Update No. 21 – 21/08/11

The global share-markets seemed to settle somewhat this week until Friday, when I had cause to think of famous bush poet John O’Brien’s words in his Australian classic – Said Hanrahan.


 "We'll all be rooned," said Hanrahan, "Before the year is out”.


As long as the market is ‘rooned’ by October, I’ll be happy.  Sharp-eyed readers will notice our ‘per share’ values (below) didn’t change this week, I didn’t forget to update, just through the vagaries of movements in the prices of our holdings this week, we ended exactly where we began.  Fund-holders need remember it is to our financial advantage if markets stay down until October, when we will likely have a substantial proportion of the fund in cash and looking to deploy.

The US market, like ours is in the middle of reporting – in their case, quarter 2 results, whereas our reporting season is predominantly full year results.  I follow the US reporting season closely, because although we hold no economic interest in US businesses, the inescapable fact is when the US is weak, the world is weak, it always makes sense to keep an eye on ¼ of the global economy.

This week, I was particularly interested to observe some US retailers reporting.  Walmart, for example improved Q2 earnings by 12.4%, Home Depot by 13.9% and Costco by nearly 20%.  These figures are very impressive and would seem to belie the stream of fairly negative economic data; as usual we need to look a little closer.

Walmart are the world’s biggest retailer with a US$180b market capitalisation, they trade on a fairly modest multiple of 12x (indicating about a US$15b current annual profit).  This multiple would indicate any significant growth is behind them, making any 12% quarter such as their June quarter very impressive.  The most significant (in relation to assessing how the US is going) part was that substantially all of the growth came outside the US, sales in the US were slightly worse than flat, whilst international sales were up over 16%, so the US retail environment is pretty weak still according to Walmart.  The weak US dollar and their substantial international footprint substantially supported their result.

Costco and Home Depot haven’t nearly as large an international footprint as Walmart and that makes their results even more impressive.  Sydney (and Canberra) based readers will be aware of Costco opening its first Sydney (and Canberra) stores, I had my second visit there this week and I have to say it’s a pretty compelling offering.  I have spent a lot of time thinking about the likely effect of this development on Australian grocers.

The most amusing thing about the reporting of Costco’s push into Australia is how I keep seeing ‘American Giant’ in the media-reporting relating to it.  Costco’s market capitalisation is about US$33b, which would make it just a little smaller than Woolworths based on the current exchange rates.  If they are successful in Australia, it will not be because of their size and power, but because of a superior business model.

If Woolworths and Coles truly want to compete with Costco, they would be far better rolling out their own ‘membership’ based offering, with their existing logistical advantages; it would be very difficult for any newcomer to compete.  Walmart compete with Costco with ‘Sams Club’ – though the US market is much bigger.

The issue here (for Coles and Woolworths) is that they would be cannibalising their own stores in the catchments of each new ‘membership’ store, this is a likely reason for not pre-emptively competing in the ‘membership’ business.  After poking around the Woolworths ‘store locator’, I estimate there would be about 25 of their supermarkets closer than the approximately 15 kilometres I drive to get to Costco (2 are walking distance – less than 1 kilometre), I would imagine there are approximately 50 other reasonably large supermarket alternatives (between Coles/Franklins/Aldi/IGA etc) in the same radius.  So it is reasonable to assume that in medium density areas at least, that while Coles or Woolworths would cannibalise some turnover from existing stores, they would likely ‘steal’ about twice that amount from their competitors.  Judicious site selection could probably further distort that ratio to cause less harm to their own stores (and correspondingly more to their competitors).

By the way, I’m not joining the chorus-line of people who want to bash Coles and Woolworths.  I sympathise – people think our grocery duopoly has led to price-gouging, or grocers earning unreasonable returns, I have read many reports such as this which would indicate that not only are our grocers generally efficient on most commonly used metrics, but they also operate on much leaner margins than their international counterparts.  Don’t forget Australia is a large, distant and sparsely populated country, transport adds enormously to the cost of both local and imported products compared to most countries.


Reporting Season:

It’s my blog, so I guess I can report on the things that interest me most, though there were much larger/more important results announced this week, I wanted to mention a little business I have been interested in for some time.  One that gets relatively little attention in financial press – Slater & Gordon (SGH) – a listed law firm.  The listed law firm is a fairly recent innovation in Australia, SGH listed in mid-2007, given how the market has performed since; their performance has been comparatively good.  The company is capitalised at just over $300m, they are not in the ASX300, but I would imagine, given that there are smaller entities within that index that they will probably be in it soon enough (this type of entry usually generates a short-term spike in prices as index-trackers add the stock).

Their result gave media the chance to (again) trumpet one of the most misrepresented reporting figures – NPAT; headlines read ‘Slater & Gordon profit up 40.9%’.  Now this figure is not wrong, SGH grew NPAT by 40.9% (from $19.8m to $27.9m), however, more importantly EPS ‘only’ grew by 6.7% to 19.1 cps, and this is the shareholders result out of the growth.  I could be wrong here, but I would hazard SGH could probably have grown EPS by about 6.7% organically (I outline why below).  I explained in more detail here a fortnight ago that NPAT is essentially worthless to shareholders unless it translates into EPS.  If NPAT growth is not reflected in EPS growth, the only benefits are likely so be in the salaries of senior executives who now preside over a much larger empire.

In order to examine the benefits to shareholders of the acquisitions we can compare various ratios from last year to the current year.  For example in FY2011, SGH have converted 15.31% of revenue into NPAT ($27.908m/$182.309m) last year the conversion rate was higher – 15.87% ($19.8m/$124.73m).  So in growing the business, management would seem to have made it less profitable.

Other ways of looking at whether the acquisition has delivered cost savings is by examining whether various important expenses have grown more slowly than NPAT (this will deliver efficiency benefits to the business and EPS growth to the shareholder).  The biggest single SGH expense was salaries, which grew by exactly the same as NPAT (40.9%).  I can cop this, you are not going to retain good lawyers by paying uncompetitive salaries, truth is I probably would not expect savings here.  The next biggest expense is administration, and it is in this area most acquisitive companies would seek to make big savings by removing duplicated functions and eliminating excess costs caused by the combination of businesses.  Here though is the greatest failing of the report, administration expense grew by 44.5%, or about 10% faster than profit.  Now it could be that there have been additional costs incurred in the short term, but I would be eagle eyed on this area in future reports, if you cannot reduce administrative costs through acquiring more firms (scale), it is hard to argue the acquisitions will have significant shareholder benefits.  Advertising costs were up 60.6%, provided the spending generates future revenue and helps imbed the brands then it is justified.  The only area where a significant instant pay-off in expense reduction (I define as expenses growing more slowly than corresponding NPAT) came was in rental.  Rental expense only grew by 23.8%, much slower than profit growth, this was probably due to acquiring businesses with footprints in areas with substantially cheaper rental costs, but there will likely be further savings as when it comes time as a larger player to negotiate new deals.

I still like the business idea, but without any obvious benefits deriving from scale, it is hard to see what the real SGH competitive advantage is.  I don’t believe a law firm has a realistic hope of properly creating a brand as law is so reliant on individual talent.  However, I do think that owning listed equity gives the partners of the firm a much more tangible and visible attachment to their employer and could result in less leaving with their portfolio of clients to start their own firm.

I think SGH equity is very reasonably priced at the moment, but I would like to be able to assess with a little more certainty the flow-through (to EPS not NPAT) of benefits through acquisitive growth before I commit.  I think slowing the growth trajectory down a little and trying to make purchases with a greater portion of cash and less new equity would also ensure more of the growth in NPAT appears in EPS.  Helluva post again this week (lengthwise – you be the judge of quality…), but I think it helps my investors to know the types of things I am considering when I deploy your cash – Tony Hansen 21/08/11


April 1st 2011

July 1st 2011

Current Price

Current Period

Since Inception

EGP Fund No. 1












EGP 20






EGP Fund No. 1 Pty Ltd. Down by 2.92%, leading the benchmark by 7.67% since July 1st. Since inception, EGP Fund No. 1 Pty Ltd is Up by 5.23%, leading the benchmark by 19.41% all-time (April 1st2011).

EGP 20.  The EGP20 index is Down by 13.71%, lagging the benchmark by 2.12% since July 1st.  Since inception the EGP20 is Down by 23.75%, lagging the benchmark by 9.57% all-time (since April 1st2011).

S&PASX200TR  The benchmark index is Down by 10.59% since July 1st. The benchmark is Down 14.18% all-time (since April 1st2011).