run starts now?, page-13

1. Prologue

If I have been silent recently, it is because I had a minor health issue that upset my sleep pattern, and tiredness disinclined me to delve into TGA's 1H14 results, plus I had an Internet access issue that limited the broadband resource to do the research anyway. Both issues are now behind me, so here goes..

Although I was disappointed with TGA's 1H14 result, the truth is that it was in line with management's prognosis. I expected that to placate the hoi polloi, management would tweak one or more of the levers they had (provisioning, for one) to favourably manipulate reported NPAT, or at least not under report it. Management increased provisioning to 20% in respect to Smartphone business, where TGA had historically used between 10% and 15% for so-called technology products, and this negatively impacted 1H14's reported NPAT significantly.

Some two or three years ago, management decided to ramp up Thorn Equipment Finance (TEF); transform Cashfirst into a broader financing business (Thorn Financial Services – TFS); fix NCML; continue expanding Radio Rentals outlets, commence establishing TFS outlets (both stand-alone and shop-within-shop outlets); and improve head office resourcing and systems. These initiatives require human and other resources in anticipation of future growth – hence depressing profits for two or three years initially. Consequently, 2012, 2013 and 2014 were expected to have flat profit growth, with 2015 expected to show improvement and 2016 even more improvement. 2016 should be a bonanza, because in addition to the benefits of new initiatives having gained traction, the 5-year $1.76M per annum amortisation of the NCML customer relations asset ceases (cash-flow neutral, but EPS positive).

Fairly small expenses, like increasing provisions, opening new outlets or hiring a few senior staff can shift TGA's EPS a few percentage points. TGA's NPAT is about $28 million, so in loose terms every additional $280K equates to 1% of NPAT, or EPS. This equates to $280K ÷ .7, or $400K of marginal expense, or revenue on the other side of the same coin. Each new set of related initiatives typically cost TGA anywhere between $500K and $1,500K in the kick-off year, bearing in mind that for TGA, new initiatives tend to make a loss in Year 1, break even in Year 2 and become profitable in Year 3 (a crude verbalisation of a reality that would be represented graphically by a continuum that does not cease abruptly after three years, and the duration of their profit drags varies a bit).

2. Radio Rentals/Rentlo (Rental Division)

Four new Radio Rentals satellite outlets were opened in 2H13, and two in 1H14. I would presume that the loss that six outlets would make in Y1 would be about $1M, a sucked-from-thumb metric.

Smartphone sales had a massive spike in 1H14. Smartphones are sold at about a 10% retail margin, and handled via 2-year financial leases, which means that the retail profit is recognised on delivery. However, TGA has decided to create a provision for loss of 20% of the retail price on Smartphones, so the massive spike in sales would have been recorded at a loss in 1H14. Rental Division's contribution to NPAT was a reduction from 1H13 of some $300K, in spite of an increase in revenue. The financing profit (interest) is recognised as the periodic payments due are made. The provisioning may also be adjusted then to reflect the lower risk after each payment is received, thus increasing profit. Provisions of RadioRentals/Rentlo increased by $1M compared to 1H13. Both Peter Eaton and James Marshall said in the Boardroom Radio presentation of 20/11/2013 (http://www.brrmedia.com/event/117900/john-hughes-ceo-peter-eaton-cfo-james-marshall-coo) that this detracted from profits initially, but portended good profits in the last 18 months of the lease term from interest revenue. This suggests that 2H14 will be better than 1H14, because the massive growth rate in Smartphones is unlikely to continue. The spike suggests to me that TGA could have taken a slightly higher margin than 10% (maybe there is a better margin, but skulking within the financing profit).

The Rent-Try-Buy, grouped within Rental Division, had a $300K start up cost recorded in 1H14.

3. Thorn Equipment Finance (TEF)

TEF avoided the initial loss-making phase of a new innitiative, because it morphed out of a long-established deal that Radio Rentals established with the TAB. However, the upgrading of the TAB-based business (at a cost of about $1M a year – mainly the expense of a GM, an underwriter and a few other staff) to what we now know as TEF detracted from profitability initially, and TEF is only expected to reach its full profitability potential when its annual revenue reaches $100M, about two years hence. FY2013 would have carried the largest burden of that drag. At 30/3/2012 the loan book was $12M. By 30/3/2013 it was $36 million, and it was $55M by 30/9/2013.

Development work on a solar leasing product came to fruition at the end of the half, and the first merchant contract was initiated in October 2013 when a partnership commenced with solar energy system distributor, Ingenero.

TEF should have a better 2H14 than its 1H14.

4. Thorn Financial Services (TFS)

TFS, which morphed out of Cashfirst, is going down the same path as TEF, but a year later at a resourcing expense fillip of about $.8M a year, which started in late 2H13, and hence TFS should do better as this relatively fixed cost is set off against rising revenue.

Thorn Money launched in October 2013 is one of TFS's first initiatives – it targets a higher, mid-prime demographic through an increased range of financial products that recognises key differentials of risk and return.

A stand-alone Cashfirst outlet was commenced in 2013, with the first store-within-store slated for FY2014.

5. NCML

NCML is stated to be improving profitability, in spite of an increased cost (mainly human resources) of a $1M a year, and so its 2H14 should be better than 1H14.

6. Head Office

Head Office expense also increased, mainly because of hiring a business development resource, plus improvements to the ERP (Enterprise Resource Planning) software systems – namely, Microsoft Dynamic NAV, but in time these two will enjoy a payback. The enhancement of the ERP system was a $5M investment, and it only commenced operation in December 2013.

7. Conclusion

On balance, I think TGA's 2H14 will be an improvement on 1H14, 2015 will be a good year, and 2016 even better.

8. More Concluding Waffle

I am sorry I only sold 15,500 recently at $2.60, because had I sold a large chunk of my TGA holding, I would have had the funds to top up again at below $2.20. I think I have written before that the SP should hit $3.00 by 31/12/2014, and for now I retain that view. I'll venture an SP of $4.00 by 31/12/2015. Obviously, things can go awry – one never knows.

TGA's SP tends to move in a saw-tooth fashion with large gaps between the peaks and the troughs. I should train myself to take advantage of this, rather than holding onto shares through troughs and peaks like a badger. From a TA perspective, I would imagine that this saw-tooth pattern flows from the changing shareholder profile – growth investors are being replaced by value investors (mainly retail investors). I understand the former prefer earnings to be ploughed back in favour of future growth, and the latter look for a bit of both (dividend growth, in effect). Growth investors are often institutional investors who have large holdings, so if they decide to exit, the SP is depressed until they have sold out, which may take many weeks, and then the SP climbs slowly on the back of the smaller value investors taking a position. This is not a topic about which I can claim much expertise, so I may be wrong. I would describe myself as a value investor of the FA variety.

On the negative side of the foregoing relatively rosy picture I have depicted, black swan events can always occur (like the NCML acquisition in late FY2010), and we can be certain of retail-margin erosion, because much of the TEF expansion will be be on near-zero margin, with profits coming mainly from financing; TFS expansion has no retail margin; and Smartphones and similar will not enjoy the 30%-35% margins enjoyed by the directly-imported Thorn brand products. Also, additional new-name stores could be opened to focus on a higher socio-economic demographic, and these will drag on profits in their early years. TGA will switch its focus from ROCE to ROE (stated by Peter Eaton in the BRR presentation) as it uses more debt to fund TEF's expansion, and hopefully ROE will not be eroded.

It is useful to ponder on TGA's core competence – collecting money from myriads of small payers. This core competence acts like the central set of lift shaft of a tall building, from which all the floors hang. New businesses that exploit this core competence can easily be added to keep the 76-year-old TGA relevant for decades. The need to get folk to pay what they owe will never cease to be a commercial necessity.

An abnormal volume of TGA was traded today – more than twice TGA's average, but the SP closed at yesterday's closing price. More growth investors replaced by value investors, perhaps.