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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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What happens when you buy great businesses cheap?

Shares need to be treated as pieces of businesses rather than bits of paper that wiggle up and down on a computer screen. This seems pretty rational and yet professional investors might buy a company that is a manufacturer of pet rocks loaded with debt because its inclusion in the portfolio reduces its overall volatility.

The same professional might not buy shares of a great business when they are truly cheap, having instead to wait until the shares have risen sufficiently to cause them to be included in the S&P/ASX 200. Buying shares this way, or simply buying in the hope they will rise, is not the same as buying a piece of a business.

The purchase of shares on the baseless hope of a capital gain is no different to betting on black or red at the casino.

Perhaps, because it is seen as too difficult, few investors simply purchase at attractive prices, a portfolio of 10 – 20 great businesses. This is despite the fact that such an approach produces substantial outperformance.[1]

To prove that quality counts, back in the June 2009 issue of Money Magazine I listed eleven stocks that I believe constitute great businesses – Cochlear, CSL, all four major banks, Realestate.com, Woolworths, Reece, The Reject Shop and Fleetwood.  Their combined return since July 1 has been 30 percent compared to the S&P/ASX 200 Accumulation Index return of 24 percent. Four of those companies have also risen by more than 40 percent in that time.

In July 2009 I also commenced a portfolio of eight stocks for Alan Kohler’s Eureka Report that included JB Hi-Fi and Platinum Asset Management. An equally weighted portfolio invested in those eight stocks would have risen 27 per cent and Platinum, one of the companies in the portfolio, is up over 53 per cent.

And the shares at the time were not even bargains. Imagine the returns if you had purchased them when they were at significant discounts to their intrinsic values back in February and March this year!

By Roger Montgomery, 26 October 2009

[1] For the year to June 30, 2009, and prior to my resignation, the boutique funds management firm I established, floated and sold, produced a return of +11% for clients with individually managed accounts (IMA). The Listed Investment Company I founded and was Chairman and Chief Investment Officer of produced a return of +3%.  For the same period the S&P/ASX 200 Accumulation Index produced a negative return of -20.7%.

By Roger Montgomery, 26 October 2009

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by Roger Montgomery Posted in In the Press.

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by Roger Montgomery Posted in On the Internet.

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Paul from WA asks to value ServCorp.  Don’t get excited, I am not going to make a habit of doing this.

Management have delivered returns on equity in excess of 20% over the past five years. This is desirable given the amount of profits being retained to organically grow equity and fund its expansion plans. The balance sheet is strong with plenty of net cash and the business is generating high quality cash flows.

Because of the recent capital raising of circa $80m to fund an expansion program of around 100 floors, any valuation must contain a caveat that it is subject to the rate of return the company manages to achieve on the incremental equity.

So, watch the capital raising development closely. Up until recently, management has been content to slowly and organically growing the business via the reinvestment of profits to fund the roll out of new floors. I like this and the model appears to have worked, with around 67 floors being opened to date.

The capital raising signals a departure from SRV’s original approach. Management plan on opening ‘at least’ 100 new floors – that’s more than double the current level over the next three to four years.

As with any aggressive growth plan, scalable systems must exist particularly when growth of circa 150% in such a short period of time, needs to be managed.  Always a challenge.

Management believe that they will be able to enter into leases within A-grade properties and new markets at attractive rates, taking advantage of any recovery in economic activity.

If they can deliver returns commensurate with recently reported ROE levels, on a materially expanded equity base, investors should be handsomely rewarded. All bets are off if green shoots fail to germinate.  Remember Servcorp is a cyclical business.

So what is the value?  Without taking into account the profitability of the recent capital raising, the value is $2.39.  I wouldn’t pay much attention to this valuation because if the company can employ the capital it recently raised at previously recorded rates of return, the value is closer to the current price.

By Roger Montgomery, 22 October 2009

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How will the sagging US dollar affect your portfolio?

by Roger Montgomery Posted in On the Internet.

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On Your Money Your Call with Nina May on 24 September 2009 I promised to value Worley Parsons.

What is WOR worth? After running my ruler over the business’ historical fundamentals, I estimate WOR is currently valued at $27.44 (2010). The share price is $29.43, making it a little expensive at the moment.

But WOR is a business with attractive underlying long-term investment fundamentals, including an average return on equity of 23%, a modest net gearing level of 33% and bright prospects with ongoing demand for Australia’s resources.

This demand should underpin capital spending programs by our miners in the future and hence the need for engineering companies to continue servicing a market that has grown remarkably over the past 10 years.

WOR is one to add to your watchlist should a more rational share-price present itself.

By Roger Montgomery, 20 October 2009

Update 28 October, 2009

Please keep in mind that for WOR there is a very strong likelihood that the businesses future earnings will be materially impacted by the strong Australian dollar. 25% of Worley’s revenues come from Canada, 24% for the US and latin America, 15% from the Middle east / Asia and 11% from Europe and Africa.

Although many analysts and market commentators currently have concerns about the currency and the headwinds facing earnings, these have to be weighed up against the strong cash flows WOR is generating and the fact it is a leader in its sector globally. Also, a high oil price will be a positive. A high oil price makes previously uneconomical finds profitable and increases revenues for many firms which are already producing. More revenue equals bigger budgets for capital projects. Obviously. Saying this, consensus forecasts have fallen in recent days. This has led to a revision in my valuation to $26.08. This is by no means is a recommendation, merely a discussion about the strengths of the business and also its weaknesses in the face of a higher Australian dollar.

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by Roger Montgomery Posted in In the Press, Media Room.

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Dividend stripping involves buying a stock before it goes ex dividend and selling it after. The idea is to pick up the dividend, swapping it for the capital loss (which occurs because the shares usually fall ex dividend by the amount of the dividend). You also get the franking credit, and if the market is strong, you may not get a capital loss at all. If you do get a capital loss, there are tax benefits there too.

Many stocks, particularly the big ones, rally (rise) well in advance of the ex dividend date, so don’t buy the day before. There are also large gains when interest rates are low and when the market is strong, so there is an element of predictability under these conditions.

A warning to eager dividend strippers: If you are going to make more than $5000 in franking credits (equivalent to 5% on $100,000) in the same tax year, you need to appreciate the 45 day rule. In such circumstances you need to own the shares for 45 days, excluding the buy and sell date, to qualify for the franking credits and you can’t hedge away the stock exposure with futures, options or CFD’s.

Usually shares drop by the size of the dividend on the ex dividend date. Because they don’t drop by the dividend and the franking credit’s value, you ‘earn’ the franking credits. International investors, who generally stick to the very large companies, don’t get the benefit of the franking credits so if all goes to plan, they may sell in advance ahead of the dividend (as locals who do receive the franking support the shares) and buy back after the ex dividend date, providing support for the local dividend seller to sell into.

By Roger Montgomery, 17 October 2009

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