Fashionable JD not for me

I enjoyed jettisoning my baggage so much before profiling T Clarke, I’m going to do the same now, as I think about JD. It’s a way of purging issues that probably don’t matter, and focusing on those that do.

Last Friday’s quick profile revealed plenty to think about, but there was nothing to put me off plugging JD’s numbers into my spread sheet. The comments on the post made me pause for thought, though.

Both John Kingham, aka UK Value Investor, and Blippy, aka Mark Carter, revealed they own the shares. Worse, far worse, Sharescope tells me the three analysts that follow JD all recommend buying, and the FT likes JD too.

It’s not a very contrarian idea then, but I must put the company’s apparent popularity out of my mind. I’m not a naive contrarian in the sense of doing the opposite of everyone else. I’m a bloody-minded contrarian in the sense of ignoring everybody else. And just to be clear, I don’t make a habit of ignoring fellow value investors John and Mark, I’m simply more interested in learning how they do what they do than the end the result.

The summary table reveals a highly profitable company, at a cheap price (promising a 15% earnings yield), at a good time (the F_Score is seven out of nine). One of its fans on the discussion boards sums the figures up rather succinctly:

If operating cashflow never increases in the next 10 years, it would be still undervalued at todays price. It`s valued at less than 3 times book value and considering the return on equity, I can`t think of a company that`s better value as a growth company can you?

The charts are even more impressive. JD has all but maintained its level of profitability (green lines), increased profit margins (blue line) and dramatically increased shareholder wealth through a recession (orange bars).

But I think I think one element of this story might be too good to be true: That it’s done it all with minimal leverage…

There’s an elephant in the room. A gargantuan woolly mammoth in fact. JD leases most of its shops and warehouses and the cost of those leases isn’t accounted for in any of the basic financial measures I use. It isn’t even disclosed in the company’s preliminary results, where my figures for 2011 come from, although It will be disclosed in the annual report when it’s published in June.

JD, like many retailers, rents stores under agreements known as non-cancellable operating leases obliging the company to pay rent in return for use of the properties. At the end of the term, and many of them are for more than five years, the company will have to renew the lease, if it is to keep trading from the premises. It’s like paying interest on a debt the company continually rolls-over. Indeed, that would be an alternative way of financing the stores.

To give you an idea of the size of that commitment, JD owed landlords a minimum of £571m in future lease payments in 2010, which to my mind is a kind of debt. It paid £76m in rent, which is like interest on the debt. Straight away we can see that the value of its leases (albeit undiscounted) is greater than the market value of the company itself and the value of the assets actually listed on its balance sheet. JD also paid more in rent than it made in profit in 2010.

But because the company doesn’t own the properties, they’re not included in its balance sheet and we don’t see that £571m woolly mammoth unless we look very closely at the notes to the accounts. Last year rent was included in the breakdown of profit before tax (note 3) and total commitments under operating leases in note 28.

I’m very grateful to Steve Baines, aka Cautious Bull, who shared some basic tools to help account for operating leases. The idea is to capitalise them, i.e. treat them as if they are assets and liabilities of the company, instead of expenses lost in the gross profit figure. By capitalising the operating leases, they’ll influence the company’s leverage ratios, which are important in determining where a company’s profit comes from. Steve’s rule of thumb is to add eight times annual rental payments to both the company’s assets and its liabilities.

In 2010, JD had total assets of £306m and shareholders’ equity of £139m. The difference is liabilities, debt of one kind or another, of £167m.

If we add eight times the annual rental payments of £76m to assets and liabilities, the numbers in the balance sheet equation (assets – liabilities = shareholders’ equity) change to:

£914m – £775m = £139m

And so the ratio of total assets to shareholders’ equity, the simplest measure of financial leverage, increases from:

306 / 139 = 2.2

To:

914 / 139 = 6.6.

Suddenly the company looks heavily indebted. 85% of its (enlarged) assets are funded by debt of one kind or another, and only 15% by shareholders.

Another way of looking at rent, is to treat it as another form of interest and see how comfortably operating profit covers the rent and interest payments. Because rent is expensed before operating profit is calculated, we have to add it back and then divide our adjusted operating profit figure by rent plus interest. As JD’s interest expense was tiny, less than £1m, I’ve ignored it.

In 2010, operating profit was £67m, so:

(£67m + £76m) / £76m = 1.9

In other words, adjusted operating profit was less than two times rent payments and if it halved, JD wouldn’t be able to pay the rent.

I think that explains why the shares are so cheap. By normal measures the company is highly profitable, and financially strong but in reality, like a company in hoc to its bank, its profitability is dependent on leverage, and staying in business is dependent on it remaining highly profitable.

The situation reminds me of investment banks in the years before 2008. I couldn’t understand why the shares were so cheap, but they blew up when it turned out they were using fantastic amounts of leverage. My intrinsic distrust of leverage (and opaque accounts) kept me away from banks, and it may keep me away from retailers.

While I agree JD doesn’t even have to grow to be good value at its current price, I don’t like the opposite side of the equation which is if profits slumped drastically the result could be catastrophic.

I suppose the investment case rests on whether you think that could happen, and I always do…

Which is a shame, for a while I had that sure-fire feeling about JD.

29 Comments

John Kingham May 19, 2011 at 4:44 pm

Interestingly different viewpoint. What would be useful is a comparison to a range of other similar and not so similar retailers (Next, M&S, Comets, or whatever’s on your high street) to see how they stack up.

My guess is this is fairly normal for retailers. Of course it’s a risk, but I think things would have to get incredibly unpleasant for the company as a whole not to be able to cover the rent. In the case of individual stores it’s par for the course. Their finance director says (apologies for the long quote, please berate me in private if you like):

“The retail landscape has seen significant changes in recent years with a
number of new developments opened and a high volume of retail units
becoming vacant. The Group can be exposed where it has committed
itself to a long lease in a location which, as a result of a more recent retail
development, is no longer as attractive to the customer so suffers from
reduced footfall. Wherever possible, the Group will seek either to take
out new leases for a period not exceeding 10 years or to negotiate lease
breaks, thereby limiting this potential exposure and affording the Group
increased flexibility to respond to such changes.

When the Group realises store performance is unsatisfactory it
approaches the landlords to agree a surrender of the lease. Where this
is not possible, the Group would seek to assign the lease or sublet it
to another retailer. In many cases, this necessitates the payment of an
incentive to the other retailer. However assigning the lease or finding a
sub-tenant is not without risk because if the other retailer fails then the
liability to pay the rent usually reverts to the head lessee.

The Group is mindful of current economic factors and the higher volume
of vacant units available as a consequence of a number of retailers going
out of business. This has an impact on the Group’s ability to dispose of
its own surplus premises and increases the risk that previously assigned or
sublet leases will revert to the Group.”

If not JD, how about JJB?

Reply
- Calum May 19, 2011 at 9:33 pm
  
  @ John – I’ve actually got a summary of operating leases in my latest post (although half are US companies). A general rule appears to be that once operating leases get over 100% of assets and more than 50% are coming due in under 5 years then the company is probably in trouble. The best example is Clinton Cards which is in a terrible state, although the trend appears to be towards landlords renegotiating a la JJB,
  
  Reply
  - blippy May 19, 2011 at 9:59 pm
    
    Calum, do I understand you right here? According to MSN Money (http://bit.ly/iU7O4j), JD has total assets of £368m. Richard notes £571m in future lease payments. So operating leases are greater than total assets by a wide margin, and therefore investors should be nervous (leaving aside the maturity of the leases)?
    
    Reply
    - Richard Beddard May 19, 2011 at 10:17 pm
      
      Except, JD is trading very well so there’s no clear and present danger. My conclusion sounds a bit more apocalyptic than I meant it too. While JD can carry on cranking out the profit there simply isn’t a problem.
      
      Reply
    - Calum May 19, 2011 at 10:31 pm
      
      The discrepancy in total assets is because I only used annual reports (the leases sometimes aren’t in the first set of finals). So the 2011 results from JD were released early last month but the annual report isn’t out yet. The OL/TA measure is a rough one and I intended it more as a relative measure than an absolute one. Tbh, Richard says it better than it could in that there appears to be some “hidden” leverage so it depends what you think of operations?
      
      Reply
  - Richard Beddard May 19, 2011 at 10:36 pm
    
    That’s a useful looking table Calum: http://www.valuhunteruk.com/stock-ideas/aeropostale-thinking-about-operating-leases-and-the-outlook-for-retail-stocks/
    
    Thanks for sharing it.
    
    Reply
    - blippy May 20, 2011 at 7:42 am
      
      Good find. It really changes ones perspective. For example, just looking at the balance sheet, JD looks better than Next because it has net cash compared with net debt. Factoring in operating leases, though, Next looks much better. Marks & Spencers looks very good, too.
      
      Richard, very good article.
      
      On interesting retailer is FCCN (French Connection), which I think I need to look at in a bit more detail. It has an EV/EBITDA of 2.3. What’s interesting about it is that it’s not just a clothes shop, it is also a brand. I hear that it has been doing rather well on on-line, selling through ASOS (??). I think that this is an interesting point to make in the context of leases.
      
      In the tech boom of 2000, it really seemed as though online retailing was a bit of a fad. I don’t think Amazon were making any profits, for example. Fast forward a decade to Web 2.0, and it looks like clothes retailing online is actually a much more commercially viable option.
      
      Reply
      - Richard Beddard May 20, 2011 at 8:50 am
        
        Cheers Blippy but I don’t feel that responsible for it. Let’s not forget Westwind3 who posed the question in the first place in his comment on my first JD article, you and John, who added lots of detail, Steve who introduced us to the eight times rent multiplier and Calum – that table’s his!
        
        Any way, it could be a good article, but wrong. But I do think the notion that retail in general is good value is not true and that advocates of retail cannot ignore the operating lease question. However it is possible there is value in retail, likely perhaps, as the sector is generally down.
        
        The trick would be to find companies that are profitable and have low overall leverage including operating leases.
        
        French Connection is, in fact the best performing T30 company. I didn’t look at its operating leases. I will when I come to review it
- Richard Beddard May 19, 2011 at 10:29 pm
  
  Absolutely right John, I wouldn’t be at all surprised if JD was in a better situation than many other retailers, some of whom have a combination of debt, leases, and obnoxious pension funds!
  
  Thanks for the detail from the FD, that’s very interesting. We’re amassing quite a repository of info on operating leases – do his words make you feel more confident, or less confident? I think they confirm my suspicion that if it came to it, disposing of leases could be very difficult.
  
  Part of my nervousness about leases stems back to my experience with SCS Upholstery back at the dawn of the credit crunch, a debt free company that went under because it couldn’t pay the rent, basically.
  
  As for JJB, it’s a bit too near the eye of the storm at the moment, but who knows, maybe when recovery seems inevitable.
  
  Reply
  - John May 20, 2011 at 10:14 am
    
    I try not to have any confidence in my investments any more, I just do the best analysis I can and go from there. The operating lease questions doesn’t change my position on JD though. I think it might if I were investing in a turnaround as it would then be a key issue. But for a company that has done very well through the recession and still looks in good shape, I think it’s less of a concern.
    
    As for disposing of leases, that’s just an ongoing process that they do every year, just a bit more at the moment and yes it would be more difficult. The numbers involved are 538 stores at the end of the year with 21 closures, so about 5%, but they said “it remains very difficult to dispose of underperforming and/or duplicate stores” so how many more they are trying to close is anyone’s guess, but I don’t imagine it’s a huge number.
    
    SCS is a different deal altogether as they sell sofas which everyone just stopped buying. JD sells fashion sports items which teenagers would rather starve than not buy; the same goes for switching to a cheap outlet like Matalan. But of course only time will tell…
    
    Reply
    - blippy May 20, 2011 at 9:12 pm
      
      “JD sells fashion sports items which teenagers would rather starve than not buy”
      
      That’s been part of my thinking, too; although I don’t have solid facts to back them up. Economic pressures on teenagers might be different from when you’ve got a mortgage to worry about.
      
      BTW, I have some tracksuit bottoms that I bought out of JD Sports a few years ago, despite the fact that I’m not their typical target audience. They’re actually good quality.
      
      I should probably do a little tour of the mall some time soon. My general observations at the time were that HMV and Waterstones were fairly empty, Debenhams were a bit of a wasteland, Primarks had long queues at the tills, and JD had customers. Not many, but considering the shop was tiny, I actually came away with a positive feeling about it.
      
      I don’t own any M&S, but they actually look like quite good shares. PFCF of less than 10, good divvie, good balance sheet, EV/EBITDA of 6.7. Plus they don’t seem to have the lease problems that are being discussed here. I heard some negativity about them the other day, saying that they were dressing up their accounts, although I’m not aware of the specific accusations.
      
      Reply
Crucible May 19, 2011 at 8:06 pm

Hi Richard,

Long time reader, first time commenter; so first off a big thanks for all your analysis. I hadn’t a clue about investing on fundamental analysis prior to a few months ago, and yours was one of the first places I found, which was a springboard for even more research and all the other great blogs around the internet.

On this one – this is the kind of analysis I love; digging deeper into potential pitfalls and where the figures can deceive the inexperienced.

A quick question while I’m here – did you ever get round to looking at the housebuilders again? I saw a quick snippet for you on Persimmon, and Barratt (a housebuilder around the same market cap) is a share that I personally like a lot, though definitely not one that meshes with your recent style!

All the best,
Crucible

Reply
- blippy May 19, 2011 at 10:18 pm
  
  Crucible, I highly recommend you buy the book Intelligent Investor by Ben Graham http://amzn.to/mAMAOk ; sometimes referred to as the “best book on investment ever written”. It will be an enlightening experience for you.
  
  Additionally, or alternatively, The Little Book That Still Beats the Market by Joel Greenblatt http://amzn.to/ixzqCB is will really whet your appetitite for investing.
  
  Some of Peter Lynch’s books are also worth reading. Peter has a very qualitative feel for companies (although he doesn’t eskew quantitative aspects), which separates him from Graham and Greenblatt, who tend to look at the numbers. Graham was considered to be an incredibly smart man, and considered as “the father of value investing”. I think he thought that qualitative factors were very “ethereal”
  
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  - Crucible May 19, 2011 at 10:45 pm
    
    Hi Blippy,
    
    I’ve actually got this one (probably) sitting in my post at home along with Aswath Damodaran’s new one on valuation techniques – so not too long before I’ll start reading them.
    
    With any luck I’ll start a blog in a few months when things clear up – it looks like a great community round here and a good way to motivate myself to keep up learning and discussing!
    
    - Crucible
    
    Reply
- Richard Beddard May 19, 2011 at 10:46 pm
  
  Thanks for the compliment Crucible, and I’m very pleased you like what you read here, and the things I link to – as you can see the comments bit can be the best bit of all.
  
  I’m afraid I haven’t looked at Persimmon, partly because I’m not familiar with housebuilders and partly because I’m wary of companies where a major determinant of their performance is unpredictable changes in the value of their assets (land in the case of housebuilders).
  
  Cautious Bull did a very good post on Persimmon, but even though he made a good case for buying it based on fundamentals, he shied away from actually doing that because of the outlook for house prices. That’s where it all gets a bit speculative for me.
  
  Here’s the link: http://cautiousbull.wordpress.com/2011/03/22/the-case-for-and-against-persimmon/
  
  I’m not saying I won’t take a look at it – we should always be trying to increase our knowledge after all!
  
  Oh, and if you haven’t already read them I absolutely endorse Blippy’s booklist.
  
  Reply
blippy May 19, 2011 at 9:26 pm

Yes, interesting analysis Richard; and it definitely gives pause for thought. Re John’s comment “My guess is this is fairly normal for retailers”, I think he is likely to be right. Actually, I suspect that many retailers don’t fare nearly so well.

I vaguely recall someone having a discusion about Greggs the bakers, and how they “only” made operating profit equal to rent – giving it a ratio of 2, similar to JD., on the basis of your calculation. A respondent said that rather than being a poor figure, this was actually an exceptionally good showing for a retailer. I’m working from memory, though.

Greggs would seem a less riskier proposition than JD., though, as the former is relatively insulated from economic downturns owing to its defensive nature.

I can’t make up my mind as to whether investment sentiment towards retailers is hotting up, or cooling down. Clothing retailers as businesses seem to have done fairly well the last year, having increased revenues on a like-for-like basis, compared with, say, electrical goods. Fears over the economy and costs of goods do seem a significant worry for the retailers, so I wouldn’t say that it’s impossible for share prices to halve from this point. It topped at 602p in mid 2007, and bottomed at about 214p in early 2009. Having said that, the actual performance of the company itself had been one of progress during that period, so you never can tell. Let us also remember that JD never made a loss during the last decade – although 2003-5 it did look like it came close. There may have been some fudging of the figures, though, because tax rates looked abnormally high during some of that time, suggesting that true profits were actually greater than the ones reported.

BTW, JD is ranked number 4 on the list of magic formulas.

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- Richard Beddard May 19, 2011 at 10:55 pm
  
  Yup, I agree JD may well turn out to be a paragon of virtue.
  
  I’ve noticed a lot of interest among value investors in retailers and its hardly surprising as they appear to be cheap and many of them free of debt.
  
  I just think its a risky business. Not only have retailers got more leveraged due to sale and lease back, but retail is facing the twin challenge of monster supermarkets and online (even fashion – ASOS). The two may be connected after all if they can’t increase profits the old fashioned ‘Stuart Rose’ way by refurbishing stores, getting the product and packaging right etc. because of increased competition, then selling your stores and leasing them back is the answer.
  
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John May 20, 2011 at 10:25 am

This discussion and Mark’s comments on NEXT have led to me removing my cap on gearing and replace it with a minimum interest cover instead. That way companies that look highly geared relative to equity but actually don’t have much debt relative to profits and don’t have interest eating up a big chunk of profits will make the grade, or at least make it through to further analysis. This does only add a handful of companies to my short list, but NEXT is one of them, although it doesn’t make the top 10 by PE, yield or PEG.

Reply
- Richard Beddard May 20, 2011 at 10:42 am
  
  That’s interesting John, are you comparing interest payments against one year’s operating profit or an average? I suppose my worry is businesses with little equity always look good when they are doing well but when they are doing badly confidence evaporates. A case in point is HMV. I know it’s a different situation, the market for physical media delivered in the high street appears to be in terminal decline but that wasn’t obvious in say 2006 – I owned it briefly before I got cold feet!
  
  I suppose my attitude towards JD is informed by my intention (not always successfully followed through) to put safety before profit or to look after risk and trust the rewards will follow. I think words to that effect were a mantra of Graham, or someone! I don’t think JD will fail, I just find it hard to add it to the portfolio when I can see the mechanism by which it might.
  
  Reply
  - John May 20, 2011 at 9:12 pm
    
    Just the current profits in the screen but with what I’m buying at the moment the companies tend to have very stable growing profits over a long time so an average doesn’t add much. I think your main point relates to HMV perfectly. Long term leases are a major fixed expense so if profits nose dive you can get in a lot of trouble in no time.
    
    If I were still in the turnaround business I’d probably think about adding leases to my check list, but given that I’m after fairly defensive well run companies now it’s not such an issue (famous last words). Maybe I’ll give them a glance though to be on the safe side…
    
    Also diversification should help since it would perhaps be reckless to be too heavily into any one sector anyway (like manufacturing?).
    
    Keep up the good work old chap.
    
    Reply
    - blippy May 20, 2011 at 9:39 pm
      
      Just some thoughts about JD. I’m not keen to classify it as a defensive, because it is in the clothes business, and I’m a little worried that it’s cyclical.
      
      One great defensive at the moment is MRW (Morrisons) I think. The downsides are that returns on equities are reasonably low, which is fairly consistent for supermarkets. Their share buybacks have been criticised by Terry Smith. I like their balance sheet, and downside protection. Analyst forecasts are in mid-double-digits. I’m actually quite bullish on Morrisons; and, famous last words, call it a bit of a “no-brainer”. It’s clearly not a company that you can double your money one, but then again, you wont halve it, either. At a PER of 13, I still think it’s cheap enough to buy. I know you guys are probably looking for single-digit PERs, but I think Morrisons will do reasonably well.
      
      Reply
    - Richard Beddard May 23, 2011 at 9:09 am
      
      Yes, we’ve both flirted with the good company at a reasonable price philosophy but I think I resist it more! Maybe it’s because I try to back all horses, net-nets, turnarounds, hidden champs as I call them but can’t quite jump from one mentality to the other yet
      
      Likewise, I feel like I’d developing as an investor much quicker because of all our discussions, so keep up the good work.
      
      Reply
JD Sports Fashion PLC < Valuhunteruk May 21, 2011 at 12:02 am

[...] having to struggle through problems at ARO. We have some help now from a few other assessments at Richard Beddard and Mark Carter. A quick explanation about the above table is in order before we get into the [...]

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Matt Johnson May 21, 2011 at 1:48 pm

Just to throw my two cents in.

Excellent analysis Richard, had thrown up some points I hadn’t considered.

I have actually been invested in JD. for the last year or so, and made nearly 30% over the course of that year, but recently sold out my investment due to uncertainties over current economic climate.

I think there are some novel points to add to the discussion.

There is a growth story hidden within JD. Though its sports fashion business JD sports is quite mature and unlikely to be a growth area, its fashion fascias – predominantly Bank – is a rapidly growing business, with the potential to be a national chain in its own right.

There is also a very strong degree of vertical integration. JD is an active buyer of brands, and own many of the brands it sells, and this is one of the things which contributes to its high margins. As an aside, the huge profitability of NEXT comes from a similar factor, the fact that it is selling predominantly its own brand meaning it has both retail and wholessale

While the margins on the fashion business are nowhere as close to the sports side, you can see that as the numer of stores increase -and they habe been increasing at a rate of 10 – 20% over the last couple of years – that greater economies of scale will come into play.

Another growth area is in international expansion of the brand, the store own a small Irish chain and a french sportswear business that it is successfuly turning around. It has also trialled a few french JD fascias.

Talking of qualatative factors, Peter Cosgrove has excellent operation ability and I would be quite happy betting in his favour in terms of internation expansion.

In terms of why the shares trade at a discount, there is the issue of liquidity with it being very difficult to acquire meaningful stakes in the business. Along with the risk inherent with Majority stock ownership.

In terms of the leverage question. How many people rent their own property?

Rent in a sense is a kind of leverage, but a growth company like JD. is likely to be able to meet its obligations. The key I suppose is your timeframe and the degree of certainty you require from an investment.

Given all these factors, while I was happy buying JD at a PE of 5/6 now the price has risen, I would agree that the balance of unkowns outweight the potential for further profits.

Reply
- Richard Beddard May 23, 2011 at 9:16 am
  
  Hi Matt, thanks for sharing those insights – definitely adds to the qualitative debate. It’s difficult to be believe I have an edge when so many knowledgeable investors add info I hadn’t considered! Perhaps that’s another reason for my scepticism about JD – bigger, higher profile company than I’d normally investigate.
  
  Reply
Sunday Link-Fest and Consuelo Mack Interview with David Herro of Oakmark | ValueWalk.com May 22, 2011 at 4:07 pm

[...] Fashionable JD not for me [...]

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matt johnson May 24, 2011 at 12:19 am

Just to complete the discussion,

Here is a very interesting financial times article on the very crux of the issue:

http://www.ft.com/cms/s/0/30c01138-7d8e-11e0-b418-00144feabdc0.html#axzz1NDihafEh

Reply
Matt Johnson May 24, 2011 at 12:24 am

Forgot to add, unless you have an FT subscription, the best way to access that article is via a google search by its title “Retailers may shut stores in rents row”.

I think the article adds an empirical bend to the somewhat theoretical discussion on rent covenants.

Matt

Reply
- Richard Beddard May 24, 2011 at 9:19 am
  
  Thanks Matt, good article with a befuddling pie chart. I suppose rents coming down is good news in the long-run and companies that are opening new shops like JD are in a good position but it seems the retailers having most success renegotiating are ones either in danger of going bust, or coming out of administration! i.e. JJB, Officer’s Club.
  
  Reply