Why we continue to hold Vita Group
Vita Group Limited (ASX: VTG) released an announcement that spooked the market, but was the news really that bad or did the market over-react? In this post we cover the main points of the announcement.
Last week I discussed Woolworths Group (ASX: WOW) with a view to continuing that discussion today. Wednesday’s news on Vita Group Limited (ASX: VTG) however and our subsequent conversations with the CFO and CEO Maxine Horne, validates the postponing of our Woolworths discussion to focus on VTG in a little detail today.
The main points of VTG’s announcement are;
- Telstra Corporation Limited’s (ASX: TLS) changes to the remuneration structure have softened the firm’s economics such that the run rate in EBITDA is lower.
- The firm expects to “retain a sizeable portion of the network, of which it currently owns and runs 107 retail stores…”.
- The firm is suspending its plans to expand its number of stores in the network.
The announcement was poorly worded, particularly as to point 2 above, and we forcefully asked CEO Maxine Horne & CFO Andrew Leyden whether they were deliberately obfuscating.
The market’s reaction reflected a belief that TLS could reduce the size of VTG’s network unilaterally. Maxine and Andrew assured us that this is not the case.
The decline in the EBITDA run rate clearly has a negative impact on the valuation that can be ascribed to the shares of VTG. VTG is still in the process of negotiating a new commission structure with TLS and because of this, a great deal of uncertainty has been incorporated into the current share price (i.e. there is the potential for further declines in the EBITDA run rate to come)
On Wednesday, VTG’s share price fell from roughly $2.25 to around $1.50. Factoring in the possibility of very poor outcomes, our valuation in VTG is well in excess of the current share price. Given such a large differential between our estimate of intrinsic value, we are retaining our investment in VTG, however the lower market capitalisation prevents us from acquiring more.
Montgomery funds hold share in Vita Group.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
INVEST WITH MONTGOMERY
Lachlan
:
What do we think about VTG after today’s more positive media release?
Rhys
:
Hi team, reading May’s investment report can you confirm that the fund has exited its position in Vita?
Roger Montgomery
:
Keep an eye out for a blog post tomorrow.
nihal bhat
:
investors are keenly waiting the outcome of the negotiation. Have you spoken to management , any latest insights Roger/team?
Lindsay Byrnes
:
Hi Roger
No one could have possibly predicted what has happened to Vita in what has been nearly a 20 year partnership with Telstra. I have decided to hold on because my analysis indicates on a worse case scenario the stock’s intrinsic value still exceeds the current share price, given a a modest multiple, This assumes a 10% discount on commissions from TLS without any allowance for compensatory measures. eg The growing B to B sector or for improved product mix to yield better returns and any cost savings ,
There is also the question of an unconscionable conduct By TLS. There might exist grounds to support a anti competitive claim to ASIC or a misuse of market power.
Hence I do not believe TLS could succeed in the 2nd and 3yd year with their further 10% reductions. Such a tactic in my view is grossly unfair and prima facie breaches the anti-competitive guidelines.
The other point to make is the 10% reduction in renumeration only relates to the Fee and commission income portion of the P& L. The bulk of sales are not effected by the 10% reduction. albeit the gross margin on those sales is only about 10%.
I get the feeling the business would still be good in the future, albeit at a lower level of return on capital. But I would be surprised to see the Montgomery Fund exit the stock at these prices ? .
gary briton
:
Very well said Roger! As a new investor in the Montgomery funds, I have complete trust in the team over the long term. I’ll keep it brief….
If you don’t make mistakes you can’t make decisions. Warren Buffett
and…
“You will never reach your destination if you stop and throw stones at every dog that barks.” Winston Churchill.
There is a long way to go, let’s focus on that.
nihal
:
the remuneration cuts are proposed, it hasnt been concluded yet.
i very much doubt 10% cuts is realistic, no small company can survive this sort of cutting, there should be compromise i imagine.
Justin Carroll
:
Thinking about VTG’s valuation further: its current EV after today’s crash is around $121 million.
Between 2007 and 2013, VTG’s average annual EBITDA was around $17 million. Apply to that a 10 x multiple and you have a forecast EV of around $174 million or $1.15 per share.
This is a rough back-of-the-envelope calculation. But I think anyone looking at VTG going forward has to expect that its earning power has now been and will continue to be seriously clipped and if you look at VTG’s cash earnings between 2007 and 2013 they came in and around $17 million.
The earnings for the years 2014 to 2016 were the real outliers – and it is these earnings that have suckered investors in to thinking that they were sustainable.
Vihar
:
Roger, Scott,
What are your thoughts about VTG’s future prospects in light of today’s announcement that Telstra will be reducing remuneration by 10% from 1st July 2017 and further 10% at start of each FY19 and FY20?
Justin Carroll
:
Maxine (and a few others) have been thoroughly schooled here. How this stock was ever able to trade at over $5 a share given the structural fragility at its core is amazing.
A conservative valuation should allow for the possibility that VTG’s EBIT will be cut in half, given that a 10% reduction annually in commissions will see VTG’s operational leverage work in reverse.
In that scenario, VTG is probably trading at fair value where it closed today.
John
:
Thoughts now Scott after the recent announcement? Was the 30% reduction in margin over the next few years part of your “very poor performance” analysis?
Scott Shuttleworth
:
Hi John,
A disappointing announcement. But actually it’s a 10% reduction in commission p.a. for several years which would hit retail EBITDA margins much more than that.
We were considering something worse for our downside case.
All the best.
Jaye MAnkelow
:
Hi Scott,
The reduction of commissions was proposed by Telstra, but not yet confirmed or agreed on. This was my interpretation.
Further, the assumption that the proposal will have an absolute affect on Vita’s EBITDA, without considering Vita’s ability to restructure it’s workforce accordingly is misguided.
FY16 included employment expenses of $123M & Commission Revenue of $180M. A 10% fall in commissions could be offset through realigning employee remuneration, commission and bonus structures. I however, cannot see any scenarios where a 30% reduction in commissions is manageable , especially in an increasingly competitive market.
Scott, you mentioned your base case scenario was much worse and your previous comment on this blog resulted in a $3.50 valuation based on a “pessimistic view”, I’m interested in your thoughts and valuations now that we have further guidance.
Kelvin Ng
:
Hi Scott, the announcement from VTG this afternoon says:
“From 1 July 2017, Telstra intends to reduce remuneration by approximately 10 per cent. It also
announced an intent to reduce remuneration by a further 10 per cent at the start of each of the FY19 and FY20 financial years.”
How can Telstra just unilaterally reduce remuneration like this during the contract term? Did the market know that Telstra has this power? Did any analyst ask this question? Did Maxine disclose this? If not, there’s something very wrong. There may well be grounds for litigation against VTG for misleading the market.
Kelvin
nihal bhat
:
this entire page should be closed. VTG down 35% today
simon
:
my goodness have yu seen VTG today ???
James Cork
:
Well, there you go! A classic case study in what can go wrong when a business is completely at the mercy of one counterparty that holds all the aces in any negotiation.
Scott Shuttleworth
:
Yes James, its a very disappointing outcome.
GB
:
Writing has been on the wall for some time. Check my comment from Nov 2016: https://rogermontgomery.com/vitagroup-update/
Sounds like you’re digging your heels in rather than seeing the wood for the trees. What exactly is meant by the ‘we are retaining our investment in VTG, however the lower market capitalisation prevents us from acquiring more’? Surely the lower market cap now means VTG represents a significantly lower portion of your diversified portfolio (so headroom to “top up” exists if you have the courage of your convictions)?
Scott Shuttleworth
:
Hi GB, thanks for your question.
There’s a difference between management of a small sum of capital and that of a large sum of capital. When your investing with a large sum of capital, you have to make an allowance for when you wish to exit in that the volume of your trading could move the price around adversely.
Hence we base our position sizes around both the potential for capital appreciation/capital loss and market liquidity.
We also wouldn’t want to be stuck with say a 5% position in an illiquid stock which takes us say 6 months to exit if we were to find something adverse.
So it’s less of a question of conviction and more so around liquidity management and the potential for risk/reward.
A good example transpired today. VTG fell by 30% but since it was already a small position, it had only a small impact on the overall performance of the fund (26 basis points).
That’s largely the thinking.
Timothy
:
Nihal should (at the very least) be grateful Montgomery IM are sharing their insights and rationale for critical decisions.
Since mid-2016, domestic and global equity benchmarks have been extremely challenging for fund managers (equities/long/growth) … an unintelligent and unnecessary comment. Performance is a function of time horizon, etc
Herman
:
Hey Guys,
Looking back in hindsight at this decision one thing becomes clear to me (and it has already been alluded to in this discussion)
The inherent business risk didn’t seem to have been correctly priced into the market’s valuation when it traded at 5 bucks and a P/E of 20 as if it were “safe as houses”. Maxine knew this and sold a good chunk of her stock (and good on her for doing so).
There is somewhat of a ceiling on VTG’s earnings ability and thus share price given they have to regularly re-negotiate with Telstra their remuneration terms/ no. of store licenses. A negotiation they have little leverage in (and even less when they are making good cash).
Furthermore, the balance sheet of VTG as a retailer provides little support. Their only asset is whatever cash they hold and the “goodwill value” of their licenses.
For this reason I appreciate the point alluded to earlier about modelling a series of outcomes.
In my view this stock hasn’t priced in the re-negotiation risk correctly for a long time and now the risk is overly priced into the stock. Thus, I see it as “worth a punt”. I view the market’s valuation of VTG as very similar to how commercial/retail property is valued. A property with a long dated lease will be valued with a low-yield and when that lease is about to drop off you see the valuation plummet with the uncertainty the lease will be renewed or a new tenant will be found.
peter.johns.52090
:
Good article guys. Could the fund rules require you to become a forced seller if price gets low enough?
Lester Green
:
Hi Scott,
Thanks for the report back……appreciate the update.
You mention that MF remains invested but keen to know whether you have reduced your portfolio sizing as a result of this latest announcement.
Matt
:
Interesting insight Scott, hopefully the market change course and realises the stock is over sold!
I bought a small parcel of VTG at $3.18, and another one today at $1.45, as while I can see the price being hammered by the market, when I have looked at the value of the stock VTG gives the view of a good buy opportunity.
Thank you for your article, after I saw your questions in the transcript from the 11th I was planning to write in and ask about VTG, and you beat me too it!
All the best,
Matt
Bill McGeachie
:
Hi Roger and Scott,
This has been an interesting dialogue. I also hold about about 3 % of my portfolio in VTG; however I have a holding in Challenger (since 2015) which has helped my portfolio outperform the market. So thanks Roger for putting me on to that one. I am a founder member of Skaffold and note that both these stocks have interesting quality ratings and safety margins. Challenger is rated C5 and is 44 % overvalued whereas VTG is rated A1 and is 70 % undervalued. As a long term investor I will continue to hold both. In the meantime I enjoy the learning curve and the earning curve.
Keith Love
:
I think I’m a buyer at current price levels. VTG are better at selling, and better positioned to sell, Telstras products than anybody else and soon Telstra and the market will realise this.
nihal bhat
:
worked back calculation
todays close approx $1.37 x 152.5mil shares = 208$m market cap
Cash on hand = cash on hand current($14M(+ 2nd half earnings is $28M EBITDA (say 20mil net) = $33M.
EV = $208-33M = $175M.
Standard industrial stock EV/EBITDA in mature but stable phase is about 6.5-7x EBITDA(low interest rates)
175/7X = $25M EBITDA per annum
Market is implying a fall in base level run rate EBITDA to $25M to $30M per annum – long term. Currently it is around $60M, so market is pricing another 50 to 60% cut in earnings.
James Cork
:
Hi Scott
Yes, agree on EBITDA vs. EBIT multiples, that’s fair. So, let’s say this business is an 8x FY20 EBIT; at today’s $205m EV and a 15% return to justify the risk of this stock (which is obviously elevated), i target an FY20 EV of ($205 * 1.15^2) = $270m. Based on an 8x EBIT, i need to feel that this business can generate at least (270/8) = $34m EBIT in FY20 to justify today’s valuation.
And this is where we are apart – you’re looking at today’s ~$50m EBIT and saying one would have to be extremely pessimistic to assume that could become $34m (or lower) in FY20 to justify today’s market price (or ever lower). I look at the 10-year history of VTG’s earnings and particularly earnings per store, and the composition of those earnings, and i see it as very easy to imagine a scenario where operating earnings revert to <$35m in FY20. The telecoms side of VTG's business was earning <$200k EBITDA per store every year from FY10-FY14, and then EBITDA per store went vertical in FY15-16 such that it was $450k per store in FY16. The driving force behind EBITDA per store going vertical in FY15-16 (in addition to SSS growth) was the fee & commission revenue they get from TLS – this went from $85m on $350m sale of G&S in FY13 (i.e. they earned 24 cents of TLS commission for every dollar of sales), to $180m on $465m sale of G&S in FY16 (i.e. VTG earned 39 cents of TLS commission for every dollar of sales). From FY10-FY13, TLS paid VTG $272m aggregate commission revenue on $1,252m sales, i.e. 22 cents of every dollar of sales went to VTG.
So, i don't think it's far-fetched at all to say that TLS – a business that is under pressure to pick some 'low-hanging fruit' in terms of cost savings – might be asking itself why its reseller, VTG, has gone from earning $150k to $450k EBITDA per store in the space of 3 years. And TLS might also ask itself why, under the basic tenets of capitalism, its reseller partner is earning 35%+ ROICs (and 50% returns on tangible capital) for doing what is a pretty simple job.
And none of the above considers a scenario where TLS actually takes some stores off VTG in 2020 – it simply assumes TLS wakes up to itself and decides to normalize VTG's earnings back to where they should be (which isn't 10%+ EBITDA margins and 30%+ ROICs, in my mind) by renegotiating the remuneration agreement it has with VTG, which has led to VTG significantly over-earning in the last few years.
Best of luck with the holding.
nihal bhat
:
for what its worth, i also picked this poorly indeed, i am down nearly to 25% of my original investment now.
Its one of those ‘punishment machines’ like SGH, WLD, VOC etc. The down days never let up and feed in on itself, 30%, 10%, 5% declines a day are very common.
Such declines are massive, in light of the risked rate typically being around 5-6% per annum. Fundamentally also looks a bit uncertain with the constant REM changes from telstra(and alleged ‘leaks’ in the press). This is the 2nd REM change in just the past few months, and VTG have guided to further REM changes being likely(3rd, 4th etc). We have no idea where the base level of EBITDA will be. Will it be $50m, 40m, or 30m or less?
One wonders what is going on with TLS, as TLS’s EBITDA in mobile is projected to be flattish only, which suggests huge earnings declines in VTG are a bit unfair. TLS’s SP is up over 10% from the low of $4.00. TLS’s EBITDA in mobile is projected slight growth to 2021. There is the threat of TPG competition but it has an inferior proposition and unlikely to affect TLS.
When i read the original announcement it doesn’t look as bad as the market is saying. “licensees will be invited to build their networks within geographical clusters” – build word meaning- some scope for growth going forward for VTG – market was thinking VTG will lose stores as per the recent leaked document, and the slightly poor wording suggests a loss of stores. The transcript reiterates no loss of stores however.
Steve Moriarty
:
As usual I will state up front that I have a portion of my SMSF with 3 Montgomery funds.
It never ceases to amaze me that there are “investors” are often very slow to thank of Roger and Co when the share price of a particular stock is rising but are quick on the keyboard for the stocks that dont.
Firstly, go back and ask yourself if YOU foresaw any of the VTG announcements? If you didn’t then how did you expect Roger to? Could Roger foresee Telstra’s change of plans – of course not. Montgomery value stocks – they dont forecast or predict futures.
I use Skaffold and it showed that VTG was just above its intrinsic value in September last year when it peaked around $5. It also showed that it had enjoyed a stellar run in the previous 5 years (up 2000% to a peak of $5). Only if you had bought after February 2015 would you be in the red and that depends on when you bought.
When I have losing investments, I simply broadframe their impact on my wealth. I have had plenty of 60% losses on stocks that I lose 5 figures on. But if I measure the loss again my total net worth, then it usually shows me that it is not the end of the world. Put it into % terms and it’s usually a blip (unless of course you have gone all-in).
My take is that most of the recent VTG announcements are speculative in nature. Lots of “If this happens….” “Maybe….” “could happen” etc. If you argue that there is a possibility of a material impact on future earnings declines then you might need to think about why you invested in the first place. As an investor, that is what you are supposed to do. If you invested on the premise that it is a good company, you should be delighted to get a bargain price on such a good company (I know Roger hates P/E ratio, but VTG is on a P/E of 5). I tell people all the time – don’t take your cue from prices. I bought some more last week after the conference call and I’ll probably buy a little more in the future. I’m not expecting it to turn around tomorrow.
When stocks lose 70% in 9 months after a great run, it is a good opportunity to decide if value investing if for you. Maybe some will reassess their risk tolerance and discover that value investing is not for them since they only like rising prices.
If that’s the case, then I would suggest you invest with Roger and look at your invetsments as a whole and not as a series of single investments. Even Uncle Warren makes mistakes. If you insist on cherry picking any single investment then I’m sure Roger and Co could counter their “losers” with a corresponding winner.
I have had my differences with Roger in the past, but it’s a tad unreasonable to expect Montgomery to foresee every potential outcome.
Regards
Steve
James Cork
:
Do you honestly expect management of any company to be completely frank with bad news when asked, even if ‘forcefully’ asked? Something about barbers and haircuts springs to mind.
I have no idea how you’re deriving an estimate of intrinsic value, given the very large range of potential business outcomes post 2020. Even if you were to use probabilistic / monte carlo analyses, the range of potential assumption inputs in VTG’s case would be so broad as to render the exercise largely meaningless.
Scott Shuttleworth
:
Hi James,
Every company on earth has a wide range of outcomes however one important one is the market implied outcome which can be calculated by back solving from the market price via a DCF model. Neither Monte Carlo analysis or Bayesian analysis would be of much help here.
After back solving this outcome, an investor can then decide as to the likelihood of such an outcome occurring given it’s magnitude.
James Cork
:
Yes, but i think VTG’s range of potential business outcomes is very much broader than most as they’re almost exclusively a reseller of one company’s product (although management seem keen to pivot their business into other areas…i wonder why that may be?), and that one company has made it abundantly clear it is seeking to fundamentally redefine the business relationship shared with VTG.
So, what’s the fair multiple for a business of this quality – 6x stabilized EBITDA (maybe 7x if you want to be generous)? I think that’s fair for what is just a pure reseller with, as is now obvious, little negotiating power. So with an EV of ~$250m, perhaps the market is implying a sustainable EBITDA in the region of ~$40m, which is what this business did only two years ago in FY15. Can you honestly say EBITDA in FY20, post remuneration structure changes and TLS internalizing an as-yet unquantified portion of VTG’s network, will be greater than ~$40m? I don’t think anyone can, and i don’t think anyone can even attempt to put probabilities around this.
And how have you valued reinvestment risk, given VTG management seem keen to diversify earnings away from TLS reselling to other businesses (i wonder why VTG management is keen to do that…)? It’s not possible.
Scott Shuttleworth
:
I’m personally not huge on EBITDA multiples…EBIT multiples are a better starting point since if we know the tax rate, we can back solve for what the company has to actually do to achieve the multiple in terms of NOPAT or even NPAT.
The firm is expecting to make perhaps $60m-$65m p.a. EBITDA assuming that they never grow/decline again. D&A is circa $11m so let’s call it $50m EBIT p.a.
Market cap is $206m as of today, so that’s a little over 4x EBIT. Cash is smaller now than at end 1H17 due to dividends/reinvestment so we won’t deduct that from the market cap.
So given you have $50m p.a. EBIT today and little debt…most of that is from TLS retail stores and a little from business centres/enterprise. The latter two will likely grow into something more significant and the company has guided numbers for this.
If you back solve from here I think you’ll find you have to take an extraordinarily high amount of profit out of the retail network – much more than even we’ve seen recently in the recent remuneration changes.
Obviously, anything better than the very pessimistic case examined above would result in a higher valuation. One scenario could be to assume remuneration changes in future are value neutral and that the EBITDA per store grows a little – that gets you to the circa >$3.50 region.
I wouldn’t assign a probability to any of these scenarios, that’s really hard to get right. But I can see that there is ample more upside than downside.
Yiannis
:
Thanks for this update Scott. Can you please elaborate on your comment “the lower market capitalisation prevents us from acquiring more”? I’m unsure why this would prevent you from acquiring more.
Thanks
Scott Shuttleworth
:
Hi Yiannis,
Our mandate in TMF has a soft bottom limit on investment in companies small market capitalisations. VTG is now at the size which we would view to be as too small to invest in.
However given how undervalued the shares are, we would prefer to hold on and sell at a fairer price in the future.
Michael McGlone
:
Prior to the recent announcement VTG was trading at approx 10 times 2017 EPS
At $1.37 the current price implies a circa 40% decline in 2018 EPS – an over reaction i would say.
I would be interested in views from the Montgomery team if they see any strategic options for VTG.
For example, TPG is making an aggressive foray into mobile – Would they be interested in 100 stores selling their mobile plans?
Scott Shuttleworth
:
Hi Michael, we have different numbers to yours but yes it requires a very large correction indeed.
With regards to TPG – probably not. TLS has a much larger customer base for VTG to service.
Jaye
:
Hi Scott,
Thanks for the update.
The silence is deafening and Vita’s announcements are worded extremely poor, it will only lead to more volatility. Further, Vita’s previous announcement indicated that Telstra & Vita would release a “joint statement” to ease market concerns resulting from the previous Telstra leaks, this never happened.
Until the market has clarity surrounding the contract negotiations, the share price will continue to be punished. For investors willing to ride the wave of uncertainty, it may prove a great buying opportunity. Only time will tell….
Scott Shuttleworth
:
It certainly will.
nihal bhat
:
this has been an extremely poor call from your end Roger. This has declined nearly 80% since your calls at $5 plus.
Roger Montgomery
:
Yep you are right Nihal. It was about 3% of our portfolio (and one of 26 stocks in the portfolios) so there is no escaping the impact to our returns and as the CIO of our team of 18 people, I have to take full responsibility. Unfortunately over a long enough time frame, we will make a variety of errors that will also be inescapable. To mitigate the impact of these, we deliberately build portfolios in a way that ensures that if any of the team of players is benched (eg VTG or TPG), we can continue to field a team and continue to win games. In six years since December 2010, we have had one year of underperformance against the benchmark and 2016 was it. We are working hard to avoid a repeat for at least another five or six years but I can virtually guarantee we will have another and another. There is simply a zero probability that even if we avoided every mistake in the future, that the shares of the stocks we pick will always go up. For that reason alone, there will be future years of underperformance.