Description

Introduction

I am submitting my views on HGG, which I find highly attractive (long) at current prices of under 0.04x Sales and 1.8x FY +1 EBITDA (FYE 3/31/2017).  There are ample risks, but I believe the current stock price severely overcompensates for these risks.  On the other hand, I believe we have the opportunity to make as much as, or more than, six times our money in just a couple of years. 

HGG was written up just over six months ago, and the author did a very good job in my estimation laying out the situation and making a case for why HGG can turn its business around.  I believe this writeup addresses upcoming cost cuts in more detail, lays out some detailed projections for the coming year (which may only be worth the paper they’re written on, but set the table for how far from distressed HGG is if they can hit their plan), and adds some analysis regarding liquidity.  And, the stock price has dropped 43% since the last writeup, so while the risks may or may not have changed, I believe the reward is substantially greater and worth revisiting in detail.  While I recommend reading the prior write-ups, I am intending for this writeup to stand on its own.

Background

HGG is a retailer concentrated in the Southeast (45% of stores), Midwest (41%) and mid-Atlantic (14%), primarily selling major household appliances (over 50% of sales), consumer electronics (over 40%, specializing in large-format TV’s) and furniture/mattresses (a newer, growing category currently only 5% of sales).

The firm is controlled by private equity sponsor Freeman Spogli (“FS”), which bought Gregg Appliances in 2005 and took HGG public in 2007 at $13 per share.  A secondary was completed in 2009 at $16.50, with proceeds used to fuel an aggressive store growth plan.  The sponsor, having taken some off the table in the IPO, actually bought into the secondary.  Today they own 48% of the firm.  Shares peaked following the secondary and some share creep to around 39-40m in 2011, however ambitious share repurchases reduced the share count to its current level below 28m shares.

Hindsight is 20/20, but obviously it would be nice to have that $150m back, in context of a current total market cap of under $100m and share price of $3.52!

From 2007 to 2013, stores grew at close to a 20% CAGR, more than tripling from 77 to 228, where they remain today.  The footprint went from over two thirds of the store base in three states (Ohio, Indiana and Georgia) in 2007 to a multi-regional player in 20 states today, with over 10 stores each in FL (36), OH (28), IN (19), IL (19), PA (19), NC (17), GA (16), VA (15), TN (11) and MD (11).  They do not exist in the northeast, or west of the Mississippi, but they have significant local market presence.

What happened?  The store base grew considerably, however same store sales (“comps”) have been negative since 2009, and have yet to recover.  HGG has grown appliances to over half of total sales, de-emphasizing consumer electronics (besides large TV’s) and eliminating fitness and mobile categories.   Gross margins compressed roughly 200 bps, as the video category saw negative mix shift in 2012 and has yet to recover.  Meanwhile, little was done to control SG&A and marketing spend, which have de-leveraged by approximately 300-400 bps in recent years.  EBITDA margins, seemingly stable around 5-6% until as recently as 2012, dropped and turned negative in 2015.  EBITDA, which consistently exceeded $80m from 2008 through 2013 and reached $143m in 2012, went negative in the year just ended 3/31/2015.  It is worth comparing historical EBITDA (achieved at some points with half the stores or fewer) to the current enterprise value of around $72m (using LTM average cash balance of $25m, vs. the most recent balance of $30m).

Opportunity

The six-bagger I referenced earlier may sound unlikely, but it happens in successful retail turnarounds for all the reasons retail is a risky business… mostly massive operating leverage.  HGG should do around $2 billion in sales going forward.  At a 5% EBITDA margin, which it has achieved consistently in the past and may be a conservative hurdle if they can successfully transition their product mix toward more furniture and mattresses and more credit-driven sales, a 6x multiple means 0.3x TEV/Sales.  Using my projected 3/2017 average trailing net cash and $2 billion in sales, we would have a $24 stock (+580%).  Precedents including URGI, KIRK, BBW and many others illustrate this is not uncommon.  It is also not the most likely outcome… retailers face unprecedented challenges today, and there has been a high percentage of failures in the sector over time.  So I don’t mean to be dismissive of risks, but it is important to frame why we think these risks are worth living with at this price.

Why cheap?

• Consensus is not very important to a sub-$5 stock with a sub $100m market cap, but it is very negative (3 Sells, 11 holds as per Bloomberg).   

• HGG will, unsurprisingly, get kicked out of the Russell in June.   

• JPMorgan has been selling according to 13F disclosures.  They still had almost 2.4m shares at 3/31/15… and maybe 1.3m shares (or more) as of 4/30/15 if I’m reading the holders list correctly?  (comments welcome)

• Shorts say the company is broken and going away due to increased competition in appliances.

This last point is important.  If this investment does not work, it will most likely be because the company cannot withstand the increased competitive pressure from HD, LOW, BBY, SHLD and others competing for market share in major appliances.  This historically attractive category (which seems difficult for AMZN to disintermediate and comes with high-margin delivery/installation, warranty sales and financing opportunities) is seemingly up for grabs as SHLD flounders, and this has attracted new competition as HD/LOW/BBY smell market share opportunity.  I argue that HGG can hold its own.

Downside protection

There is no hard downside protection.  They own no real estate, they rely on trade credit, and there would be nothing left after a bankruptcy despite trading at 56% of tangible book value.  My argument is simply that things need to get worse, not better, and stay worse for a while, for this not to work really well… whereas I believe the “bottom” in the business may already be in.  If comps get more negative, or gross margins implode, this is ultimately a zero.  But there is a long runway for newly competent and well-motivated management to figure out how to compete more effectively and reclaim their market position, as well as improve in several attractive areas. 

The following quarterly liquidity review shows that liquidity, defined as cash plus availability on the credit facility, may have bottomed out around $165m in March.  With $112m of trade payables, I don’t want to overstate how much liquidity HGG has at its disposal in a downside scenario, but they are currently in very good shape.  Cash, most recently at $30m, may approach zero as the company uses its revolver on a seasonal basis, however on a FYE basis, it has very likely already bottomed, and on an LTM average basis, it probably will not go negative before inflecting positively.  Meanwhile, I do not see availability on the credit facility dropping below $130m in my base case.  Note that as they continue to take inventory out of the system, availability is converted to cash.  Like any model, none of this will happen the way I think it will, but I think this is a reasonable base case meant to illustrate how inappropriate I find the stock’s currently highly distressed valuation. 

Finally, anticipating the question “Who would miss this company?”, I believe its customer base would.  JD Power awards and a reputation for great service (corroborated by stable conversion rates) are not flukes.  Gregg has an excellent brand in certain core markets.  I do suspect they have overextended beyond their best and natural markets, and I don’t see an opportunity to fix this mistake quickly as leases do not contain kick-outs; however, there are offsetting benefits from greater scale.

Ways to Win

 Turnaround… upside is enormous if they succeed and remain independent.  $100m EBITDA means a stock well into the $20's, and probably well beyond.  Maybe those share repurchases will end up looking smart after all. 

• Take-under… why wouldn't FS try to take out shares they don’t already own at $5 for $70m?  Valuation would be 0.05x TEV/Sales, 5-6x 3/16E EBITDA and 2.1x 3/17E EBITDA.  I wouldn’t vote for it, but it seems worth a shot.  They could make 5x in a couple of years, and maybe move the investment into a new fund (currently ten years in, believe it’s in their Fund 4 vs. current Fund 7)

• Take-out… CONN can afford to do a stock deal at a huge premium.  CONN was a successful short for me, and I am no fan of their absurd business model.  However, if they can sell their credit portfolio, they could make a great acquisition from a position of strength, and if they cannot, HGG might offer a great way to spread the burden.  The commercial and financial logic for this combination is significant: 

   

  • Geography: lack of overlap is highly attractive, as CONN has recently entered the Southeast, where HGG is highly established.  Only 16% of CONN’s store base is located in HGG’s markets, and only 24% of HGG’s store base is located in CONN’s markets (and only 17% if you exclude Georgia, where CONN is in the process of opening its first store in Atlanta). 

  • Scale: Vendor support would increase materially, and in fact, CONN has highlighted getting from 300 overnight. 

  • Credit penetration: CONN has 93% of its sales on credit, vs. HGG at 41% (and growing).  Not saying 93% is natural or healthy, but if anyone can help HGG increase credit penetration, it’s CONN.  This is important because credit-driven purchases are much higher ticket and higher margin (not just for CONN, but also for those exclusively using third-party credit providers, like HGG). 

  • Furniture/mattress mix: HGG wants to go from 5% to 10%, for now.  CONN has made a killing by pushing much more aggressively into this category, surpassing 27% penetration last year. 

  • Appliance mix: CONN wants to double this category, currently 30% of sales, in three years.  HGG does over half its business in appliances, already up significantly in the past few years. 

  • Cost synergy: I haven’t put a fine pen to it, but both companies have said they have excess distribution capacity (there would be immediate rationalization in the Southeast), and total marketing and G&A would likely each be reduced significantly.  HGG is currently running national TV ads (despite not being in 30 states including CA, TX and NY!) because it is cheaper than splitting it up.  Anyone watching the NHL playoffs has seen their new ads promoting appliances and financing options. 

  • Most importantly, CONN trades well over 0.5x EV/Sales, even imagining a clean sale of its credit portfolio for full value.  A stock deal for HGG, perhaps at 0.1x TEV/Sales ($9+ stock price) would be a steal given the likely acceleration of HGG’s turnaround.  Again, not sure I’d vote for it.

Opportunities for CONN to Extend Runway

Marketing cost cuts.  Marketing budget will be down $20m this year.  This is scaring people (in light of recent negative comps), however McKinsey just spent many months (and $4+ million of shareholder money) focused almost solely on determining that recent marketing efforts in direct mail and newspaper inserts were mostly wasted, and a new marketing strategy is being implemented that management says is working, with comps going from down -HSD to down -MSD so far in Q1 (ending June). 

SG&A cost cuts.  This is a Q2 event (and the reason I still have negative yoy EBITDA comparison in Q1 ending June), but they will take $50m of costs out.  $30m hits this fiscal year, and another $20m comes out next year.  This should significantly help stem the tide, and could create significant operating leverage if/when comps turn positive. 

Variable SG&A is significant, given the commission-based sales force.  A -9% comp in FYE 3/16 with flat GM would still get us to zero EBITDA this year, and they are tracking -MSD YTD, which could get us to 15-20m positive EBITDA.  Flat sales the next year would imply 35-40m EBITDA in FYE 3/17, and the stock currently trading less than 2x this EBITDA number.  6x the 35-40m, or 0.11x Sales, would imply a $10.25 stock, or almost a triple.  To be clear, I believe that management expects better than a -MSD comp this year, and I hope they’re right. 

Anticipated SHLD store closings. Management sounds more constructive than they did last fall that projected Sears closings will help HGG get to a positive appliances comp this year.  I am not banking on this, however I understand from management that HGG stores near Sears closures typically get a +20% bump in sales. 

Inventory reduction.  HGG will take about $50m out of average inventory this year.  Since the starting point was depressed due to the port situation and TV shortages, 3/31/16 will only be down around $30 million, however average inventory for the year is projected down $50 million.  This actually doesn’t create much liquidity, as it reduces availability under the borrowing base calculation, but even as payables contract, it does transfer availability to cash (and is roughly neutral to liquidity).  I’d rather have cash than availability any day. 

Assumptions

Is a -MSD comp in FY 2016, and then flat in FY 2017, inconceivable, given easy comps, significantly refreshed marketing (currently highlighting more aggressive financing options), and a major competitor closing stores?  I don’t anticipate any recovery in gross margin, and I give management the benefit of the doubt with respect to SG&A and Marketing cost cuts only because they have expressed high levels of conviction when we have walked through the guidance.  Working capital reflects the inventory reduction, but does not continue this trend beyond this year (although management believes there may be more to come).  Here is what my base case model looks like, for what it’s worth:

Management

I have the least to say about the CEO.  I have not met him but have heard from multiple sources that he is very good, although I find it hard to believe he is still there after presiding over the past few years.  FS seems to have replaced everyone but the CEO, so perhaps he is a figurehead at this point and is the glue that keeps things from unraveling, culturally, as the company goes through significant cost cuts and shifts in strategy.  Or maybe they are entertaining alternatives that don’t require a new CEO. 

New CFO Bob Riesbeck came from Sun Capital, where retail turnarounds are a specialty.  He has been CFO of Sun as well as several of their portfolio companies, and he is no stranger to duress and turnaround efforts.  This mentality was sorely needed, as HGG had not really needed an austerity program until recently, and the cost structure reflected this reality.  He is the biggest piece of the puzzle.  In November, Bob bought half a million bucks worth of stock 38% higher than current price.  I believe this is because he agrees that regaining $100m in EBITDA is a reasonable medium-term goal. 

Merchandising management was replaced in January.  New Chief Merchandising Officer Keith Zimmerman comes most recently from PC Richards, but he spent most of his career at American TV in Madison, WI and is particularly focused on furniture and home products, in addition to core HGG categories (appliances and CE).   It will be very margin accretive if HGG can successfully shift sales from CE to furniture/mattresses.  It is not lost on me that American TV is in the process of liquidating.  Tough business!  11 stores averaging 130k square feet apiece probably didn’t help.  (HGG and CONN are closer to 30-35k). 

A new SVP-Logistics was also hired around the same time.  Logistics is apparently a huge area of focus.  HGG has high shrinkage rates (damage, not theft) from products being touched too many times.  Damage not only costs money, it also represents opportunity cost, as it leads to product outages and lost sales.  The whole distribution network is likely to be streamlined and rationalized in the next couple of years, and some of the five larger “RDC’s” which range from 250k to almost 400k square feet will likely be shut down, replaced by more “LDC’s” (which range from 20-100k sq ft).  Apparently there is $10m in annual rent just for the DC’s, which resides in SG&A. 

Finally, I have heard that non-NEO's have been buying stock very recently, including the head of stores.  I can’t verify this, so take it for what little it’s worth. 

Notes on merchandise / credit strategy

It’s worth noting that while not a great category long-term, larger TV's are a very good place to be right now.  1m 4K ultra HD TV's are going to 4m this year.  Overall units won’t shift much, but this mix shift to 4K is good for HGG, as HGG beats WMT/COST et al in the 50-inch and up realm.  As for pricing, Panasonic is out of the business, Sony is smaller, and Sharp is out of North America.  Hopefully (for retailers) more rational pricing will ensue now that Samsung is half the market, and LG is a strong #2.  The longer units stay in this range, the better.  The problem is that when the industry goes to 10m units, they all get sold irrespective of price, and retailer economics can deteriorate quickly. 

Appliance trends are supposedly getting better.  Recent optimism from SHOS is interesting on this front, as they report a month later.  The port situation hurt in-stock / availability, so getting past that should be helpful. 

Furniture used to only be Ashley Furniture… now expanding to 5-6 brands, which will be a big boost.  It is still merchandised poorly (laid out in rows, rather than set up like rooms), however they are working on fixing this and don’t expect it to cost much at all (no expensive store remodels needed).  Also, furniture/mattresses going to 10% of sales from 5% in near-term (12-24 mos) should be a boost for margins.  CONN’s product category margin disclosures are illustrative, at least on a relative basis: 41% in furniture/mattresses, vs. approximately 30% in appliances and under 25% in CE.  If they can gain 15 points of margin as they move 5% of sales from CE to furniture/mattresses, that results in 75 bps of overall GM expansion (I have not modeled any). 

Credit: 37% of sales went to 41% in FY 15… can go much higher, which helps because credit sales are bigger ticket and higher margin (just ask CONN).  To be clear, HGG bears zero credit risk.  GE (Synchrony) is the provider. 

Stores

Little opportunity to close underperforming stores, unfortunately.  However, stores are generally new and in great shape, and store operations can be improved without investment.  Specifically, while the company is looking at the commission structure and making some tweaks, the opportunity resides mostly in overhauling the staffing model.  Historically, salespeople have been staffed on a full-time basis, working 43 hrs/wk full-time.  They are now looking to change scheduling, allow part-timers, and more appropriately staff the stores to reflect traffic patterns. 

Capex

Capex can run at 15-20m for now, and will until they are back on their feet.  25-30m is max they would want to spend when recovered (1/3 on e-comm would be the plan, but 2/3 this year).  Let’s hold them to this. 

Catalyst

Selling abates related to Russell re-balance and large holder exiting

Q1 shows comp improvement

Q2 shows SG&A improvement

Q3 shows return to positive LTM EBITDA?

Q4 shows increased year-end cash balance

Potential takeout