First look: JD Sports Fashion

20 Comments

• 
  UK Value Investor May 13, 2011 at 3:48 pm

  Hi Richard. It will be interesting to see what you think since I own a wee slice of this company. This was an opening shot into the world of ‘good’ companies that were doing just fine, rather than turnarounds and the like. My one (long) line summary would be:

  Pretty decent sports fashion retailer, ticking along buying up bits and pieces here and there until they bought First Sport from Blacks in 2002-ish, which went very wrong resulting in the chairman ‘stepping aside’ and the old finance director taking over with a turnaround strategy which they’ve been putting to good use ever since and are now looking to expand overseas after deciding not to buy JJB.

  I think the price has gone down since I bought (doesn’t everything!) so you’d get them at a better price than I did if you decide to buy. Or perhaps you’ll side-step a disaster if you don’t!

  Reply
  • 
    Richard Beddard May 13, 2011 at 5:33 pm

    Thanks for the history lesson UKVI!

    Reply
• Weekend reading: Grab those index-linked certificates May 14, 2011 at 11:02 am

  [...] Richard at iii considers JD Sports – iii [...]

  Reply
• 
  Westwinds3 May 14, 2011 at 5:28 pm

  Richard,
  You are the only person I have seen comment on rent. You have pointed out in the past that rent that has to be paid is broadly equivalent to the interest on debt. For a retailer, the shops are key. If JD rents its retail space, will this not decrease its book value and increase the apparent ROE? Or do you expect an equivalent reduction in free cash flow?
  If rent does not appear as gearing, where do you see rent in the accounts? Can you tell from the price to book of a retailer? Or is rent invisible and is making a profitable company less safe than the figures suggest?
  Cheers
  Michael

  Reply
  • 
    Richard Beddard May 15, 2011 at 1:26 pm

    Hi Westwinds3 I’ve left a general comment on adjusting for operating leases below Mark Carter’s and Calum’s comments because they are on the same subject. But to answer your last point directly, non-cancellable operating leases are detailed in the notes to the accounts (if like me you read the PDF, you can search for ‘operating lease’ and click next until you find the particular note). However they’re not included in the balance sheet so the usual balance sheet and profitability ratios I use screening for companies don’t account for them. In that sense they are hidden, or ‘off balance sheet’, although I believe the accounting bodies are talking about changing this. They’re also hidden in another sense. Many investors don’t wait for the annual report of a company, but use the preliminary results announcements issued via the stock exchange. These are often unaudited and don’t contain a full set of notes. They often do not include details of operating leases. So detail about operating leases is not invisible, but it is more difficult to find and invisible to some investors.

    Reply
• 
  Mark Carter May 14, 2011 at 9:27 pm

  Richard, I would be interested to know what kind of adjustments you make, too.

  Your article has prompted some musing by me, which is a little too long to reproduce here: http://bit.ly/itgMUi

  The short version is: I produced a “rent-adjusted” ROCE calculation which came out at 23% (down from 48%), which I still thought was a cracking number.

  Reply
• 
  Calum May 15, 2011 at 1:00 pm

  As I have mainly been looking at retailers now this has been a problem I have come over again and again. I’ll try and simplify it though. Rent expenses are almost expensed within COGS. The main problem though is that Assets are understated i.e the leased assets aren’t in PPE). The result is that RNOA/ROIC is overstated.

  However, and this is more confusing area, operating leases lower borrowing costs (most of the time) as the debt is secured on the leased property (I looked at MKS/DEB and I reckon they pay about 50-100bp less on leases than debt) so the net effect on shareholder returns isn’t as large. In addition, you should add back some portion of rental expenses, if your trying to get RNOA, that represents the implicit financing charge to operating profit which again narrows the gap.

  The net effect is usually a slightly lower ROCE however, and this is a big one, this only works if it is cheaper to lease assets than go to the market and get financing and then buy them. There is a recent article in the FT which suggests this hasn’t been the case and this, in my mind, is essential to working out the value of companies that have expanded stores heavily since 2005. Firms are trying to renegotiate leases (i.e Mothercare, Dixons) but in some sectors the market for commercial property is still tight (from what I’ve heard large city centre is worst).

  Reply
• Sunday Link-Fest and Consuelo Mack Interview | ValueWalk.com May 15, 2011 at 1:14 pm

  [...] First look: JD Sports Fashion [...]

  Reply
• 
  Richard Beddard May 15, 2011 at 1:19 pm

  @Westwinds3 @Mark Carter @Calum

  Thanks for your comments, which are very insightful. I don’t think my answer is going to do them justice!

  I don’t make any adjustments for operating leases, I’m just ‘aware’ of them. If I knew an easy way to adjust ROE/gearing I’d do it, but Calum’s reply gives you an idea of the kind of adjustments I don’t want to have to try and make!

  Once, I can’t remember in respect of which company, I simply added the commitments under operating leases as both an asset and a liability, which didn’t change the NAV figure that much.

  Usually I look at the rest of the balance sheet and the company’s profitability and cash-flows in previous downturns and if it looks strong i.e. it has no debt, remains cash positive, pension deficits look manageable etc. I assume it will be able to pay its rent.

  To be honest, this is the reason I largely avoid retailers, but they’re increasingly coming up on my screens so I’m going to have to grapple with it. It may be that I have some more ideas in response to yours when I look at Sports Direct’s numbers, and also Mark’s attempt at adjustment of ROCE, and if I do I’ll post them in reply to your comments.

  Reply
  • 
    blippy May 16, 2011 at 1:10 pm

    Adding commitments under operating leases as both a debt and an asset seems like a pretty logical idea to me. At least it allows you to paint a much truer picture of debt/equity ratios.

    I’ve also been wondering if measuring gross profit to other costs is a good idea, especially on a comparative basis across retailers, as it give you some kind of feel for how much “fixed” costs are covered by gross profits; the higher the better.

    Reply
    • 
      Richard Beddard May 16, 2011 at 1:39 pm

      The problem is, it rather implies you could sell the leases if you needed to (i.e. they actually have value). I’m not sure if that’s true for two reasons. My experience with SCS was that the decline was so swift they didn’t have time. And any way, they’re described as non-cancellable, leases so I’d imagine that things could get quite complicated if you tried. Really need to find out more about them!

      Reply
• 
  Steve Baines May 16, 2011 at 3:58 pm

  A commenters have correctly identified, an operating lease (rent) is a debt-like instrument in that it requires the company to make a regular stream of interest-like payments in order to continue making use of the property. However, unlike debt, there is no repayment required at maturity, though the company will clearly need to enter into a new lease in order to continue operating its business.

  In order to reflect this in the accounts, the most common, simple and straightforward method is to add 8x the annual lease payments to both the asset and liabilities sides of the balance sheet (to represent the use of the property – an asset – and the financing against it – a liability). Financial ratios can then be calculated as before. Also adjusted coverage ratios can be calculated by adding-back annual lease costs to each side of the ratio (eg adj interest cover = (EBITDA + Rents)/(Interest + Rents). Clearly, the effect of this is to substantially increase reported leverage and reduce return on capital employed.

  A more detailed (but complex method) would be to determine the dates each lease fell due and discount them back to present value using a particular interest rate. The sum of these payments provides a estimate of the value of the lease which can then be added to the balance sheet as described above. Clearly, this is much more time-consuming and requires the analyst to choose a suitable discount rate.

  Also, the operating lease payments are typically found within Selling, General & Administrative expenses, not within cost of goods sold as suggested by some commenters.

  In addition, ROE is not impacted at all by adjusting for operating leases. ROE would be the same whether the business used operating leases or took on debt to acquire the property freeholds. However, ROE with operating leases will likely be much higher than if freehold property was purchased using equity.

  The following is a document by Moody’s Investor Services which includes a description of how they deal with operating leases in the credit rating process: http://www.nd.edu/~carecob/April%202007%20Conference/Analytical%20Adjustments%20-%20Part%20I%20updated.pdf

  Reply
  • 
    Richard Beddard May 16, 2011 at 4:35 pm

    Steve, that’s terrific. Thanks for answering my Twitter plea (I presume – in fact I meant to add @spbaines to get your attention but forgot!).

    Probably a silly question but why 8X? Is that effectively to capitalise the lease payments and therefore are you assuming they’re like a 12.5% interest rate.

    Why not just add the value of the leases recorded in the notes as liabilities and assets?

    Reply
  • 
    Calum May 16, 2011 at 5:13 pm

    Cheers for that, esp interesting to hear how the “pros” do it. The problem I have had has been switching between US and UK companies where the leases seem to be slightly different. For example, Marks and Spencer seem to take out 50 year leases wheras a company like Aeropostale appears to be taking out much shorter ones. I presumed the 8x multiple wouldn’t be appropriate as it appears to be based on the 15 year lease which seems to be more standard in the US, I believe. So I wonder if anyone has any insight into this?

    I’m also slightly ambiguous about wether the practice is to recognize cash rental expense or depreciation based on the value of the total lease? I’ve wondered as i’ve seen some wildly different rental expenses/total property lease ratios which is slightly disconcerting and was behind my, seemingly incorrect, statment that ROE is affected by the choice to buy property or lease it (i.e through the effect on borrowing costs).

    Reply
    • 
      Steve Baines May 16, 2011 at 5:38 pm

      Callum – I should clarify, when I said ROE is unchanged, I was assuming all-else-equal, ie the interest rate on the debt being the same as the implied interest rate on the operating lease. Clearly, if either of these has a lower (higher) interest rate then ROE will be higher (lower). As for recognition in the P&L, I’ve always used the cash rental expense for the relevant year. I’m not sure I understand what the rationale might be for doing things differently.

      Richard – Yes, I did see your Twitter plea. Adding the total value of the leases (to assets & liabilities) is also a valid approach. However, it’s useful to remember that these would be undiscounted for a very long lease (ie. overestimate the asset/liability) and would not reflect a necessary renewal if the lease was particularly short (ie. underestimate the asset/liability). With regard to the choice of 8x, I have no idea where it came from, but it is effectively used as a standard by professional analysts (not that this makes it correct) as a short-cut to capitalise the lease payments. The rate is not 12.5% (unless the lease is a fixed amount rate in perpetuity). The rate depends on the exact profile and timing of lease payments. For example, a £100m per annum lease for ten years has an NPV of £623m if discounted at 12.5%. You would need to discount it at ~5.3% to get to £800m. Therefore, the 8x model cold be assuming a vastly different implied interest rate depending on the exact profile of the leases.

      Reply
      • 
        Richard Beddard May 17, 2011 at 9:25 am

        Thanks Steve, I take your point about discounting. I’m sure some companies do discount the value of their leases in their accounts but JD doesn’t and neither does the last company I looked at. That makes your eight times rule for capitalising lease payments look like an attractive bit of shorthand. The one thing that concerns me about it is surely that figure changes, so while it might be relevant now, analysts will adjust their multiplier as the costs of leasing property rises and falls.

        Reply
• 
  Yiannis May 16, 2011 at 5:43 pm

  Sales space for a main street retailer is in a way part of the “raw materials”

  shop front + product cost + sales persons = cost of “production”

  with that in mind would classify operating leases as capital commitments

  Reply
• 
  Westwinds3 May 16, 2011 at 11:44 pm

  Thank you Richard and others for interesting and helpful replies. I am still a bit suspicious about leases.
  Looking at a much larger company, I read recently that Tesco had paid down £1.7b of debt. This seemed surprising for a company that is expanding aggressively and has to buy or rent expensive property to grow its business. Sure enough, further down the page they appear to have raised £1.8b through sale and leaseback, paying rent at a rate of 5-5.2% (2010 accounts p42). I am a lay trustee of a pension fund and I know that this sort of long lease strong tenant property is very attractive. We would happily own a Tesco store (I think they cost about £50m+). Further down the accounts Tesco conventional debt appears to cost between 5% and 6% (p88).
  What puzzles me is that I know that a pension fund will want the rent to be inflation-linked, or at least subject to regular upward review. Would you rather borrow at 6% fixed, or at 5% linked to inflation? Either my maths is wrong, or there is some short term cosmetic advantage to renting and leaseback.
  Michael

  Reply
  • 
    Richard Beddard May 17, 2011 at 8:40 am

    Thanks for the insight Westwinds3, and I agree. There is a cosmetic advantage to sale and lease back. Unless you adjust for it, it reduces gearing (and for that reason I’d be reluctant to invest in a retailer that rented large numbers of properties and also had debt, I think Dixons, for example, fits into that category). It also has an impact on profitability, but I’m less clear about the relationship. It’s not just retailers. Airlines rent planes, hauliers rent warehouses, manufacturers rent factories. Companies like Tesco also borrow from their suppliers by taking a relatively long time to pay them, while being paid by their customers in cash. This is often regarded as good debt because it’s interest free but coupled with leases, pension liabilities etc. it means that their overall levels of liabilities are really high, even though they have little or no bank debt, which may be OK because of their relatively predictable and smooth earnings. Perhaps it’s the only way a company can get as big as Tesco. Imagine if it had to fund all those £50m properties itself.

    Reply
  • 
    blippy May 19, 2011 at 10:28 pm

    I’m only a little aware of the arguments surrounding Tesco and their properties; so if anyone can give greater accuracy, I would appreciate it.

    I think that one criticism that has been levelled at Tesco is that it has been revaluing its freeholds, and booking the increases as profits. The accusation here is that it is using these revaluations to flatter its performance.

    I believe there’s also been a bit of a heated debate as to what the whole S&L (Sale and Leaseback) means for Tesco. Some are saying that it is short-changing their future, some are saying that it is a shrewd financing move. Some are sanguine about Tesco’s stated goals of putting 70% of its property under S&L, saying that there is nothing outrageous to see here because Tesco has performing this kind of procedure for a long time.

    Reply