I believe that the overwhelming majority of contributors to this...

I believe that the overwhelming majority of contributors to this site do so - understandably, probably - from a position of bias.

Many talk freely and openly about the stocks they promoted which have done well, but are silent on unsuccessful investments.

Many embellish the positive attributes of a company, while actively omitting to draw attention to the potential pitfalls of a business in which they are shareholders.

This is a real pity because it: a) robs others of the chance to be aware of issues of risk that they should do, and b) it probably also robs the stock "promoters" of being able to better assess those risks through the process of collegiate debate.

I try very hard to be as open and objective as possible when it comes to companies in which I am a shareholder, for the sake of others...and also for my own benefit!


Which brings me to this little retailer SFH.


I think that there are some serious misconceptions about the mechanics of this company's P&L.

Firstly, there's the seasonality in earnings: on average 53% of SFH's revenues are earned in the Dec half of the year (this should be perfectly intuitive given the Christmas shopping period falls into this period).

That doesn't seem like such a big deal, one might say; however, one needs to consider that the bottom line margins are very skinny in this business (averaging around a mere 4% over time [its highest level ever was 5%, in FY08, the year of rampant consumer enthusiasm, just before the GCF struck]).

The outworking of this is that reduced June half revenues quickly chews away into the P&L - even when the cost base is adjusted partially in the June half (e.g., fewer temporary sales staff on the payroll), meaning that, on average, 70% of EBITDA is earned in the December half, as historical data shows:

Half-Yearly EBITDA ($m)
DH04: 19.8
JH05: 15.3
DH05: 32.3
JH06: 20.6
DH06: 31.7
JH07: 17.2
DH07: 36.0
JH08: 17.3
DH08: 31.7
JH09: 21.8
DH09: 46.1
JH10: 14.3
DH10: 34.7
JH11: 6.6
DH11: 22.0
JH12: 0.0 (that's right, zero)
DH12: 37.5 (per guidance)
JH12: 15.0 (per recent management guidance)

It can be observed that the DH:JH skew has become markedly more pronounced post the GFC, to the extent that the company reported zero EBITDA for JH12.

And the adverse impact of this on the NPAT line has clearly been even more dramatic:

Half-Yearly NPAT ($m)
DH04: 7.7
JH05: 7.6
DH05: 16.9
JH06: 7.7
DH06: 18.5
JH07: 6.6
DH07: 19.5
JH08: 7.2
DH08: 17.5
JH09: 6.8
DH09: 26.6
JH10: 3.8
DH10: 17.2
JH11: -2.6
DH11: 6.2
JH12: -9.0 (no, that's not a typo; they reported a $9m LOSS at the NPAT line)
DH12: 17.7 (per recent management guidance)
JH12: 3.0 (per my modelling)

So I think the first thing that should become clear from history is that NPAT in the JH has never been higher than $7.7m.

That clearly makes assumptions of a simple “doubling” of first half guidance to get a full-year result of $36m, which “puts the stock on a P/E of 5x”, to be grossly flawed and dangerous.

Full-year NPAT, I’m afraid, will be far closer to $20m than it will be to $30m.

That’s just the nature of the business.


Now onto the prospect of a 20 cps dividend: I’m afraid this is also too fanciful a concept.

Here’s why:

Yes, this is a cash-generative business, and yes, it has no debt (I expect the December 31, 2012 balance sheet will reflect a net cash balance in excess of $20m when the company reports its results).

And while the company has accumulated losses of $80m, new Corporations Law legislation dictates that companies don’t need to have positive retained earnings balances in order to declare dividends; they simply need to be “solvent”.

And yes, the franking credit balance is healthy, at some $39m (@ JH12) [equivalent to 20cps], so scope to pay a special dividend could – normally – be considered high given these figures.


The problem is that SFH is actually not a solvent as she might appear by just glancing at the balance sheet. One needs to delve into the notes to the accounts to understand the full extent of the company’s liabilities, notably its lease obligations.

The company has $270m of non-cancellable lease commitments, $71m of which are payable in one year, $186m payable between one and five years, and the balance between five and seven years. (These are essentially lease agreements entered into with commercial property landlords).

So the company might indeed have no debt, but it has a lot of other financial commitments (lease expenses in FY12 amounted to $114m, making up 21% of the company’s total operating cost base...so it is a big deal)

Now how the investment industry, and indeed the banking industry, view this obligation and the company’s ability to service it, is by looking at a ratio called the Fixed Charge Coverage Ratio (FCC).

The FCC Ratio is derived from the formula: (EBIT + Lease Payments)/((Lease Payments + Interest)

Clearly, this higher this ratio, the greater the company’s ability to service its lease commitments.

Put another way, the FCC ratio is the number of times the company can cover its fixed charges each year.

And the trouble with SFH is that its FCC is under somewhat acute pressure, as evidenced by the historical trends:

FY06: 1.49
FY07: 1.47
FY08: 1.39
FY09: 1.32
FY10: 1.43
FY11: 1.20
FY12: 0.97

(By comparison, WOW’s FCC is 2.54 and WES’s is over 2.80)

This explains a question I often get when it comes to SFH and its dividend history: people can’t understand why the company, which consistently generates free cash flow, and had no debt in FY12, failed to declare dividends for the entire FY12.

The board – quite rightly – recognised the operating leverage in the business and prudently retained cash.

My modelling suggests that the FCC will be back above 1.20 for FY13 which is a healthy improvement on the dangerous level of FY12, but is certainly not solid enough for any dramatic action on the dividend front.

Certainly there is no way that a 20cps dividend would be permissible. The off-balance sheet liabilities simply don’t permit it. [For contextual record, the biggest dividend declared was a total of 15cps (9.5cps interim, 6.0cps final) in the booming FY07 year.]


In closing, I trust that this exercise – in the interests of providing balanced assessment (and remember, I’m a shareholder in this company) – serves to highlight some of the less-obvious aspects of SFH’s financial pedigree.

That all said, I still think the stock is undervalued even on my more sober JH13 forecast of just $3m NPAT.

I estimate the stock is trading on a P/E of 8x, an EV/EBITDA multiple of 2.6x, and a FCF yield of some 19% on the EV and 16% on the Market Cap.

Investors simply need to appreciate that the company is acutely leveraged in an operational sense (thin margins & high levels of lease liabilities), and when the consumer cycle turns against you the leverage bites painfully (as it has done for the past few years).

Conversely, it works dramatically in favour of the bottom-line when the retail cycle turns into a tailwind, as it thankfully now looks like doing. Combined with an internal improvement in the company’s operating performance, this bodes well for future financial performance (even if dividends don’t quite get to 20cps!)


All in the interests of prudent investing

Cam