I held off on the purchase of Quarto, which I still plan to buy, after a reader emailed me asking about one of the portfolio’s holdings which hasn’t done so well – H&T Group. I bought the pawnbroking group in full knowledge of the problems they were facing; most notably, they made a lot of their money through the recession in the booming gold buying industry. As that source of profits is drying up, both through competition (minor) and the rising gold price (far more important), one has to ask what the underlying value of the core group is – which should be, and has to be, the pawnbroking business doing what pawnbrokers traditionally do. There’s other stuff on top of that, of course – the cheque cashing, for instance, but that’s clearly directly related in a consumer finance sort of way. The gold seems more to me far more one-off. Perhaps that just says more about my view of the gold price than anything else!
The purchase decision needs a bit of scrutiny, though, because as I mentioned in my 2-year review, HAT is down a pretty significant 40%. The bulk of that fall has come since their May trading update this year, which was rather bearish. What I want to know, primarily, is twofold – firstly, did I identify the potential weaknesses in the first place? This is mostly for my own interest. While a falling share price doesn’t mean I got the decision wrong, it does mean I feel I should scrutinise my thought processes. I want to know I’m thinking about the right things when looking to buy a company. Secondly, and more importantly, where do I go from here? This has two obvious competing sides; if I bought HAT at a price far higher, this might suggest at this price the stock is even cheaper, and I should buy more. On the other hand, if things have materially changed, or my decision was flawed in the first place, it’s a fool game trying to chase losses. Better to cut and move on.
The first question, I think, has a pretty simple answer. Yes, I did identify their glaring weakness, and the damage it might cause the company. Here’s the bit from the May trading statement that soured sentiment so:
“Overall results however are inevitably impacted by the highly volatile gold price, and market consensus has not yet reflected price movements since the Group last reported on 7 March 2013 when the gold price was £1,054. The Board estimates that a 10% movement in the gold price will impact profit before tax by approximately £2m”
And here’s a snippet from my first piece on H&T, before I changed my mind and decided to buy in the significantly more bullish second piece I linked above:
I’m not sure I completely buy that story, though. I reckon the market will turn out to be more cyclical than he’s giving it credit for, and that a big drop off in gold – if it happens – will really sting.
Obviously, a big drop off in gold is exactly what has happened. We can do some quick mental arithmetic on the board’s comments above; the gold price is currently about £840 per ounce, and it’s been falling significantly since May – when it was down about 10%. We can probably assume that the the second 10% fall (it’s fallen roughly 10% twice) does more damage than the first – in the same way miners are exponentially affected by each drop in the end price because of the costs of production. Perhaps we can pencil in a £5 or £6m fall in pre-tax profit, then. This leads us nicely on to the second question, with a little analysis of the underlying business. If we want to be really conservative, we could simply chop out all the gross profit from the gold purchasing segment entirely – £12m last year – and pretend this year, they’ll make none at all. Since gold purchasing is a secondary activity, there’s probably not that many costs associated with it – though there are doubtless some, so assuming there are no central costs (by not adding back some profit for ‘cost saving) is harsh.
Either way, dumping gold profit out of the equation leaves H&T earning ~£6m in operating profit last year. Taking off finance costs and tax leaves us with a net profit of ~£3.5m, or thereabouts. This, I have to say, for a ‘end-of-gold’ scenario, doesn’t seem too bad. It’s also a little simplistic. There are all sorts of other factors at play. If customers can’t sell gold for cash, will the core pawnbroking business get better, as people turn to that option instead? Conversely, perhaps a fall in the price of gold will negatively affect pawnbroking – after all, if gold is the collateral, it being so valuable really lubricates the wheels of the machine and makes pawnbroking a much more efficient business.
We have two, slightly competing factors, then. We want to know what the group will do in the future, but we only have what it’s done in the past to go on. We want to squeeze as much information as we can out of their past performance so we can reasonably make a decision on how they might perform in the next couple of years. There’s a few things we can do in this vein. Here’s an obvious one; H&T has about twice as many stores as they did pre-recession, as they used their hefty gold buying profits to expand. In 2007, the gold price was about £400, and gold purchasing was only just getting started. Hence, if we assume gold purchasing will come to an end, we might use 2007’s ‘per-store’ operating profit as a reasonable baseline. Here’s the chart:
We might say using operating profit per-store is a little harsh, because there’s scale efficiencies as a business gets bigger – centralised costs (director salaries, for instance) are spread over a wider base. However, we might also say that we can assume that each shop is less profitable than the last – the marginal profitability of an extra store is lower than your average profitability. This makes sense – HAT presumably has stores at all the real prime, money making locations, so each additional store might either have a slight overlap or be in a worse area. More problematically, it’s very likely that the obfuscation the gold-buying profits has created means some of the group’s stores won’t be profitable at all – or at least return enough to be worth the investment – in a normal environment. Either way, if we multiply the current number of stores by 2007’s operating profit per store, we get an estimated normalised operating profit of 186 * £112.5k = £20.9m.
Why might this year’s operating profit come in so much lower than that? After all, above I said that something like £6m might be a conservative baseline for operating profit for the full year. The answer is in store maturation. In nearly all customer facing businesses, stores take a while to get up to speed and start earning their keep. This isn’t by any means an ‘excuse’ for H&T, nor is it unique to them – it’s one of the drivers I profited greatly from with Howden Joinery, for instance. Luckily for us, the way pawnbrokers work gives us quite a nice way of visualising exactly what their new store underperformance means. The pledge book shows how much money H&T have out on loan to customers; so it’s essentially an indicator of how their core business is performing. Gold purchasing doesn’t factor in. So, if we get a per-store pledge book figure..:
.. we have an indicator of one of two things. Either yes, store maturation is likely to drive that pledge book figure up over time – after all, they’ve opened 51 stores in the last 3 years alone – or the marginal profitability of each of these new stores is far more dependent on gold buying than we might like to believe! I should note that the ’07 figure, in this case, might not be the best comparator – in 2007, H&T had opened 18 new stores in the previous two years (a 25% increase), and so that figure too might be dampened. Either way, since we’d expect pledge books to at least increase in line with inflation, I would suspect there’s some decent upside here. 2007, I should add, was a year with relatively little financial ‘tightness’ – at least compared with this year.
The balance sheet looks safe, and at £60m the valuation of the business doesn’t seem at all demanding. I think, in a no-growth (or even negative growth) scenario; which is probably reasonable, given it’ll take a few years to really see the underlying profitability of the business – £60m will prove to be too cheap. The group might well need to spend some time closing poorly performing stores and seeing where their cards lie – but this is a business which earnt £10m of operating profit in 2007, without any gold buying at all, and with half the number of stores. Do we believe that all of the stores opened post-2007 are loss making on an aggregate scale? To me, that seems unlikely, and I’d suggest there was upward potential from 2007’s figures anyway.
HAT’s sentiment problem, I think, has come from the dive in the price of gold. Its underlying profitability has been obscured by the focus on that side of things. It might take some clean up over the next couple of years as the company reassesses its position on its (leased) stores, and whether they’re truly viable, but I can’t see the business at the end of it being worth less than £60m.
Comments and slating, as ever, welcome!