian Credit Licence granted by ASIC. This deters some firms from entering the sort of business that Thorn has.
       f) Make-good provisions
       Rental contracts, which covers the bulk of Thorn’s business, have make-good provisions, which add a burden that is not easy for all firms to shoulder, and which online competition would struggle to duplicate, particularly in rural areas where Radio Rentals/Rentlo does well. Having a narrow range of items and a delivery vehicle gadding about allows for faulty goods to be replaced efficiently.
       g) Contented employees
       Thorn employees work with minimal supervision in small branches, and the teams in outlets seem to be very happy and loyal. The close relationship that these employees have with the community with whom they deal allows them to do much of the skip tracing, and resolving other problems, efficaciously. Employee turnover and absenteeism are low. It would take a would-be competitor time to build up a comparable team, and its senior management would need the right mindset and aptitude to do so. This opinion stems from interviewing key staff in a single outlet, so the foregoing generalisation is a presumption.
       Future Trajectory
       Recent valuations of TGA shares are based on there being no or little growth, in FY2013 and FY2014. Considering Thorn’s spectacular growth since listing in December 2006, that it should skid to a halt is questionable. I think that Thorn’s growth will slow for 2013, do better in 2014, then experience an up-tick as initiatives like Cashfirst, Thorn Equipment Finance and individual expansion initiatives in Radio Rentals/Rentlo and NCML move from making losses, or small profits, to being acceptably profitable. EPS will grow, but nothing like the EPS CAGR of the last five years.
       On longer-term growth, Thorn can expand catchment relatively cheaply compared to its historic pattern of having full-service outlets. This can be done via single service hubs that service satellite outlets that can vary from lifestyle display centres, shopping mall kiosks and so-called one-person branches (typically, one full-timer and two part-timers). The last mentioned relate to expanding rural outlets to smaller population centres, but some may not be remote. John Hughes said in the May 2012 results presentation that a new one-person branch (OPB) typically loses $100K in Y1, breaks even in Y2, and contributes $100K in Y3. OPBs that started a year ago will emerge from loss making in FY2013, and make a profit in FY2014. Newer OPBs will follow that pattern, but in later time slots.
       Switching full service branches (FSBs) to more satellite outlets serviced by a low-rental service hub probably gives a faster payback than investing in OPBs. Where this has been done with two outlets serviced from one hub, Thorn has doubled its customer exposure at the same expense of running a single FSB. This has been Thorn’s experience in Ipswitch, Queensland, and, perhaps, in North-West Sydney (Blacktown and Mount Druit).
       Radio Rentals/Rentlo’s underlying market is growing. John Hughes’ November 2011 comments on http://www.abc.net.au/lateline/business/items/201111/s3373608.htm can be paraphrased as “The cash and credit constrained market, which is the focus of the Radio Rentals/Rentlo business, is growing faster than total households in Australia – a sad indictment on the total economy, but a good indicator for our business.”
       Neither the FY2012 annual report nor the May 2012 presentation hint that TGA will cease to grow – refer to http://www.brrmedia.com/event/98189/john-hughes-ceo-peter-eaton-cfo-james-marshall-general-manager-radio-rentals–rentlo . Radio Rentals/Rentlo is growing for the reasons mentioned above, and it can grow by extending the product range, and hence the revenue per customer and the customers’ propensity to extend on contract expiry (customer retention improved from 40% to 42% in FY2011, and to 44% in FY2012).
       The words below are substantially a copy “Opportunities for Growth” from a market presentation, with my comments added in brackets:
       a) Extend furniture ranges (tweak current range, add new lines like garden furniture)
       b) Launch of new products & brands (e.g., Apple products under discussion)
       c) Increased range of direct import Thorn product (refrigerators added in May 2012)
       d) Development contracts to meet diverse customer needs (e.g., 24 and 48 months)
       e) Continued expansion and refinement of store network structure: All initiatives showing strong results to-date – namely:
       * Transition from single Full Service Branch to multi outlet footprint
       * One Person Branches in regional areas
       * Kiosks and showrooms in metropolitan areas
       * Up to 5 new outlets in FY2013, dependent on quality of available locations
       Thorn can expand business units via internally developed bolt-ons, and via acquisitions. The latter is risky – perhaps best avoided. Thorn can push established business units down new paths, like supplying equipment to pubs and clubs to whom they have been supplying IT equipment for years, pushing down other franchises (e.g., fast food), or supplying credit management to new organisations that have moribund debtors ledgers. Cashfirst can leverage the Radio Rentals/Rentlo network more than has hitherto occurred, and it can push into different demographics.
       FY2012 was a year of investment in units like Cashfirst, Thorn Equipment Finance (TEF) and some aspects of NCML. In 2011 Antoine Laval was appointed as general manager of TEF, plus other finance/underwriting specialists were appointed to create the 10-person team required to drive TEF forward. Brenton Glaister the founder of NCML is now the GM of NCML. Brenton’s fortè is in marketing and operations, so he was happy to step into the GM role once various administrative functions (accounting, HR etc.) were moved to Thorn head office. When the position can be filled, a GM will be appointed for Cashfirst, or rather a Financial Services division that will include Cashfirst. Expect a greater contribution from these business units in future.
       Headoffice support teams in NCML, Cashfirst and Thorn Equipment Finance will remain relatively static as these units expand, so their contributions in FY2013 and FY2014 should be good, taking into account their low base relative to Radio Rentals/Rentlo.
       I have deduced Thorn’s performance in FY2013 from the perspective of guestimating what its operating leases are going to do – see Addendum ‘B’. Performance metrics like ROE, ROCE, bad debts, average length of rental contracts and contract extensions may on balance improve, rather than deteriorate.
       Valuation
       Irrespective of the methodology that one uses to value stocks, quality of the business is part of the consideration, and hence I have gone to great lengths to cover qualitative aspects of Thorn as a business. The idea being that if stocks A, B, C , D and E are good stocks valued at these or those multiples, then if TGA is of similar quality (and this includes capitalisation and share liquidity on the ASX), it should enjoy similar multiples. For the want of obvious candidates, I have yet to develop comparative information for stocks A, B, C, D and E, which in itself underscores the quality of TGA.
       This evaluation does not call for much work and great skill, because all one has do is to find a few good ASX-listed stocks, and then for a list of qualities rank TGA as much better, a bit better, about the same, a little worse or much worse than the others. If in the process you realise that stock C is a patently superior investment at its current SP, then focus on stock C. When Miss Feeney gives Lulu 70% for a writing assignment, Tubby 30% and the rest of the class between those two extremes, you can be reasonably sure that Lulu is the best writer in the class, and that Miss Feeney does not use a weighted-scorecard system. If the school principal wanted one of the class to write an essay for the school magazine, he could with no qualms select Lulu, and if Gloria came in at second place, he could ask her too.
       I think the two-dimension grading of stocks along the line that Roger Montgomery grades them makes sense as a first step – one dimension being risk (quality of cashflow and balance sheet, perhaps) and the other being performance. The best companies would be A1 and the worst E5 if one had five steps to each dimension. The number of dimensions was plucked out of the air to convey the concept. Roger’s matrix ranges from A1 to C5. One can then guess what grading one would give TGA, and from there obtain your rule-of-thumb multiples. If TGA is not in the top three classifications, do not waste any more time on it. Three steps in each direction would suffice, because for this exercise we could limit ourselves to only considering candidates that were A1, A2 or B1.
       You can allow factors like Market Capitalisation, Years of ASX History, ASX liquidity (or dearth of it) to influence your multiples. Although TGA scores better than WOW in a matrix that does not include these things, you may feel more comfortable giving WOW a higher PER, or a higher EBIT multiple, because its capitalisation is much larger and its shares are more liquid. After all, if an institution like PPT wants to sell $20M TGA stocks, it will trash TGA’s SP during the sell-down, which could take months, but realising $20M by selling WOW would be a minor SP blip accomplished within a day or two.
       For reasons that are contestable, I’ll give TGA a score of A2 in my 2-dimensional matrix. The A indicates it has very low risk of collapsing, or begging for money to keep going, and the 2 indicates it is performing far better than most ASX-listed stocks, but there could be a few doing better (not that I know them). I’ll add a third dimension of size. Because TGA is in the ASX 300, and its market capitalisation is about $230 million, I’ll give it a size score of (iii). Thus I end up with a classification of A2(iii). An A2 is a high score, and were TGA a large cap liquid stock we could classify it as an A2(i), and presume it would earn a PER of 16. If for the hell of it we reduce this by 10% if it were a (ii) size stock, and another 10% if it were a (iii) sized stock, then you would get 16 x .9 x .9 = 13, and hence you could give TGA a target value of 19c x 13 = $2.47.
       You could add a market sentiment factor if you wished – increase by 15% in a bull market and decrease by15% in a bear market (or whatever), and hence current negativity would suggest a PER of 16 x .9 x .9 x .85 = 11, and one gets a target SP of 19c x 11 = $2.09.
       If you apply the same sort of scoring to stocks A, B, C, D and E, you should get a feel for how reasonable your subjectivity is. There is nothing intrinsic about these classifications, factors and resultant numbers – I have just sucked them out of my thumb to indicate that qualitative factors should have a bearing when one derives a target share price using the conventional rules of thumb that investors use. I mention a few below.
       EBIT Multiple
       Morning Star has TGA’s EBIT for YE 30/03/2012 at $38.6M, and the shares outstanding as 146.4M, so a multiple of 6 would give a target SP of $1.58. A multiple of 8 gives $2.11.
       Using Morning Star metrics circa 30 May 2012, SUL (Super Retail Group) has an EBIT of $87.55M, and 146.3M shares, so to get to its then current share price of circa $7.20 implies an EBIT multiple of 12. CAB (Cabcharge) had an EBIT multiplier of 8.5. A multiple of 6 was mentioned in the prospectus for TGA’s December 2006 float. I am not familiar with what the typical EBIT multiple is, so I’ll write no more on it – 8 seems reasonable.
       PER Multiple
       The December 2006 float used a PER of 8 to arrive at the 6.25c x 8 = 50c float SP. I have used this as the bottom-rung PER. The historical performance metrics and the many qualitative factors mentioned in this report suggest a higher PER is reasonable, reduced a bit to reflect TGA’s small capitalisation and middling-to-low share trading liquidity relative to big-name stocks. Relative to what worse performers of similar or lower capitalisation and liquidity command, the PER could easily be 13, but you might feel more comfortable with a PER of 10 or 11. Look at the facts, examine alternative stocks, and take your pick of a PER that seems reasonable. With a diluted EPS of 19c, you will get:
       Target PER Target SP Target PER Target SP Target PER Target SP
       8 $1.52 11 $2.09 14 $2.66
       9 $1.71 12 $2.28 15 $2.85
       10 $1.90 13 $2.47 16 $3.04
       Another way of looking at this is via risk-adjusted required rates of return (RRR) adjusted for growth. PER is merely 1/RRR, and hence a RRR of 12.5% would render a PER of 8.
       One can adjust the PER, or the RRR, to accommodate quality, including expected growth. Alternatively, handle growth by forward guesstimating EPS for a few years, and have target SPs for those years too. This is intellectually clumsy, because if one had SPs for Y2 and Y3 that were significantly different to Y1, one would be inclined to alter one’s perception of what the Y1 target SP should be, and if your RRR already accommodated growth, you run the risk of double accounting for the growth factor.
       ROE based multiple – Equity x ROE/Required Return x Equity/share tally
       The net profit of FY12 was $27,849,000, and shareholders equity was $140,211,000. The diluted EPS that this report works with used 146,488,310 shares, which included performance rights granted. To be consistent, 146,488,310 shares will be used – not the closing share tally of 146,374,000, which Morning Star records as 146.4M.
       I use clumsy numbers here because I do not want rounding to interfere with a point that I want to make reconciling to a simple PER multiple methodology. ROE divided by 12.5% gives a multiple of ($27,849,000/$140,211,000)/12.5%, which multiplied by equity per share (EqPS) of $140,211,000/146,488,310 gives (($27,849,000 / $140,211,000)/ 12.5%) x ($140,211,000 /146,488,310) = $1.52. This gives the exact same answer as multiplying the EPS by 8 (which is 1/12.5%), because ROE = EPS/EqPS, and hence EPS = ROE x EqPS. Consequently, EPS x 1/RRR = ROE/RRR x EqPS. This figure is too low because the capital raising during the year distorts the ROE if one uses the year-end equity metric, which the Morning Star ROE metric of 19.9% does.
       You will get a higher target SP if you use average equity to calculate ROE, or rather ROAE. Taking the average as the midpoint between opening equity and closing equity is probably not valid either, so for YE 30/03/2012 I prefer to use a PER-based valuation approach. If you used a diluted EPS of 19c, equity per share of $140,211,000/ 146,488,310 = 95.71 cents, a ROAE of 23.68% and an RRR of 12.5%, then you will get a target SP of 95.71c x 23.68/12.5 = $1.813.
       Dividend NPV
       Working out a dividend stream seems to be such a subjective matter in distant years, that I have not attempted to do it, so I do not have the basis to do an NPV calculation. Short-run dividend estimates followed by the equivalent of a residual value, an assumed share price in Yn, is so biased by the assumed future SP, that the results may not be as sound as some investors like to think. The examples that I have seen undervalue stocks that are undervalued, and overvalue stocks that are overvalued, which runs the risk of ignoring the very stocks we want to find – the unloved ones that deserve to be loved.
       Conclusion
       Work out TGA’s fair-value SP, or target SP, or whatever you call it, in your own way, and it would probably work out between $1.50 and $2.00 for many conservative investors. Numbers between $2.00 and $2.50 are not silly in my view, it is just a question of when. Also, the price at which investors buy is not the same as the one at which they will sell. A target SP of $2.00 does not suggest you should buy TGA at $2.00 and below, because if you want a 25% margin of safety, you might set your buying limit at $2.00 x .75 = $1.50.
       It is easy to derive a low target SP. If you use an RRR of 15%, then you would get a PER of 1/15%, which is 6.67, and if you wanted a 25% margin of safety, you would get 19c x 6.667 x .75 = 95c. This is not a problem if you stumble over gems that are such a bargain.
       Now you know why I dislike the words Intrinsic Value and Fundamental Analysis. There is nothing intrinsic or fundamental about these postulated share prices, and the metrics and arithmetic used are rubbery.
       All this mumbo jumbo is a waste of time if you can invest in something as good as TGA, or better, at say $1 a share. All you should do in this blissful situation is ignore TGA, and invest in the gem you have discovered. Much the same applies to pure chartist, ignore the analysis of the underlying business, and do what the charts tell you to do – understanding the underlying business is of little concern to chartists.
       ADDENDUM A

       Justification for using 5.1c for the diluted EPS of FY2007, and 19c for FY2012.

       In the 2007 annual report, under Financial Highlights one can read “EPS of 5.1 cents – 6.2% ahead of Prospectus forecast”. These words do not match the prospectus, which held out an EPS of 6.25 cents, a PER of 8 to get an SP of 50 cents, and it suggested an EBIT multiple of 6.
       At subsection 5.2 of the 2007 annual report, one can read the following:
       “The Company listed on the Australian Securities Exchange on 13 December 2006 and at the time of listing a total of 127,360,000 shares were on issue at a value of $0.50 per share. The number of shares has not changed since that date.
       Net profit attributable to equity holders of the parent $6,542,000
       Basic EPS (weighted average) 11.77c
       Diluted EPS (including performance rights) 11.64c
       Proposed dividend per share 0.97c
       ALTERNATIVE [and this is important]
       Effective basic EPS based on total number of shares on issue at balance date 5.14c.
       Due to a major capital restructure on listing the alternative denominator is considered to provide more meaningful earnings per share information.”
       The 2008 annual report has the following:
       “ALTERNATIVE
       Effective basic EPS based on total number of shares on issue at balance date 8.52c [for 2008] and 5.14c [for 2007]. The 2007 EPS reflects 25,000,000 shares on issue prior to the issue of an additional 112,850,000 shares in December 2006.”
       If 127,360,000 shares give a basic EPS of 5.14, then the share numbers used by Morning Star of 128.9M can be presumed to be the diluted shareholder numbers, and hence the diluted EPS should be $6.542M, divided by 128.9M shares, or $0.05075 – say 5.1 cents. Morning Star has the EPS at 11.5 cents, which is misleading.
       Changing the 2007 baseline EPS to 5.1 cents, rather than using 11.5 cents makes a large difference to the CAGR for the five years since YE 30/03/2007. Also, analysts and shar valuation system relying on Morning Star metrics comment adversely on the apparent, but misleading, retreat of TGA’s EPS to 8 cents and 9 cents respectively for 2008 and 2009, which one presumes affects their valuations.
       Basic EPS at 31/03/2012 of 19.24 c is $27,849,000 divided by a weighted average number of shares during the year of 144,722,948. Diluted earnings per share of 19.01 is based $27,849,000 divided by a weighted average number of ordinary shares during the year 146,488,310, which includes performance rights granted.
       In conclusion, this analysis uses the following diluted EPS metrics:

       YE 30/3/07 – YE 30/3/08 – YE 30/3/09 – YE 30/3/10 -YE 30/3/11 – YE 30/3/12
       5.1 8.3 9.4 14.9 16.7 19.0

       ADDENDUM B
       EPS Growth
       Thorn’s management does not broadcast what they expect in future, even though normal budgeting gives them an accurate picture of the current year’s financial performance, and probably a year or two beyond. This is because the recurring nature of Thorn’s revenue and the granularity of its customer base facilitates prediction. Thorn keeps relatively silent about the future, which gives rise to the following words in its annual report:
       “Further information about likely developments in the operations of the consolidated entity and the expected results of those operations in future financial years has not been included in this report because disclosure of the information would be likely to result in unreasonable prejudice to the consolidated entity.”

       In the presentation slides you can see the dichotomy of wanting to extol Thorn’s strengths and expected progress with words like “solid”, “strong”, “increased contribution”, gaining traction”, “resilient”, and then downplaying the outlook. See the words below:

       Group
       – Strong core business with substantial recurring revenue streams generating significant Operating cash
       – Solid capital base to enable expansion & healthy ROCE
       – Growth initiatives gaining traction and well positioned for increased contribution
       By Division
       – Resilient rental business with further opportunities to grow
       – Continue to evolve and expand Cashfirst offerings
       – Emergence of Thorn Equipment Finance as a key segment
       – Solid growth of NCML through new initiatives in business development
       Outlook:
       – Market factors may slow growth rate
       – Investment in strategic initiatives impact short term – but generate longer term rewards

       Management cannot suppress their exuberance and pride, so one can glean more from the presentation at http://www.brrmedia.com/event/98189/john-hughes-ceo-peter-eaton-cfo-james-marshall-general-manager-radio-rentals–rentlo than one finds written.

       As was the case for FY2012, the growth in profitability will spring from operation leases. This is where Radio Rentals/Rentlo is doing well, particularly with furniture, and Thorn Equipment Finance’s business adds to that. This is where I have focused my attempt to guess what might happen to TGA’s EPS in FY2013. I assume the other business on balance remains static – contributing the same cents to the EPS as they did for FY2012. The expected slight (“slightly” is used in the EOY presentation) decline in the contribution of finance leases to profit should be covered by other units (NCML and Cashfirst) improving. I assume NCML will recover the loss of the ATO business ($400 to EBITDA in FY2012), and toss a bit in to assist covering the decline in finance lease business. I do not know the appropriate number to use, to adjust for the higher interest paid in FY2012 that will not be repeated, so I use $800K.

       For operating leases, revenue and profit recognition occurs as customers pay, so there is committed revenue at the start of each year, to which new business is added. I have attempted to calculate the new business values for FY2012 and FY2011, and then extrapolated that growth to FY2013. To this end I have added the estimated committed payments streams for FY2013., and I arrive at the revenue figures below.

       I have assumed that the ratio of expenses to revenue will remain static, except for an estimated $800K in interest paid. I know that Thorn has slimmed its head office count since it merged NCML into its business, but I have assumed this can fund expenses like appointing a GM to manage the loans business centred around Cashfirst.

       The figures below are a mixture of extractions from the FY2011 and FY2012 financial reports, and extrapolations thereof.

       Minimum lease payments under non-cancellable operating leases are as follows:

       2012 2011 2010
       Less than one year to expiry 36,091 30,161 27,124
       Between one and five years 9,205 6,628 5,897

       I’ll assume that expiry dates are spread evenly through the year, so in the following year 50% of the value listed flows in as lease payments. I’ll assume that older leases are evenly spread over four years and so 25% will flow in as lease payments. This gives:

       2013 Est 2012 2011
       Carry-over expiring lease revenue 18,045 15,080 13,562
       Carry-over longer lease revenue 2,103 1,657 1,474
       New operating lease revenue 86,716 76,825 68,062
       Total operating lease revenue 106,864 93,562 83,098
       Other Revenue 94,789 94,789 (note: both years are the same)
       Total Revenue 201,653 188,351
       Costs/expenses 159,059 148,567
       Adjust for interest paid (800)
       Gross profit 43,394 39,784
       Tax 13,018 11,935

       Net Profit 30,376 27,849 (9.07% increase of net profit)

       The percentage increase in net profit is sensitive to relatively small changes – every $278.5K makes a one percentage difference. Simply altering provisions, or hiring or culling a few people can alter it by one or two percentage points. My original hunch was that EPS growth could lie between 8% and 12%, and so for convenience I invented EPS growth of 8% for 2013, 10% for 2014 and 12% for 2015. I’ll stick with that, and alter the numbers with each half-year announcement.

       For now, my actual diluted EPS metrics until 2012 and guesstimated ones thereafter are:

       2007 2008 2009 2010 2011 2012 2013 est 2014 est 2015 est
       5.1c* 8.3c 9.4c 14.9c 16.7c 19.0c 20.5c 22.6c 25.3c
       incr 62.75% 13.25% 58.51% 12.08% 13.77% 8.00% 10.00% 12.00%

       * see Addendum A for reason why 5.1c is used.

       Accounting for provisions is fairly arbitrary, and Thorn’s accounting is so conservative, that if FY2014 and a year or so thereafter look exceptionally good, then FY2013 could easily be made to be 10% or more without raising a questioning eyebrow, because Thorn admits there is over provisioning in Cashfirst and Thorn Equipment Finance. Deciding to amortise NCML’s customer relationships over 5 years rather than 7 is an example of arbitrariness.

     • 

       Eddie
       July 2, 2012 at 10:43 am:

       wow,
       You did that for FUN :)
       Nice work,
       Stream of consciousness that came out of your keyboard.
       I hold TGA for many of the reasons above, although I also know many people would not for exactly the same reasons.
       Thank you and Roger for putting it out there to read.
       regards,
       Eddie.

     • 

       Michael Horn
       July 9, 2012 at 4:09 pm:

       It’s a weird world that we live in, and some folk have perverse notions of “fun”. I once read “advantage springs from the weird”. I wish I had come up with that.

       If you think of TGA as being in the collections business, then you are well on your way to understanding it. Thinking of TGA as a supplier of electrical household goods misses the point – whatever it rents, sells or lends (cash) are merely vehicles to gain a collections stream that is worth more than the oof that TGA plonks down. If PCs and TVs go down the path of radios and radiograms of yesteryear, it’s not the end of the world for TGA, other vehicles that occasions collections streams can replace them.

       The concept of target demographics is interesting. For now TGA substantially relies on the sub-prime demographic, and I cannot see that demographic migrating en masse to to the kingdom of Yuppydom. John Hughes mentioned the new-migrant demographic in his May presentation, which struck a chord with me. When I immigrated to Australia in 1971, I soon landed a good job, but I rented a second-hand black and white TV from Radio rentals for x months, because I could not instantly fund all the items I needed to set up house here, plus buy a car as a prerequisite to the well-paid job that I had landed.

       TGA can locate new products and services to address the needs of its current major customer demographic, and it can expand its customer base into other demographics. Consequently, TGA’s future profitability is only limited by its managers’ imagination, which is why I do not concur with those who think TGA has reached the end of its tether. Time will tell who is right.

2. 

   Woody
   June 27, 2012 at 2:44 pm:

   Im concerned at the dates in American format

3. 

   dave n
   June 27, 2012 at 3:18 am:

   Montgomery is awesome!!!

   • 

     Roger Montgomery
     June 27, 2012 at 6:47 am:

     I hope you are saying that with tongue in cheek! Otherwise thank you.

4. 

   Chris W
   June 26, 2012 at 8:24 pm:

   I’ve been thinking about TGA for a few months and never felt a compelling reason to buy it. Their Rent Try Buy I beleive may have a few more years of increasing earning as it has in the last few years. They have the acquisitions that will increase earnings in the next few years. Management seem to be doing a decent job.
   They pay 6% dividend. They may even open a few more stores. But they don’t have much growth in store numbers left. They need a new concept maybe with the small kiosks.
   You can buy a nice big TV for under $1,000 theseday, thats less reason to rent. You pay back more than double over the life of the loan. PC’s are declining, laptops are cheap. I think they need to offer another option for consumers.
   I wonder how much the company has been affected by less tourism in QLD (some companies have announced they have).

   Its quite cheap on a MC/Assets view. They pay 6% dividend. I’m just not able to judge their rate of earnings increase in the medium term. They are not a long term hold. There is a little bit of margin of safety but I’d like more. They are not a long term hold so unless they are really cheap I won’t buy but they may get you some returns. The price may increase 60% in 2 years but I might go for something more sure.
   I had a look at Silver Chef too and didn’t want to invest in them.

   • 

     Roger Montgomery
     June 27, 2012 at 6:49 am:

     Indeed Chris. The deflation in digital and electronics is the reason they have experienced weaker sales in that area.

5. 

   Mike Grams
   June 25, 2012 at 9:43 am:

   Roger,
   Interesting thoughts there, and a different perspective from the seemingly upbeat company presentation that accompanied their 2012 Annual Report. To get some of the data you have shown, I am guessing there must have been another company presentation somewhere Unfortunately it doesn’t seem to appear on their or the ASX’s website.

   In any event, at least TGA is a company recognising the need to continue to innovate and generate additional revenue streams.

   PS – I don’t own TGA but seems a quality company well worth monitoring closely.

6. 

   Michael Horn
   June 24, 2012 at 10:39 pm:

   On a small point, TGA tends to “sell” TVs and PCs via finance leases, and “rent” other items via operating leases. The accounting treatment is different, and so is the legal issue of ownership of the items. When speaking to customer-facing staff on this issue, I realised that they did not understand the terminology, or fully understood the accounting and legal issues pertaining to the different types of leases, so I assume it is not fully understood by the customers either – they sign a bit of paper and the the goods are delivered, and if they stop paying the man from TGA tries to get the items returned, because even where ownership has passed to the customer, TGA holds a chattel mortgage over the goods, if that is the right terminology.

   The nub of the lease-type distinction is the assumed useful life of the item, and for TVs and PCs it is three years, and as this does not exceed the length of TGA’s typical 3-year contract, TGA handles the items via finance leases, and will not accept shorter contracts. Ownership passes on delivery, and except for interest, revenue recognition occurs on delivery. Finance leases are declining, because the TV and PC business is declining – not because TGA prefers operating leases.

   For other items like furniture and whitegoods, TGA tends to use operating leases, and it is prepared to write contracts for less than three years, but the end-of-term buy-out price is high, whereas for three-year contracts it is typically a token $1. Most contracts are for thee years. Revenue recognition is spread over the life of the contract, and the rental assets (as depreciated) sit in the balance sheet, in lieu of having debtors there as is the case with finance leases.

   Although profitability and cashflow remain constant whatever the type of lease, the slower revenue recognition of the growing rental business (operating leases) will skew profits to Y2 and Y3 at the expense of Y1. Operating leases are also growing via Thorn Equipment’s growing business with SMEs. All this is covered in my so-called Magnus Opus – tedius as it is.

   • 

     Roger Montgomery
     June 25, 2012 at 10:33 pm:

     Indeed Michael, now the cats sort of out of the bag…

7. 

   Dan S
   June 24, 2012 at 6:51 pm:

   Is this a business which is should be compared to Harvey Norman et al?

   Consumer goods, yes, but are shareholder returns driven by retail sales or interest payments?

   You have twirled around the distinction as gracefully as Brendan Fevola on Dancing with the Stars (?!?) on my (fully paid) flat screen.

   • 

     Roger Montgomery
     June 25, 2012 at 10:34 pm:

     Interest payments have to be ‘on’ something. Hey, what about on retail sales? Thanks Brendan!

     • 

       Dan S
       June 26, 2012 at 4:42 pm:

       You could look at it that way, I’m sure the vast majority of their customers think they’re leasing an LG plasma for $29.95 a week for 3 years.

       Personally, as a TGA shareholder, I like to think I’m lending Brendan Fevola $1,400 today (probably less at my end given scale purchasing) for a weekly interest payment of $29.95 (paid in advance) for 3 years. I also get a whole dollar at maturity and Brendan gets to keep the TV.

       If Brendan spends too much at Crown, or Star or Packerangaroo, then I should be able to go to his place and get my TV back and “lease” it to his mate Will Minson.

       I just think we’re looking at a very particular customer base, who might not be indicative of the general discretionary retail community. A lease is a lease is a loan…

     • 

       Michael Horn
       June 27, 2012 at 12:58 pm:

       I hope that if Brendan wants to play the slots, he uses a slot machine supplied by Thorn Equipment Finance (TEF), because is leveraging off its multi-year relationship with TAB to supply all manner of items to pubs and clubs, and probably other franchises by now. The May presentation lists TEF’s product mix thus:

       – – IT- – – – – – – – – – – – – – – 19% – – – – Printers & copiers – — – 11%
       – – Telephony – — – – – – – – 15% – – – – Security – – – – – – – – – – – 9%
       – – Gaming – – – – — – – – – – 15% – – – – Point of sale – – – – – – – – 7%
       – – Commercial kitchen – – 13% – – – – Other – – – – – – – – – – – – 11%

       “Gaming” means slot machines. “Commercial kitchen” intrudes into SIV’s playground, so that company (Silver Chef) is worth watching to get an idea of the profitability of that space. If TGA runs out of opportunities to invest in items historically sold/rented by Radio Rentals/Rentlo, part of the resulting cash embarrassment will find a home in TEF, and some can be usefully used by Cashfirst to make small loans to buy tombstones, or whatever.

   • 

     Michael Horn
     June 26, 2012 at 4:44 pm:

     Thorn makes two sets of profits per deal – one is a retail profit, and the other is a finance profit (interest and fees).

     There may be some minor error of my understanding of Thorn’s accounting, but the gist of the matter is that if Thorn uses a finance lease, the two streams of profit are obvious within its accounting system – there is an immediate retail profit and the creation in the accounts of a debtor, and as the money dribbles in later, the interest component is recognised, as is any fee-based component. If Thorn uses an operating lease, the total profitability is the same, but the interest component, the set-up fee component, the retail profit component and the cost of the items are bundled into “rental”, and as rentals dribble in over the years, the various profit components are recognised. This is why the drift towards operating leases tends to dampen profits in Y1, relative to Y2 and Y3, but not make any difference to the timing of cashflow.

     Thorn also lends money via Cashfirst, and the payment streams that the loans generate are in part repayment of principal and set-up fees, and in part interest. Set up fees, late payment fees, contract restructuring fees and the like also pertain to the finance leases and operating leases.

     It is difficult to compare Thorn to other companies, and probably unhelpful to try. It is a bit like CCV in that Cashfirst offers unsecured loans. It is a bit like SIV in that Thorn Equipment Finance leases commercial kitchen items to SMEs. It is a bit like MMS in that MMS leases items (fleet cars). It is a bit like HVN in that some of its products overlap and it requires bricks and mortar outlets. What makes Thorn different is that it has a strong balance sheet and self-funds its rental stock, and 90% of its customers belong to a demographic that relies on welfare. If Roger provides a link to the report that he mentioned, all this is therein detailed.

     Thorn