value?, page-10

G'day TP,

Yes, that BlackDupp stuff was a bit bizarre. I have this zany theory that he/she was actually a very nice person, and is really a Master's psychology student doing a pHD on chat room responses to really, really obtuse behaviour. For surely no one could naturally behave that way.

But to SFH: be careful of some of the flaws inherent in your assessment of SFH?s ROE, as it is significantly distorted by "accounting oddities". Specifically, in 2005 SFH (then named "Miller?s Retail") underwent a Road to Damascus kind of experience. Following one of those once-a-decade strategic reviews that companies tend to subject themselves, several major provisions and restructuring charges were booked, principally related to the Discount Variety business:
$28m inventory writedown
$32m restructuring provision
$69m writedown of intangible assets of the discount Variety businesses, (Go-Lo, Crazy Clarks, Chickenfeed and Look Sharp)

As a result Retained Earnings fell from $19m at the June 31, 2004 balance date, to $94m in Accumulated Loss at June 31, 2005. Shareholders' Equity fell from $208m at the end of FY04, to $98m at the end of FY05.

Then, in 2006 when the Discount Variety business was sold, a further $38m loss on the sale of the business was booked, taking Accumulated Losses to $122m, and Shareholders' equity to $69m.

In 2007, a capital return to shareholders of $49m was made, and a $9m share buyback was also undertaken, these two capital management exercises effectively wiping out the remaining Shareholders' Equity (a mere $19m as at 31 June 2007 balance date). Yet, in 2007 SFH reported NPAT of $25m, equivalent to 130% ROE. Clearly, this is meaningless and is the outworking of a balance sheet historically altered so dramatically that it is not able to reconcile it with the underlying profitability of the business, i.e., the balance sheet has been artificially "devalued" by accounting practices which, although perfectly complaint with prevailing accounting standards, and is today totally misrepresentative of the financial pedigree of the SFH business. (In reality what should really happen is for the goodwill to be written back up again, but no sensible board would sanction such an action because the resulting profit that would be recognised would attract a tax charge.)

I note that SFH's Shareholders' Equity has since recovered to $61m in the most recent Annual Report, testimony to the inherent profitability of the business which is certainly to reflected in the balance sheet position. Case in point, SFH's accounts record only $12m in goodwill, a ludicrously low amount given the company currently generates $600m in sales and $30m in NPAT.

So that?s why, if you are valuing SFH on a "sustainable ROE" basis, then the starting point for the ROE fade you might be factoring into your calculation is a completely wrong figure to use.

It doesn't change the fact that the stock is undervalued, caught up in the maelstrom of Chicken Littles bemoaning the demise of the consumer, but it is undervalued for different reasons to those based on your ROE assessment. In other words, you've come to the right conclusion, in my view, but via the wrong path.

Still, you've bought well so congratulations. I am sure that this time next year, as the retail sector "cycles" the current weak period, SFH will be valued by market participants at a significantly higher level.

Cameron

PS. I think SFH is an example of many company financial statements that should not be taken at face value. Audit committees, auditors and CFO's have significant leeway into the interpretation of accounting standards, to the extent that NPAT is largely an accounting construct and merely an APPROXIMATION of company profitability (sometimes it is NPAT is a poor approximation, sometimes it is a good one, but it is still an approximation, nonetheless). So is Shareholders' Equity (in fact, it is even a less precise approximation that NPAT, given that it represents the summation of historical accounting idiosyncrasies, whereas the accounting oddities contain in NPAT represents only the particular year in question for which that NPAT is being reported).

Which is why I always subject a company's P&L and Balance Sheet to healthy doses of stress-testing and sanitising. The only financial statements that I trust implicitly is the Cash Flow Statement. You can torture and P&L and a Balance Sheet to confess to any crime you want, but hard cold cash flow cannot tell a lie, as it flows into, and out of, the company?s bank account.