| 2006 | 2007 | ||||||
| Price: | 77.50 | EPS | |||||
| Shares Out. (in M): | 0 | P/E | |||||
| Market Cap (in $M): | 1,270 | P/FCF | |||||
| Net Debt (in $M): | 0 | EBIT | 0 | 0 | |||
| TEV (in $M): | 0 | TEV/EBIT | |||||
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Private Equity are poised to take 25% of the South African retail index private. http://today.reuters.com/news/articleinvesting.aspx?type=bondsnews&storyID=2006-12-04T030010Z_01_N03434206_RTRIDST_0_EDCON-TALKS-WSJ.XML. While the current deals on the table provide an acceptable return to pe buyers I am puzzled that KKR et al did not target Ellerines (ELH.SJ) instead. Ellerines is a listed furniture retailer on the South African stock exchange. This report will show that a pe buyer could earn a before tax yield of 50% per annum on an investment in the operating stub of the business. This is more than double the yield on the current deals.
In my opinion the reason Ellerines may have been overlooked include:
- Ellerines essentially swap furniture for installment loans. The recording function is messy/confusing and does not quite capture the incredible earnings power of this business model.
- Disclosure standards are below US standards and make it difficult to immediately recognize the true earnings power of the business.
- Sell side analysts perpetuate the “misunderstood” earnings power as their analysis tends to focus on forecasting an income statement (and the almighty EPS growth) despite the fact that the recording function does such a lousy job of reflecting economic reality.
- While Ellerines have an experienced management team the hard earned returns from the operations are hurt by a capital structure that costs too much. Management are currently reviewing the funding structures and announcements in this respect should boost the rating of the stock. (This is one of the catalysts described below)
I was reluctant to submit this idea because I suspect the South African listing will result in a low rating. However, I decided to make the post mainly to promote the framework used by beep899 in his write-up of CRMT. I was also encouraged by tbone841’s excellent write-up on DFC which also blames “awkward” accounting and “misunderstood earnings power” for making DFC one of the most “undervalued stocks in the market today.”
I must admit that I used to struggle with the accounting for companies that “swap” either cash/merchandise for loans until beep899 provided his elegant short cut. Many of these types of companies (NICK, DFC, CRMT, RCS.CN etc) have been discussed on VIC and I hope to receive comments from other members on the usefulness of the model. The model essentially focuses on economic reality and skips the messy recording of revenue and bad debts. Avoiding these complications immediately focuses attention on the earnings drivers that need to be understood and monitored.
Business Description
Ellerines sells “mass produced furniture to the masses” through 1 156 retail outlets scattered around
Sixty percent of these sales are made using 24 month installment loans. The installment loan book is funded internally by Ellerines. Credit is approved centrally using information from credit bureaus and credit scoring models developed by Fair Isaac. The collection process is mostly “local” but is in the process of being centralized in call centers. Ellerines has over 2 million ** customers and centralizing the collection function is expected to speed up collections as well as lowering collection costs.
(**
Business Model
This is where things become really interesting. Lets imagine you rushed down to an Ellerines store to snap up a TV advertised for $1 000. If you opted to take the in-store credit facility the smiling sales man would require a $100 deposit (10%) plus a commitment to pay $93 per month for 24 months.
If the TV is sold at the average GP margin of 45% then Ellerines are effectively swapping $550 for $2 330 over a 24 month period. The present value of this cash stream is $2 020 (using a discount rate of 10%)
Assuming that 7% of the debt is not collected implies that Ellerines effectively swap $550 for cash flow with an npv $1 880. In easier to understand terms, Ellerines swap goods worth $1 000 for a cash stream with an npv $3 400 after bad debts.
Operating expenses for every $1 000 of sales is $600. (These expenses should fall as the costs savings from centralizing the collection process are realized). Adding this together implies that Ellerines make an EBIT npv of $730 (1 880 -550 – 600) for every $1 000 of credit sales.
Cash sales are less exciting and actually generate a loss. (sales – cos – ox = 1000 – 550 – 600 = 150 loss).
The blended EBIT assuming 60% of the sales are on credit and 40% for cash is $380 for every $1 000 of sales.
Valuation
(All these numbers are in South African Rands, $1 = R7)
Ellerines has a market cap of R8 900mil and net debt of R860mil. So for a total investment of R9760mil an investor gets the following:
What is the operating stub worth?
A private equity buyer could buy Ellerines for R9 760mil, sell off the insurance assets and book for an all-in cost of R4 030mil for the stub. (9 760 – 630 – 5 100)
Using the equation described above we know that sales of R1 000 generate an npv of R380. Using this ratio implies that the forecasted sales of R5 400mil should generate R2 050mil in npv. This translates into a 50% yield per annum to the owner of the stub. This is a remarkable return which has somehow failed to catch the eye of the pe players.
Earnings Drivers
The above analysis shows off the elegance of the model. All an investor needs to know is the following:
I will provide some guidance on these drivers below
Predicting Future Sales
- There is no fashion risk as all South African furniture retailers sell “mass produced furniture to the masses” To be precise, the majority of the furniture sold to the mass market in South Africa is supplied by one manufacturer.
- The competitive tools used by the furniture retailers are “place” and the “promotion” of different retail formats in the consumers mind. With 1156 stores and 2mil customers Ellerines is the second biggest furniture retailer and is well positioned to compete on both “place” and “brand image”.
- As a result the macro economic factors (gdp growth, interest rates, urbanization etc) are a much bigger driver of sales compared to the micro factors.
- The SA economy is growing at 5% per annum and retail sales have doubled over the last 5 years. The central bank has recently increased interest rates from 8% to 10% to dampen consumer demand. But, job growth is expected to continue as strong infrastructure spend gains momentum.
What proportion of Sales will be on Credit?
- Until recently South African banks did not focus on consumer finance. The large unbanked population and the lack of third party funding resulted in all South African retailers offering in-store credit to it’s customers.
- This has begun to change with “pre-approved” credit offerings by traditional banks to this previously underserved market.
- Because South African retailers traditionally offered in-store credit facilities they built a sophisticated credit granting system to service their needs. These systems use cutting edge technology from Experian and Fair Isaac to analyze data made available by the credit bureaus.
- To gain market share the banks have bought mailing lists and used the credit bureau scores to offer pre-approved credit to potential customers. But, pre-approved credit solicitations will be prohibited from June 2007 which make it harder for banks to infiltrate the Ellerines customer base.
- While the loss of internally funded credit sales is a risk it is reasonable to assume that a large portion of sales will use in-store credit for the foreseeable future.
Bad Debts?
- Credit is granted centrally using score cards that reliably predict the probability of credit losses.
- To date collections have been local, but, are in the process of being centralized. Initial results indicate that the centralization of the collection function combined with behavioral score cards have improved collections and lowered collection costs.
- The right to repossess items sold plus the 10% deposit are an effective inducement to discourage defaults. They also limit the severity of the loss.
- Ellerines’ has stores across the country and with over 2million customers credit risk is not focused.
- While macro economic forces will affect the timing of the cash flow and the bad debt provisions required by the accountant, management guidance indicates that on average only 7% of the expected installments are ultimately not collected.
- The granting of credit based on credit scores is effectively a bet that the customer keeps his job. As job growth is expected to continue this appears to be a safe bet for now.
Predicting the NPV(Installments) to Credit Sales
- There is currently a lot of noise that may affect this ratio as the government implements legislation to limit the cost of credit.
- All indications are that the legislation will not change economic reality and a similar ratio is expected for the future. All that will happen is that the components making up the $93 monthly installments will change.
- Also, while economic reality will not change the recording function will. Initially this will results in lower revenues and accounting earnings. Many analysts are oblivious to these changes and it will be interesting to see how the market responds to the lower accounting earnings even though economic reality remains the same.
Predicting the GP margin?
- Ellerines earn a 45% GP margin while the other furniture retailers earn 35%. Unfortunately, the GP margins are not comparable because while the competitors have a lower margin they load the back-end with higher finance charges. In contrast, Ellerines load the front end and off-set this with lower finance charges.
- The end result of this “smoke and mirrors” game is that the monthly installment as a percentage of sales are very similar for all the furniture retailers.
Operating Expenses ??
- Mostly occupational costs and wages.
- Not rocket science to predict and management provide good guidance.
Catalysts
More Efficient Balance Sheet
Management have indicated that they plan to restructure the balance sheet. There is virtually no debt on the balance sheet if one nets of the insurance asset (no longer required) against the net debt. This is a business that can support a much higher debt load and it makes sense to fund the assets using debt (cost = 9% after tax) instead of using expensive equity which hurts the ability of Ellerines to maximize the EVA it is able to produce.
Originator Model
There is an outside chance that Ellerines splits the businesses. The retail/origination function will earn a gp margin, origination fees, service fees and whole sale interest margin. The originated loans will be sold into a mortgage reit (mreit) structure which will issue debt to buy these loans. Splitting the operations into two parts will create value through segmenting the shareholder and through tax savings. The mreit structure saves tax especially for South African pension funds which only pay 9% tax on the distributions from the mreit. The corporate tax rate is 29% on income plus 12% of the dividend paid.
Private Equity Offer
Private Equity is very active in SA. PE have targeted 25% of the retail index. Two of the three casino stocks are about to be taken private. With this type of activity one wonders whether any companies will remain listed.
Changes to the Recording Function force sell side analysts to change their myopic analysis
Changes to the recording function will initially result in lower revenue and earnings. Hopefully, these events will force analysts to identify the weaknesses in the recording function and to develop models with a greater appreciation for economic reality.
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