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Like me, your Myer One card entitles you to pre register for a prospectus for the forthcoming float of Myer. Should you take the next step and buy the shares?

The answer to that question depends on three things. First, does the business have bright prospects? Second, what is the business worth? Third, at what price is it being offered?

Clearly, Bernie Brookes is the talk of the town, and his work in turning Myer around is fast becoming legend.  But is the talk about Bernie’s ability to improve returns on sales from 2 cents in the dollar to 7 cents, or is the talk because a private equity firm bought a business with $400 million of equity and $1 billion of debt then, in the first year, paid themselves back their equity – essentially getting the business for free and then a few years later still, floated the business for what many analysts believe will be $2.5 billion?

Myer may be a better business than it was and it may be that earnings next year will be higher again, but this is not a JB Hi-Fi, able to roll out another 100 highly profitable stores with short payback periods. This is a department store.

It is, I confess, now a highly profitable business and highly profitable businesses are the sorts of businesses to own. But what should you pay for it?

To value a company, we need to know a few things. How much is reasonable to expect the company to earn on its equity going forward? What will be the equity going forward? And what will be the policy for the distribution and retention of earnings? In other words, what portion of its earnings will the company pay in dividends?

The company earned $109 million on beginning equity of about $300 million. That is a return on equity of 36.3%. If we assume the company and its management earn another 30% next year, pay half out as a dividend, and if we assume that we require a twelve percent return, the business is worth about $2.4 billion.

But there’s a catch, the company will not earn 30% on its equity, particularly if its equity keeps growing as half the profits are retained. In reality, if the company kept retaining profits, the equity would rise and the return on equity would fall. As the business matures, it will have to pay an increasing proportion of its earnings as a dividend.

Now that probably means that the business’ value will not grow significantly after about three to five years.

Investors who are considering buying shares in the float need to consider what the true value of the business is and what it will do in the future. And also keep an eye on how much goodwill is added to the balance sheet and how much tangible equity is taken out prior to the float.

By Roger Montgomery, 17 September 2009

by rogermontgomeryinsights Posted in Consumer discretionary.

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Westpac and The Reject Shop have been good investments, but now it’s time to cash in.

by Roger Montgomery Posted in On the Internet.

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by Roger Montgomery Posted in In the Press.

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by Roger Montgomery Posted in In the Press.

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Nothing beats living on an island and nothing beats living on an island and owning the only bank. The cozy banking oligopoly that exists on the island of Australia as well as high switching costs for customers has produced all the benefits associated with a wide competitive advantage.

Are you going to bother moving if your bank charges you a few cents more for each ATM withdrawal, EFTPOS transaction or EFTPOS cash-out? With 70 million ATM transactions per month, 150 million EFTPOS and EFTPOS cash out transactions per month and 30 million debit card accounts, a few extra cents charged per transaction and account is a valuable revenue generator for banks with very little additional work or cost and virtually no risk of customer loss.

In the past the banks were all the same from an investors perspective too, but there’s a change in the air. The recent capital raisings have done significant damage to the value of three of the major four banks in Australia.

When ANZ, NAB and WBC were raising capital to shore up their balance sheets, CBA was raising capital to take advantage of opportunities in a distressed market, and acquired BankWest. It shored up its profitability in the process and now has the highest ROE of all the banks at 19% and based on consensus estimates will return 21% on its equity for the next 2 years. This compares favourably with the ANZ (11%), NAB (12%) and WBC (13%).

After two decades, a clear leader for investors has emerged in Australian banking.

By Roger Montgomery, 9 September 2009

by rogermontgomeryinsights Posted in Financial Services.

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The retailer has competitive advantage, high return on equity and no debt, all of which leads to the enviable “profit loop”.

by Roger Montgomery Posted in On the Internet.

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It seems the profits to be made by TPG on the re-listing of Myer will be outsized beyond what has been reported thus far. When a TPG-led consortium purchased Myer and the Bourke Street store, they paid $1.4 billion. Of that total, just shy of $450 million was equity – the contribution by the new owners and $1 billion was debt. Here’s the interesting part… in the first year of ownership, the owners held what you might recall was a massive clearance sale. They also sold the Bourke street store. The sale of the store netted around $600 million and the clearance sale, about $160 million. With the excess cash generated by these activities, the owners received a dividend of almost $200 million and a capital return of $360 million and hey presto, the owners bought Myer and got all their money back in the first year effectively buying Myer for nothing! Whatever the company lists for, subtract a billion to pay down the debt (assuming Myer is listed debt free) and the rest goes straight to the vendors – an infinite return on equity. What will be even more intriguing is whether the company is IPO’d with any debt. The more debt left on the balance sheet, the more of the float proceeds go to the vendors and remember they bought Myer for free.

By Roger Montgomery, 9 September 2009

by rogermontgomeryinsights Posted in Consumer discretionary.

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Roger Montgomery reveals his top picks in the Australian market, with CNBC’s Oriel Morrison. Watch the interview.

by Roger Montgomery Posted in Media Room, TV Appearances.

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Cash in the bank offers better returns than iSoft, which is still trading well above its intrinsic value.

by Roger Montgomery Posted in On the Internet.

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While most buyers and sellers of shares focus on earnings and earnings growth, ‘investors’ take a wide berth around the Profit and Loss Statement and focus instead on the business’ cash flow.

Why? Cash is not the same as profits. I recall the completion of my first year in business and the accountants handed me my first annual report.  Smiling, they said that I should be proud because I had ‘made’ a substantial profit.  Pulling my trouser pockets inside out, I declared “well where is it?”

For many businesses, profits are an accounting construct.  They are the accountants ‘best guess’ about what the true picture of the business is. But business cannot spend accounting profits, it can only spend cash. When a customer buys a product on June 28 the accounts record it as sales revenue. But if the sale was made on 14 days terms, the cash will not be received until the next tax year and even then, only if the debtor doesn’t skip town. So don’t be tricked by a business reporting accounting profits – it can be losing cash at the same time.

If you own shares in a business that reports a profit but does not generate cash on a continual basis, the only thing you need to understand is that you should be concerned.

Take the recently collapsed Timbercorp (ASX:TIM) as an example. Despite the business reporting accounting profits year on year, it was actually losing money for four years in a row.

Many years ago I received a recommendation from a broking-firm’s analyst to buy shares in Southern Dental at around $2.60. The report went on to say that it represented one of the best value plays in the market at the time. Unfortunately, its cash flow materially less than its reported profits so I passed up the opportunity to buy the shares which proceeded to fall below 90 cents.

To avoid these types of businesses compare a business’ reported profits to the Cash Flow Statement. A business that continually pays out more cash than it receives will have negative operating cash flows. If this situation occurs over a number of financial periods then, depending on the cash balance, the cash outflow will need to be supported by borrowings or raising fresh capital. The first increases the risk of the business and the latter dilutes your ownership. Rarely are either positive developments.

Without continued support from bankers or shareholders, a business that continually spends more than it earns cannot survive.

To ensure the ongoing health of your portfolio and avoid companies with an elevated level of risk, seek out businesses that generate positive cash from their operations equal to or greater than the profits being reported.

By Roger Montgomery, 2 September 2009

by rogermontgomeryinsights Posted in Insightful Insights.

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