Will Thorn keep its retail crown?

PORTFOLIO POINT: Thorn Group's outperformance of the retail sector is unlikely to be sustained unless its investment in new products pays off.

It goes without saying that Australian retailers are doing it tough. But just how tough? Compare the share price performance of some household names in retail to the performance of the All Ordinaries index over the past 12 and 24 months.

The high Australian dollar, record outbound tourism, high petrol prices, rising utility costs, indebtedness, a slowing economy, cautious consumers and a structural shift rendering bricks-and-mortar retailers less competitive have seen earnings downgrades come in thick and fast. As well as being tough on the businesses and their managers, retailing has also been a tough place to be an investor.

But one company appears to be bucking the trend, in business terms; that company is Thorn Group (TGA). While the past 12 months have proven just as difficult for the company’s share price as they have for its peers, it’s the 24-month performance of this business that sets it apart. And if a business does well, the shares eventually follow – it’s that simple.

Many retailers have seen their share prices decline 40-50%, yet Thorn has delivered an impressive two-year return to shareholders.

Better still, the business continues to do well. In its latest annual report, released last week, Thorn Group reported NPAT up 26.4% (EPS was up 14% post capital raising). A retailer whose bottom line is actually growing is rare in the current environment; compare Thorn with forecasts for JB Hi-Fi (JBH), Harvey Norman (HVN), Myer (MYR) and David Jones (DJS) in 2012.

Tomorrow’s returns to shareholders will be dependent on how the business performs in the future. So the question, of course, is whether this outperformance is sustainable? I always look for businesses with 'bright prospects’.

A quick look under the hood reveals Thorn’s revenue and EBIT breakdown. The key to the group’s prospects – even after the recent acquisition of NCML, which contributed 20% of EBIT growth – is the rental segment, which represents 92.5% of EBIT. It’s also identified by management as the company’s 'core’ operations.

Clearly, given its contribution to the bottom line, it is the rental segment that will help identify whether or not the business’ prospects are good. In this segment, we find Radio Rentals and Rentlo.

'Consumer rental operations’ would be an apt description for this segment, which is responsible for the retailing of browngoods, whitegoods, PCs, furniture products and other goods such as gym equipment. The revenue breakdown by product and change in product mix is estimated as follows.

The 'change’ column raises an eyebrow for me. Over the last two to three years, the rental segment of Thorn has experienced very strong customer growth, driven in the main by its $1 'Rent-Try-Buy’ promotion. High single-digit growth rates have been produced across the board.

Recently, however, this rate has fallen to the low single-digit rate of 3.1%, and as can be seen in four out of five product groups, growth is negative, flat or marginal. The hero in the product mix, however, is clearly furniture but in my observation, heroes eventually come unstuck.

I reckon the growth in furniture highlights the fact that consumers tend to 'rent’ higher ticket items. Deflation in electronics means that the decision to buy over renting is a far less taxing one. The result is more people buying the laptop and LED TV versus renting. Indeed, much has changed in retailing because that which was once aspirational is now disposable.

Couple the low rates of growth with customer churn and an increase in impairment charges on the rental book and we have a stronger case building for a period of muted to possibly negative growth.

According to a recent company presentation, 44% of customers are retained when their old rental agreement matures. That is to say, these customers purchase another product under another contract. This implies that about 56% of all customers will drop off once their first purchase is fully paid.

In strong growth years, churn is easily offset by more customers entering the business than leaving. And given the strong growth in customers over the past few years, this has been the case.

But when growth rates fall – a sign of a tighter marketplace, changing consumer trends and a potential maturing business (remembering that Thorn grew strongly during the GFC) – churn becomes harder and harder to fight, and the status quo tougher and tougher, as well as more expensive, to maintain.

With an average 27-month contract term, and given strong growth from 2009 onwards, from here the business will likely experience a larger proportion of their 100,000 customer rental agreements coming to term and maturing. Prior comparative period (PCP) comparisons could look less attractive.

Unless that retention rate can be materially lifted, new customers coming in must continue to exceed customers exiting. With the trend into 2013 on the up, the outcome here is likely to be a much tougher battle and flat to slightly negative growth in the core business, which generates in excess of 90% of EBIT.

The key question, therefore, becomes: how long will it take for the investment in new products – Cash First, Equipment Finance and Kiosks – to begin paying off? This will be the next leg in business performance and if that occurs, the share price will, of course, eventually follow.

Thorn is a well-managed business and has a strong balance sheet and management, with a track record of delivering new revenue streams through differentiated business models. But until those new models begin to gain traction, on my analysis it looks as though the business has a tougher couple of years ahead of it.

And while outperformance over the rest of the retail sector has likely to come to end, the company is one I plan to keep a close eye on.

Roger Montgomery is an analyst at Montgomery Investment Management and author of Value.able, available exclusively at rogermontgomery.com.