Sunday, April 7, 2013

Is HGL Limited a cigarbutt?

HGL Limited (HNG) is an Australian microcap listed on ASX with a market cap of $22m. Its current share price is $0.44. It has virtually no debt. Insiders own about 40% of the company. Its history traces back to First World War. It was originally founded in 1898 as Hancock & Gore, a timber mill operator.

Between 1985-2010, it was under Kevin Eley's leadership. Without a better word to describe it, I would call it a "micro-conglomerate". Eley copied Warren Buffett's Berkshire Hathaway model with 2 distinct operations: (1) investing in public listed companies and (2) buying and operating a group of private businesses. However, since 2009, HGL has shifted strategy and gradually exited its equity investments. In 2010, Eley stepped down and was replaced by then COO Michael Mahoney. HGL is now a pure operator of a bunch of unrelated businesses. (Eley remains to be a board member.)

While its businesses are largely unrelated with no syngery, they all follow a common theme: they are branded products and services operating in their very narrow niches. These niche markets are usually fragmented and allow HGL to exert some pricing power. HGL don't manufacture their products. Effectively, It is an importer/distributor.

HGL's wholly owned businesses (sale figures are FY2012's, in AUD):
  • SPOS - point-of-purchase marketing services ($23m)
  • JSB Lighting - high-end lighting ($15m)
  • Leuteneggar & XLN Fabric- fabrics for home sewing and craft ($17m)
Businesses with 50% ownership:
  • Anitech - large format printer products and services ($29m)
  • Mountcastle -  school uniforms and headwears for police and defence forces. ($12m)
  • BOC - ophthalmic equipments ($7m)
  • BLC Cosmetics - skin care ($10m)
  • Biante Model Cars - collector model cars ($5m)
Business was tough in 2012. Persisting high Australian dollar caused price deflation and consumer sentiment was the worst since GFC. Both SPOS and JSB suffered huge setback. Management at SPOS had misjudged demand. It suffered large writedowns and impairments. HGL's revenue fell 28% and its net profit was negative. Excluding the writedowns and impairments, EBIT margin was 0.3%, effectively breakeven, while historically it was in the range of 7-9% in the previous 5 years.

Our investment thesis is based on a simple idea: reverse to mean.

Between 2008 and 2011, HGL's average ROE was about 10%. However, HGL has goodwill from its past acquisitions on its book. Use HGL's own preferred measurement, EBIT / Capital Employed averages close to 20%. HGL has never lost money in the past 10 years. HGL is an above average business. If HGL manages to control its costs and achieve a typical 5% net margin, using the 2012 trough revenue of $118m, it can achieve a net profit of $5.9m. With a conservative P/E multiple of 8.5x, each share will be worth $0.68, 50% above the current price. If revenue returns back to historical average of $160m and net margin 6%, with a more "normal time" multiple of 10x, it will be worth $1.3 per share, 200% above the current price.

(HGL has non-controlling interests on its book who have a claim on HGL's profits and assets. All the above figures except EBIT and Capital Employed have been adjusted to reflect what equity holders get. All figures are in AUD.)

How likely can HGL turn around its business?

The catalyst that is helping us out is a swift improvement of consumer sentiment in the first 3 months in 2013.

(source:, Westpac Bank, Melbourne Insititute)

The chart below shows HGL's share price against 2 Australian retailers, Harvey Norman and Myer. (Harvey Norman is comparable to Best Buy in US. I'm not too sure what the US equivalence of Myer is. Maybe JC Penney?) You can see the dramatic recovery of HVN and MYR in the last 3-6 months, coinciding with the improvement of consumer sentiment. You can see HGL is lagging behind because improvement of its profitability is not yet in sight.

(source: Google Finance)

After deducted the minority interests, HGL has a net tangible asset (NTA) value of $0.41 and a net current asset value (NACV) of $0.35 per share. While the current share price is very close to NTA, HGL is definitely not a net-net. We have some safety from the value of the assets, but it's not bullet proof.

The opportunity here is the possibility of a quick turnaround. We are relying on its operating leverage to propel its profit (and share price) quickly when sales volume picks up.

Make no mistake. Turnarounds are risky businesses. Besides, there are few things I don't like about HGL:
  • Since each subsidiary operates independently with its own CEO, HGL has effectively 2 layers of management. It made sense when Eley was still around acting the capital allocator. But it's no longer the case. I think it's redundant and wasteful. (The corollary is: HGL will be worth more if it's broken up. The main it'll lose is the access of the capital market.)
  • The non-controlling interests act like preference shares: always standing in the front of the queue to take a cut before the equity owners.
  • Mahoney stepped down as the CEO because of "ill health" a few months ago. One got to wonder if HGL's poor result took a toll on his health.
On a balance, my view is the potential of a swift realisation of the upside is enough to compensate for the negatives. And I think HGL is qualified as a "cigarbutt". You quickly take your puff and then move on.

(Disclosure: Long HNG.AX)


  1. Interesting possible turnaround John. Certainly worth digging deeper. Tks for sharing.
    Myer's ticker is MYR.
    reversion to the mean?

    1. Thanks Dean. I've corrected the ticker.

      What does "OCD" mean?

  2. OCD stands for Obsessive–compulsive disorder. Commonly used/misused online to mean can't let irrelevant things slip by :)

  3. Hi John,

    I haven't had a chance to look properly yet, but surely the high AUD should be providing a beneficial environment for an importer. What happens if the AUD slips by 40% back to PPP?

    1. Hi Jesse,

      Interestingly you mentioned this. In the past few years, AUD/USD went through a few up and down cycles. When AUD was high, HGL's management blamed the high AUD for their worse than expected performance. When the AUD was low, they equally blamed the low AUD for their poor performance. This is quite a conundrum.

      I reason, for an importer, whether higher or lower AUD dollar helps really depends on your pricing power. When AUD dollar is high, the costs of your goods drop. You would expect a better gross margin. However, if your products lack pricing power, in a competitive environment, you are forced to lower the sale prices to match your competitors who are also benefited from the strength of the currency. You may be maintaining the same gross margin. But the absolute dollar figure is lower than before. If you needed to sell X units to generate $Y in the past, now you need to sell 2X units. So at the end, it's the end consumers getting the benefit.

      I suppose there is an optimal exchange rate for an importer, and it will be different for each importer because different importer has different pricing power. But I don't have any idea where that optimum is.

  4. Hello,
    I,ve been a share holder since 2000 and have recently increased my holdings. It's no cigar butt.
    It's a long term stock. Yes a Warren Buffett stock.

    1. Hi,

      Thanks for your comment. Being on the same side of the trade, I have every incentive to hope it is the case. :-)

      Btw, do you have any comment on the disposal of the Aarque business unit in NZ in 2011? Aarque looked reasonably profitable. It also looks suspicious that the proceeding roughly covered the dividends in that year.

    2. Hi John,
      Thanks for the support. Times are tough, and as Warren Buffett says be greedy when others are fearfull and fearfull when others are greedy. That why I'm buying.
      I read a whole lot of books back in the nineties, did my research on HGL and found it returned a 21 % annual return since 1971, my calcualtion may be inccorrect because HGL itself said it returned 15 % annual return, but what i saw was a company run by A number 1 management.
      My only concern with HGL is that it has concentrated on import and distrubution businesses. In my eyes a good bussiness is a good business.
      I'm not sure abour Aarquee NZ but from reading the annual reports over the years its always been a bussiness that HGl has tried to improve. I've made money on this stock on dividends alone over the years.
      Does anyone know what happened to Micheal, He was around for a long time serving under Kevin.

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