Thorn spikes again

Thorn Group's Radio Rentals subsidiary turns 80 this year but the birthday celebrations are on ice. Instead of a spring in its step this octogenarian is nursing a limp.

We discussed Thorn Group's niggles when we upgraded it in Regulatory fears snag Thorn Group, but as this week's disappointing trading update shows, things aren't getting easier.

On top of an ASIC investigation into its lending practices and a Maurice Blackburn class action, significantly lower earnings are now expected from Radio Rentals, Thorn's best business.

Earnings are down significantly, the dividend is set to be cut and Thorn's lenders are becoming more cautious. Investment narratives rarely get more negative.

But instead of running for the hills we're staying put. Significant value is now on offer to the brave souls capable of stomaching volatility.

The downgrade

Before we get into our revised investment case let's start by unpacking the downgrade.

With ASIC breathing down its neck, Thorn made several changes to its lease origination process to ensure it wouldn't fall foul again. This included a few extra hoops for prospective lessees to jump through.

A more rigorous origination process is good for weeding out clients that won't pay, but that solves a problem Radio Rentals doesn't have. Loan losses are more than acceptable. But the change has also made it more difficult for prospective lessees to become customers; so fewer have done so, and Radio Rentals has seen a big drop-off in installations.

There's a good chance this drop-off is temporary though, as prospective customers who have been unable to provide the necessary documentation cannot defer using everyday items forever. There is precedent of exactly this with Cash Converters, which experienced a drop-off in new customers when it changed its origination process in 2013, but it quickly rebounded thereafter (see page 10 of this presentation).

The devil in the detail

The other aspect of the downgrade dates to November 2013 when Radio Rentals started offering four-year leases for the first time (adding to its normal three-year offering).

This made bigger ticket items cheaper on a weekly basis by spreading their cost over a longer period; a valuable service for customers on a tight weekly budget. However, it embedded a problem that has reared its head three years later (that wasn't a concern for the chief executive at the time who departed shortly afterwards, mind you).

Part of the reason why Radio Rentals is a good business is because around half of customers renew their leases when they expire. So, you'd ordinarily expect half the customers who originated three-year leases in 2014 to renew in 2017. But the introduction of four-year leases delays this by one year.

Because four-year leases were initiated in late 2013, and widely adopted in 2014, it makes 2017 a lean year for renewals. Table 1 illustrates just how much revenue can change when lease terms are lengthened, even when the total value of new leases written each year doesn't change.

We could have seen this coming and the oversight has been costly for holders including us (bringing a new addition to the checklist: for companies that sell multi-year products, closely consider what was happening in the origination year).

That said, we think it is a timing issue and expect it to normalise over time. It certainly paints a cloudy picture, though, when Thorn is already cast in storm shadows.

What else?

Thorn also disclosed that it extended its debt facilities with Westpac until late 2018, but the amount was held at $355m and some progressive repayments were required. A sign that Westpac is becoming nervous.

Thorn may need to add a second lender or sell some non-core assets to appease their concerns.

This may mean the strong growth of Thorn's business finance division, that was reiterated in the trading update, may be capped by funding constraints in the future.  

The value case

As you'd expect investors have deserted Thorn in droves over fears of its declining earnings. But in doing so they've sold the stock to a point where earnings barely matter.

It pays to be sceptical of asset-based valuations when they're based on long-life assets that cannot be easily converted to cash. A pool of 30-year mortgages, or some rusty plant and equipment, might not be as attractive as they initially seem.

But Thorn's short leases convert quickly to cash. If the lease book was placed into run-off you'd expect to have most of it back within four years, and investors paying 64% of face value – as the current price implies – would profit handsomely.

Thorn is now worth more dead than its market value, but it's worth even more alive.

Even with a challenged profit outlook Radio Rentals still has a future, which is something current investors aren't paying a cent for. It still provides a valuable service and it's well placed to increase its industry dominance over time. There's a chance Radio Rentals' birthday celebrations could be rescheduled.

But with the share price down so much, our focal point has shifted to Thorn's net tangible assets per share, which stood at $1.19 in March this year. A 36% discount gives us comfort to maintain our recommendation, but we've lowered the buy price to build a large margin of safety.  SPECULATIVE BUY.

Note: The InvestSMART Australian Small Companies Fund owns shares in Thorn Group. You can find out about investing directly in Intelligent Investor portfolios by clicking here.

Disclosure: The author holds Thorn Group via units in the InvestSMART Australian Small Companies Fund.