Just Group, just so

The company we know today as Just Group has been built through the acquisition and integration of market-targeted brands. That is, each brand is designed for a specific demographic to reduce overlap between subdivisions and gain the greatest collective market share. The company’s brands now include (in order of acquisition): Just Jeans, Jay Jays, Jacqui E, Peter Alexander, Portmans, Dotti and Smiggle. In aggregate, they cater for casual wear, women’s wear, sleep wear and, with the addition of Smiggle, fashion stationery.

From Just Group’s humble beginnings as Just Jeans in Chapel Street, Melbourne, the company has continued to enjoy a colourful corporate history. After originally listing on the ASX in 1993, it became the subject of a leveraged buyout in 2001. Three years later in 2004, the company’s private-equity owners (Catalyst Investment Managers) made a well-timed exit and listed the company on the ASX for the second time. While some may lament this activity as disruptive, others have celebrated a company that has emerged from private-equity ownership with plenty of potential and bright prospects.

When Catalyst considered the buyout of Just Group in 2000, it was also completing a buy-out of Pacific Brands. While synchronous transactions are prima facie not unusual, these companies operated a range of competing subdivisions (especially in casual wear and sleep wear). A lot would have transpired behind the opaque cloak of private equity, but most likely, growth initiatives were formulated to exploit the synergies and we got the company we know today.

In 2007, Just Group announced an off-market buyback of its shares. This was an interesting proposition for shareholders as it could potentially increase the intrinsic value of their holdings. However, the situation was complicated by the fact that the buyback will be predominantly funded by debt. While a debt-levered buyback may appear counterintuitive, this is not always the case.

As with most buybacks, shareholders of Just Group stood to receive a greater proportion of the company’s earnings without the need to buy more shares. This is commonly believed to be best-practice capital management when the right circumstances present themselves. The complexity of a debt-levered buyback though, is that the benefits of a traditional buyback are watered-down by increased borrowing costs (fees, principal and interest). Therefore, the most pertinent question was whether Just Group’s buyback would lead to a net-positive creation of shareholder value.

* Depends on the purchase price of the shares

As the above table shows, the outcomes of a traditional buyback (equity-funded) verses a leveraged buyback (debt-funded) are quite different. This is because a company incurs additional costs with a leveraged buyback. It is important to note, however, that neither method guarantees an increase in intrinsic value. The primary reason being that even for a traditional buyback, value is very dependent on the purchase price of the shares. If a company pays too much, it is destroying value by effectively employing its capital at lower rates than usual. What this means for leveraged buybacks is that the purchase price is even more important because the company is already being disadvantaged by the associated costs of additional debt.

We’ll have to wait a little longer to evaluate the long-term outcome of this initiative.

Generally, the greatest concern regarding debt is the obligation to repay it and the subordination of equity investors to secured creditors. In the case of Just Group, though, what is the difference between its commitment to pay back debt and its commitment to pay store leases? If the company is unable to pay its leases, landlords will enact their contractual rights and have their tenants removed. Without stores, Just Group may just as easily become insolvent.

Table 2 shows an interesting ratio that considers borrowing costs and store expenses as equals. It compares Just Group to Noni B; a company that is relatively debt-free.

1. An estimate only, since 2007 did not include the full effect of buyback debt
2. EBITL = Earnings before interest, tax and lease expenses

The table shows that even with a much higher debt-to-equity ratio, Just Group has a greater ability to cover its major fixed costs. That is, if interest rates and rental yields increased equally, Just Group would be in a better financial position and less likely to default. Consensus opinion is that Just Group is a much more risky business because of its 200% debt-to-equity ratio. However, if you believe that retailers are equally obligated to paying their store leases as they are their debt, then you may disagree. Either way, the sizable burden that store leases place on retailers is certainly food for thought.

Business performance

Just Group operates a business that is highly correlated to the discretionary spending habits of its targeted markets. It also uses a plethora of global resources to provide products predominantly to Australians, but increasingly to the rest of the world. As a result, the company’s performance is correlated with a number of macroeconomic variables, such as: interest rates, foreign exchange rates, unemployment and economic growth. While the company has the ability to hedge against these macro risks, I am mostly interested in its strategy to develop a long-term, market-leading business.

Away from the challenges of external factors, the lifeblood of Just Group is its brands. Without these, the company would appear as just another retailer demanding a mark-up on a range of products. Fortunately for Just Group, brand recognition is one of the most powerful forms of competitive advantage. It distinguishes legacy, quality, service and commitment to the latest trends. This is what entices a customer to choose one of Just Group’s brands from the many others that may reside just next door.

Just Group competes with a range of brand managers including Noni B, Pacific Brands and Country Road; many of which are iconic Australian businesses. Just Group’s managing director, Jason Murray, is fixated on a range of measures designed to help him build a wonderful company, but the two most important are return on capital employed (ROCE) and stock turn. These ratios indirectly measure the company’s profitability, its ability to employ new money effectively, its production-cycle efficiency and its ability to sell stock quickly from its stores.

ROCE measures how much money the company is making in relation to the amount of money actively employed to produce returns. As the chart shows, Just Group has increased its ROCE over most years. It has generally managed to do this by refining its operations, improving its production cycle, responding to fashion trends sooner and revitalising its stores. While ROCE cannot be expected to increase indefinitely, it is certainly a good sign that it is increasing even among increasing interest rates and ventures into new markets (South Africa and the United States).

The second measure, stock turn, monitors how quickly the company recycles its inventory. The greater the number the better, because it means that stock spends less time in the hands of Just Group and more time in the hands of its customers. A corollary to a higher number is also reduced costs of storage, savings in distribution, faster reactions to the latest trends and generally improved financial margins. The relevant chart (above) shows a consistent increase in stock turn, which is evidence that Just Group is becoming more and more efficient.

Business valuation

Based on data since Just Group was re-listed, the company has sustained a Normalised ROE (NROE) of more than 100% each year. Coupled with a reinvestment rate of approximately 45% of earnings, this has led to a significant increase in shareholders’ equity and intrinsic value. This increase will continue year-on-year until either the ROE tapers off or the rate of reinvestment diminishes.

The previous table from StockVal (Table 3) shows the financial movements within Just Group over the past three years and an estimate for the year ahead (based on consensus analyst forecasts). One of the most notable trends in this table is that net profit has continued to grow each year. Another interesting note is that shareholders’ equity in 2007 is almost back to the same levels as 2004, although now it is producing a much greater profit. This is partly a result of the aforementioned leveraged buyback and the company’s previous performance.

* The abnormal distribution for 2007 is based on the buyback,
which returned money mostly as a franked dividend.

Based on the company’s sustained NROE (Table 4) and its rate of reinvestment from StockVal, I value Just Group at $4.55 (2007). This is lower than the company’s current market price of $5.10, but it does nothing to detract from the quality of the actual business. It is also important to note that our valuation is quite conservative because it uses the pre-buyback NROE. The reason being that (in addition to the cost of newly acquired debt), the company may feel pressure from investors to reduce its debt levels. This would effectively reduce the level of profitability and may lead to a reversion of NROE to previous levels.

With all of that said, Just Group most certainly exhibits the fundamentals of an attractive business. From a performance sense, it has managed to increase its efficiency and profitability year-on-year. From a strategic sense, Just Group has a competitive advantage that presents a steep learning curve and a range of impediments for new entrants. From an operational sense, the company has streamlined its production to a level only enjoyed by market leaders. Finally, from an investment sense, Just Group exhibits the criteria associated with significant increases in intrinsic value over time.

Todd Sullivan is a senior analyst with the Clime Group.