Michael Hill’s share price recently tanked to $0.44, from a high of $1.40 in January 2022.

It was its latest trading update which did the damage.

To summarise –

• Michael Hill same-store sales are down across the board.
• Total sales are slightly up in Australia, only because of the Bevilles acquisition.
• Company made a $10 million EBIT loss in Q3 (compared to an EBIT profit of $15.5m across Q1 and Q2).

At a guess, the company will make around $7 to $10 million in profit for 2024, compared to $49m last year.

Does that justify a 50% drop in share price? Maybe the market is serving us a bargain on this great NZ company – let’s take a look.

The first piece of the puzzle is figuring out why – as in why are sales down, and why did they make a loss last quarter.

First reason – sales are down most likely due to inflation and the “cost-of-living crisis”. Even with the acquisition of Bevilles (26 stores) sales are only up 4.7%. This is mostly due to the struggling NZ sector, which isn’t a surprise (NZ retail figures have been in the toilet since Covid).

Second reason – Gross margin under pressure, mostly due to high gold prices (gold is currently trading at all-time highs).

Third reason – Admin expenses due to the relocation of Bevilles HQ from Melbourne to Brisbane. Their NZ stores have also been popular targets of ram raids, which were happening multiple times a week over 2022 and 2023, and as you can imagine, have cost them millions in repairs and additional security.

Mash all those things together, and it’s looking like an 80% drop in profit for Michael Hill in 2024.

Bevilles

The Bevilles acquisition was made during April 2023, when Michael Hill was coming off record profits.

The acquisition price was $45m (actually $50m when all costs included) for a business expected to make EBITDA $8m in FY23. At a multiple of 6.5x EBITDA, sounds decent, but as Charlie Munger likes to say, EBITDA is just another name for “bullshit earnings”.

The reasoning behind using EBITDA instead of net profit in acquisition analysis is “experts” say only the actual “earning power” is relevant, since once you acquire the business you bring it into the existing infrastructure – therefore depreciation and interest pre-acquisition isn’t applicable.

However, in practice this isn’t really true – yes, Bevilles can be brought into the existing Michael Hill supply chain and distribution, but this costs money.

Unsurprisingly, Michael Hill has figured this out in the most recent quarter:

Bevilles was expected to add $65m in sales post-acquisition and $8.5m in EBITDA.

Here are Michael Hill’s Sales and EBITDA figures from last year:

So optimistic shareholders were expecting in the range of 670m in revenue, and $124m in EBITDA for 2024.

Unfortunately, it looks like both revenue and EBITDA will be down in 2024, despite paying $50m for the acquisition.

Personally – I don’t think Bevilles was a bad acquisition and I don’t believe they overpaid. In hindsight, it looks more like a case of bad timing, and management feeling like they had so much cash they needed to do something.

Which leads us to the second big issue – capital management.

Where did all the cash go?

Michael Hill was sitting on almost $100 million in cash at the end of 2022.

Take a moment to think about how much money that is – it’s about 3-4 years of profit just sitting in the bank.

They could have dumped that in a term deposit and collected a cool $3-4 million per year while they waited for the economy to clear up, but alas, they decided to go spend it all.

Interestingly, I was a shareholder briefly during that time in 2022 in the public portfolio, however I sold after a short few months as I started to get the feeling management might blow it all on something stupid.

Not to toot my horn too loud, but turns out that’s exactly what happened.

Where did it go?

A few places:

With share prices at multi-year highs, they exercised a share buyback of $10 million, at an average of $1.18 per share:

This is probably the #1 “stupid thing” they did which I was trying to avoid.

I’ve never understood management wanting to start share buybacks at high prices, yet it happens so often.

In fact, it would have been great if they had done the share buyback today, while the price is in the toilet.

But they decided it was a good idea to do when the share price was roaring.

So that’s the first issue – they’ve spent $1.18/share buying back their own stock, when they could’ve been buying it for $0.44/share today, effectively making a 70% loss on that $10 million.

(If you’ve ever felt bad about “buying high and selling low”, cut yourself some slack, even directors running the country’s biggest companies do it).

The second thing they did was spend $50m on Bevilles.

Again – I don’t think this was the worst idea, but probably wasn’t a good idea while you were blowing cash on a buyback too. In any case, I would have far preferred they had left the cash in the bank.

Finally, they paid their highest dividend in recent memory of $30 million.

Add it up and that’s your $90 million in cash gone in a blink.

Warren Buffett talks often about capital management and how important it is.

It doesn’t matter how many billions the business earns if the executives spend it on anything and everything.

Compare this situation to a more prudent and patient CEO, like Rod Duke of Briscoes.

Briscoes has been sitting on a fat cash stack for years and has made one acquisition in the last few decades (Rebel Sport), plus a small investment in Kathmandu.

Right now, they’re sitting on a growing pile of $175 million in cash and …. chilling.

(The green line below is the cash balance).

The result is they collect a cool $6m in interest each year, while being primed for any opportunities in the market.

Contrast this with Michael Hill, who is now in debt, has been forced to cut their dividend by more than half, rushed a mediocre acquisition, and has no cash on hand should obligation or opportunities arise.

While I don’t believe Michael Hill is “terribly” managed or they’re at any risk of going bankrupt (the business is still profitable and their debt is negligible), they’re definitely not a rockstar management team I’m excited to invest in.

The business is also just okay across most metrics.

Is the price low enough for them to be investable?

Let’s find out.

What’s Michael Hill worth?

In the first half of FY24 they made a profit of $15m, compared to $38m in the first half of FY23.

At their last update, they had an EBIT loss in Q3 of $10m.

Assuming they can turn that around in Q4 and break even or make a small profit, we’re looking at between $7 and $10 million in profit for 2024.

As for cash flow, they were $15 FCF negative in the first half, and normally retailers barely break even in 2H as debtors become due before year-end.

So we’re looking at maybe $10m in profit and FCF of negative $20+ million for the year.

Currently, Michael trades at a market cap of $173m, plus net debt of $11m takes us to EV of $184 million.

That’s a profit multiple of 17-18x, for a pretty average company.

For a company like Michael Hill, I would need a low single digit multiple to consider investing, maybe 5x or thereabouts.

Why? There’s nothing special about the company, they don’t make the best jewellery in the world, they don’t have the best CEO in the world, and they’re not growing at any impressive pace. The reason you buy a company like Michael Hill is because it’s cheap.

Right now it’s not cheap, but it does have the potential to be:

Against their 2022 free cash flow of $55m, the current price looks incredibly cheap – you’d be paying around 3.5x EV/FCF.

But it’s not 2022 anymore.

The question is – can they get back to their record-setting 2021 – 2022 numbers, once Bevilles is fully integrated and the economy has strengthened?

If I had to guess I’d say they’ll maybe come out of this okay, but there’s the problem. I don’t invest in guesses or maybes.

What this looks like to me is the company is getting a little messy for current management to navigate – they’re managing 4 different brands in 3 countries and capital is getting mismanaged. They’ve launched one new brand and acquired another in the last 12 months, and generally it takes time for things like that to be synergised properly, even when management is exceptional. The market has pounded these guys, but I think they’ve got it mostly right. While I think they’ll do okay long-term, it’s an easy pass for me.