Thorn Group: Result 2017

In its marketing campaigns, Radio Rentals' key message is that it focuses on the borrower's present state and not their past. Shareholders of Radio Rentals' parent company, Thorn Group, need a different message altogether: focus on the future and not the present.

With net profit up 26% on the prior year, you might think this was a cracking result. But the headline numbers are deceiving, as the growth merely reflects that this year's one-off costs were less than last year's.

2017 was a year of adjustment, in which the management lowered prices under a new regulatory regime, while grappling with an ASIC investigation, a class action and the chief executive's departure. Shareholders will be hoping 2018 has fewer headlines.

Thorn has two distinct businesses with very different market positions and prospects, so it's best to examine them separately.

Radio Rentals

2017 marked the 80^th year of operation for Radio Rentals, Thorn's best business. With strong regulatory headwinds, though, it was hardly a golden year.

Revenue increased by $5m (2.2%), which was not a bad showing given management pre-emptively adopted ASIC's proposed leasing price caps during the year. But this growth required much greater spending on marketing to achieve.

More was spent on compliance too, as well as the $8.1m provision for the investigation into overcharging (which Thorn brought to ASIC's attention), and together these additional expenses knocked earnings before interest, tax, depreciation and amortisation (EBITDA) down by 24% to $15.5m. There was a slight uptick in arrears but they remain in acceptable territory.

Lower depreciation provided some reprieve. As consumers increasingly entered longer duration leases, depreciation of leased goods was spread over a longer period, so that earnings before interest and tax (EBIT) fell only 17% $7.6m.

The 2018 financial year begins with about the same level of leased items as 2017, but with pricing caps, we expect to see lower revenue.

These pricing caps will no doubt hit profit, at least in the short term. But there is a positive over the longer term: what hit Radio Rentals hard is likely to hit smaller competitors harder.

With the lowest pricing to consumers, and the greatest ability to invest in new technology, compliance and marketing, we see a strong case for revived growth in future years at the expense of less able competitors.

2017 was undoubtedly a challenging year, but let's put it into context. Radio Rentals still produced an impressive return on opening equity of 21%. This will reduce somewhat in the coming year, but with what we regard as a strengthening moat, it is likely to stay at decent levels over the long term.

If we are correct with that assessment, it means fair value is unlikely to be much below 1.5x book value, and could well be higher.  With Radio Rentals' book value at $131.7m at the end of March, we think $200m is a reasonably conservative estimate of its standalone value.

Thorn Group's total market value is currently $194m.

Business finance

Business finance, which provides equipment and trade debtor finance, continues its growth path, with revenue up 23% and EBIT up 30%.

While growth is often pleasing, here it obscures an inconvenient truth. Return on assets declined further to 6.5%, which is less than half what Radio Rentals achieves, and management continues to direct more resources towards its lowest-performing division. If any activist investors out there want to encourage the wind-up or sale this division, you have our vote.

With dismal returns we struggle to value the business finance division, and the remaining rats and mice of the consumer loan book, much above their combined book value of $78.5m.

You are likely to receive close to that in a wind-up situation, as the book value plus any interest income is returned, less any one-off and closure costs. For conservatism, we adopt a multiple of 0.9x, which values this division at $71m.

Together, these parts add up to a conservative value of $268m, or $1.71 per share.

With a soft year ahead, and without a permanent chief executive, it's hard to get overly excited by Thorn Group. But it's cheap, and has lots of low-hanging fruit for improvement. SPECULATIVE BUY.