Number one for value

Nice to see you…

Having released Marks & Spencer back into the financial ocean, I’m hauling up schools of big fish in my thrifty nets.

United Utilities, Dixons and HMV have yet to publish their annual reports but, even though I’m suspicious of retailers and have ruled-out HMV in the past, I’m interested in another, Home Retail (HOME), a classic Piotroski share.

Piotroski demonstrated that cheap companies with strong finances make better investments than more expensive companies with weak finances. It sounds obvious, but it’s amazing how many investors ignore this simple principle.

To gauge financial strength he invented the F_Score, and to identify cheap companies he used the granddaddy of ratios, price to book value. I favour the long-term price earnings ratio but although Argos and Homebase, the retailers owned by Home Retail, are long-established companies, they only listed in 2006 when Home Retail and Experian demerged from GUS.

Home Retail doesn’t have 10 years of earnings from which to calculate the long-term PE so its cheap-looking price to book ratio of 0.7 will have to do, particularly since the shares cost only 9 times last year’s earnings. It’s a bargain by either measure.

Home Retail’s corporate website tabulates figures demonstrating it’s the UK’s number one retailer of home and general merchandise; the stuff you find in garden centres, DIY stores, electrical outlets, toy shops and jewellers.

Potential investors in Ocado should perhaps note that Home Retail was yet another disappointing IPO.

Its price briefly held above 400p before plunging below 200p during the credit crunch. The shares are little higher now (incidentally, apologies for the left hand scale on this chart, if you know how to make Excel label log scales better, please send me an email!)

Statistically, Home Retail is in a very sweet spot, only one of the indicators used by Piotroski has worsened since last year, it’s sacrificing profit margins to increase market share. Otherwise the combination of Argos and Homebase is more profitable and less indebted than it was last year.

Despite the nine financial signals incorporated in the F_Score it cannot screen out every financial risk, though. Pension liabilities, for example, are ignored by the F_Score, and so are operating leases. Retailers often have large off-balance sheet liabilities in the form of operating leases. Most of the property Home Retail stores occupy is leased under non-cancellable leases and the majority of those leases are for more than five years.

Since they can’t be cancelled, the leases look a lot like a liability, but they’re not recognised in the company’s balance sheet because Home Retail doesn’t own the properties, nor will it when the leases eventually end.

This means the company is riskier than it looks. If it gets into trouble and needs to close shops, it must still pay the rent. I’ve experienced this first hand with SCS, the Sofa seller whose branches remain open, but whose shareholders received nothing when the company went into administration in 2008.

Like Home Retail, SCS had no bank debt, but it proved an exception to the rule that a company can’t go bust if it has no debt. All it needs to do is run out of cash. Then, if it can’t borrow money, it can’t pay the bills.

Judging by the F_Score, business at the end of Home Retail’s financial year was improving, not getting worse.

Profit growth has stalled (dark blue line), and last year it wrote off some of its investment in Homebase producing an exceptional loss. In the first quarter of this financial year (2011) sales and margins slipped but the company is targeting similar levels of profitability as in 2010. Overall Home Retail seems to be treading water, rather than drowning.

To assess the risk presented by the operating leases, we can treat their current value as a liability. That’s what the company does when assessing risk and return, and credit rating agencies, so perhaps shareholders should too.

I reckon accounting for the leases would decrease the company’s ratio of equity to total assets from 67% to 39% making its balance sheet look considerably weaker.

Furthermore it plans to use up £150m of the £364m cash it had in February buying back shares. By June, it had already bought back 2.4% at a cost of over £54m.

Whether this is a good or a bad thing depends on two considerations. Whether the shares are cheap, I believe they are, and whether the company can afford it. Home Retail believes it can.

By buying back the shares when they are cheap, the company is acting like a value investor. If the market values Home Retail more highly in the future, that value will be spread over fewer shares, to the benefit of existing shareholders.

But I wouldn’t want the company to borrow to fund the buy-back. Its operating leases are significant enough without adding bank debt to them.

In its financial review, management says Home Retail expects to meet its financing needs from cash in the foreseeable future. I believe it. Chief Executive Terry Duddy has been at Home Retail long enough to know the business inside out. He became ceo of Argos in 1998. Finance director Richard Aston is also an Argos alumnus, having joined the company as finance director in 2001.

I have a soft spot for Argos, the bigger and more profitable part of the duo, I bought my first digital watch there, possibly in 1979. I remember the thrill of anticipation as I waited for it to emerge from the bowels of the warehouse through a small portal – like The Generation Game.

Supermarkets have been encroaching on Home Retail’s territory for years, and are ramping up their efforts, but there must be limits, and Argos, at least, by hiding all its stock away, is distinctive. It’s also an Internet winner, with 32% of sales online.

Maybe I’m giving my fondness for Argos undue influence, but I’m going to stay clinical. I won’t add Home Retail until I’ve looked at DSG international aka Dixons/Curry’s/PC World.

It’s a company I feel much less empathy for, but the shares are cheap. Dirt cheap.

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Thrifty 30 updates

The current Thrifty 30 portfolio

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