Fancying myself as a bit of a deep-value investor, SFH's sub-6x EV/EBITDA multiple prompted me to do some further research on the company, it's business model and its financial accounts.
Following this exercise, my conclusion is to not purchase shares in the company despite its stock appearing to be, at first glance, deeply undervalued.
The problem for me is that, when on scratching beneath the veneer (which involved going over the company's financial performance over the past decade), I found a business with:
1. Seemingly limited defensible commercial moat (witnessed by frequent need to suspend dividends as well as dramatic deterioration in the business performance over the past 5 years, with Pre-Tax Profits over the past 5 years averaging just 15% of the level of the preceding 5 years)
2. High level of capital intensity (OCF to Capex averaging just 1.7x, cumulative FCF totalling just $25m over the past 4 years, and EBIT/Assets averaging just 4%)
3. Acute operational leverage (Cost of Goods Sold plus Cost of Doing Business account for 97% of Revenue, and Lease Committments are over currently 7x annual EBITDA), and
4. Deteriorating financial position (NIBD-to-EBITDA of 2.0x is the highest it has been and Fixed Cover Charge Ratio of 0.97x is the lowest it has ever been).
My adverse findings came as a bit of a surprise to me, because I am aware that there have been/are numerous well-respected small cap managers who have been shareholders in SFH over the years.
Studying SFH's operating and financial performance over a 10-year period threw up some truly fascinating insights, the most notably being that that 10-year period can quite readily be divided into two distinctly different 5-year periods.
The fist 5 years (FY2007 to F2014) was impressive; the latter 5 years (FY2012 to FY2016) were dismal, by comparison.
To demonstrate this deterioration in financial performance over the past 5 years, at the end of this post I have included a range of financial metrics and parameters which highlight just how different the past two half-decades have been.
My intention in posting this is for no other purpose than - in the spirit of a communal stock discussion forum - to share my research findings with others who may hold the stock, or for those thinking of purchasing shares. Maybe there is something I've stumbled across that may be of use/benefit to someone.
So, here are my most salient observations:
Margins have been in secular decline over several years:
EBITDA MARGIN / EBIT MARGIN (%)
FY2007: 9.0%/ 7.0%
FY2008: 9.4% / 6.7%
FY2009: 9.5% / 6.4%
FY2010: 10.7% / 7.9%
FY2011: 9.0% / 5.8%
FY2012: 3.8% / -0.2%
FY2013: 7.3% / 3.5%
FY2014: 5.2% / 2.2%
FY2015: 2.6% / -0.1%
FY2016: 3.0% / 0.4%
As a result, underlying profitability has deteriorated significantly:
EBITDA / EBIT / PRE-TAX PROFIT ($m)
FY2007: 47.3 / 36.9 / 36.2
FY2008: 50.8 / 36.0 / 32.9
FY2009: 53.3 / 35.7 / 32.5
FY2010: 61.1 / 45.0 / 43.5
FY2011: 51.3 / 33.0 / 31.3
FY2012: 22.0 / -1.2 / -3.3
FY2013: 41.6 / 19.8 / 19.0
FY2014: 35.8 / 15.0 / 12.9
FY2015: 20.3 / -0.7 -4.5
FY2016: 25.1 / 3.6 / 0.3
And Return on Assets has plummeted:
EBITDA-to-ASSETS (%)
FY2007: 31%
FY2008: 25%
FY2009: 23%
FY2010: 31%
FY2011: 20%
FY2012: -1%
FY2013: 11%
FY2014: 7%
FY2015: 0%
FY2016: 2%
Despite this deterioration in profitability and financial returns, the company has swung from negative, to positive, working capital business. The result has been as much as a $50m investment in working capital over the past decade (an amount equivalent to half the current market value of the company).
WORKING CAPITAL ($m)
FY2007: -16.6
FY2008: -9.9
FY2009: 1.0
FY2010: 2.6
FY2011: 2.4
FY2012: -11.7
FY2013: -19.7
FY2014: 28.4
FY2015: 29.2
FY2016: 14.7
The combination of declining profits and rising working capital commitments has adversely affect cash flows. In the five years to FY2011, SFH generated cumulative Operating Cash Flow of $200m. In the last five years since then, total cumulative OCF was 40% lower, at $121m.
Despite a near-halving in capex in the period FY2012 to FY2016, compared to FY2007 to FY2011, total FCF in the latter period still fell by a third, from $67m, to $45.0m.
OPERATING CASH FLOW / FREE CASH FLOW ($m)
FY2007: 48.2 / 24.0
FY2008: 32.4 / 2.4
FY2009: 39.6 / 16.0
FY2010: 46.6 / 24.7
FY2011: 33.8 / -0.1
FY2012: 36.5 / 20.6
FY2013: 49.5 / 37.6
FY2014: 3.5 / -3.9
FY2015: 0.7 / -11.8
FY2016: 30.5 / 17.3
The upshot of all this is a company that, while not in a financial bind quite yet, is experiencing deteriorating credit metrics which, if the trend continues, will have to resort to some sort of meaningful strategic response if it wants to avoid the point at which it might be forced to issue fresh equity to recapitalise the business.
(To the credit of SFH management, while they have needed to suspend dividend payments on numerous occasions, one thing they have done an excellent job of, is not letting Issued Share Capital blow out. The number of shares on issue is today no different to what it was a decade ago. I think this excellent stewardship of the equity base of the company is testimony to the fact that the company's key managers own a very meaningful stake in the business, and are therefore disinclined to have their ownership diluted. Which is the way it should be.)
But, as can be seen below, while NIBD-to-EBITDA is not quite yet at a critical level, this does not account for the off-balance sheet liabilities. The company has been struggling to cover its fixed charges over the past two years.
NET DEBT -TO-EBITDA (x)
FY2007: 0.4
FY2008: 1.0
FY2009: 0.8
FY2010: 0.2
FY2011: 0.5
FY2012: 0.8
FY2013: 0.9
FY2014: 1.3
FY2015: 1.9
FY2016: 2.1
FIXED CHARGES COVERAGE RATIO (x)
FY2007: 1.47
FY2008: 1.36
FY2009: 1.32
FY2010: 1.44
FY2011: 1.29
FY2012: 1.01
FY2013: 1.17
FY2014: 1.10
FY2015: 1.00
FY2016: 0.97
NOTE:
1. This post is not motivated by a desire to impugn to company or to down-ramp the stock.
It is simply made because I had conducted the research, did the analysis, and instead of the results simply lying fallow, I thought I'd take the liberty of sharing it in case it ends up being of some use or some edification to others who have an interest in SFH.
2. By its very nature, the analysis above is backward-looking and the adverse trends identified are derived from "looking in the rear-view mirror". It is acknowledged that something can happen that alters the course of the current financial performance of the business for the better. And if some turnaround strategy is indeed successful, then given the operating leverage inherent in the business, then the earnings recovery would be dramatic (just as the effect of the operating leverage on the way down has brought about a dramatic fall in financial performance). It's just that I am not able to identify what such a turnaround strategy might be.
My sense is that what the company needs is a decent recovery in consumer sentiment and while I am no macroeconomic forecaster, I frankly can't see anything that will make the Australian consumer eager and willing to start opening his/her wallet in any sustainable way any time soon.
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