A deeper dive into the recent activity, quantitive and mental model valuation approach to one of the portfolio’s current holdings, Halfords Plc. (LSE: HFD)
- Averaged 3% per annum growth in revenue. 2008-16.
- Averaged 2.3% per annual growth in Earnings. Per. Share. 2008-16.
Return on tangible capital employed
A ROTCE of 42% is exceptional and indicates that despite the necessary retail space expenditure, Halfords still operates a highly profitable business, generating high returns. (Recent acquisitions of Tredz limited and Wheelies direct limited by Halfords may have slightly inflated this ROTCE figure.)
Enterprise value – to – E.B.I.T.A
An enterprise value to E.B.I.T.A of 10x is a fair reasonable price for an operation generating high consistent returns (ROTCE) along with consistently growing free cash flow. This figure normalised would be below 10x, however due to lowered operational performance in 2016 the E.B.I.T.A is lower then usually (this will be discussed more in the Recent activity).
Price-to-earnings and Price-to-Book
A normalised P/E of 11 and P/BV of 2 respectively, can certainly be considered fair premiums for the Halfords operation. Book value has consistently grown over the last 10 years and shows minimal signs of abating. The inherent quality and market leadership of Halfords will ensure an investor today will reap the benefits of owning this operation in the medium-long term at a safe investment in relations to the current premiums they are being asked to pay.
Calculations approximate Halfords to have an intrinsic market value of £ 920 Million ( £ 4.70 per share). This mental model approach uses Halfords data on the individual market division sizes, the room for growth within each division as well as Halfords market share within them (as of 2016). Such an indicated intrinsic valuation, currently makes Halfords still an undervalued operation, which will return strong performance on a relatively consistent basis to today’s investor overtime.
Taking a combination of both the overall motoring and cycling markets growth in the UK, along with Halfords historic revenue and EPS growth rate and using an average equalling to 4% it would take approximately 8 years for Halfords to reach it’s true indicated market value, using a future value calculation.
In most recent quarters (Nov. 2016 Interim), Halfords produced continued growth in robust revenue across all operational areas of the business, however noticeable declines in operating profit and margins.
It is key to gain an understanding behind such declines in operating margins in order to ensure the long-term prospects of the business remain stable and competitive.
Halfords have noted the culprits for the recent declines being 1) The average hedged US$ rate declining significantly. 2) The first time inclusion of new acquisitions (Tredz and wheelies). 3) Deeper promotional activities, especially within the cycling market.
Such culprits can be argued as being non-core impacts. Whereby, the core operating business of Halfords was not at fault or in decline (this is evident through robust revenue growth across the board). Rather, just like many other UK companies, Halfords was adversely affected by the depreciation of the sterling (creating input cost headwinds) which will inevitable reduce margins in the near term, until they are fully mitigated (Halfords is already on track to fully mitigating these risks).
Furthermore, in despite of recent acquisitions, Halfords increased free cash flow significantly as well as incurring minimal debt in the process. Therefore, one can argue Halfords still remains a strong cash flow generative operation with easily manageable debt, this further supports the continuation of the long-term prospects of the company.
Investors should take into consideration the strong defensive characteristics and cash flow generating machine of Halfords into their long-term sentiments. Recent declines in operating metrics should be seen as temporary and as a primary result of currency movements and other non-core factors, as opposed to a declining business operation. The underlying business is robust and remains in line with its long-term prospects.
Thank you for reading,
Jordonlee W. Smith