Hornby is the stuff of nightmares. An iconic brand with the very
simplest of business models brought low by persistent management incompetence. No
investor in 2003 could have foreseen what came next. I look at Hornby and I
think, “that could have been me”.
“It makes for a curious, and rather fun, office. How many corporate headquarters share their building with toy train sets and day trippers?Mr Martin doesn't seem to revel in this quirk. He's very laid-back for a chief executive, but there's no bounce in his step as we wander around admiring the 1950s corgi models, and German 0-gauge trains. And he clutches the controls of the latest Scalextric set with the enthusiasm of a tea-totaller (sic) in a pub.But then he never had a toy train set as a boy. Nor did he have Scalextric – he had to pop around to his neighbour's house in Manchester if he wanted a play with a slot car.The fact he wasn't a fan as a child gives him "perspective", he reckons. It also helps him smile at the absurdity of some of his customers, the majority of whom are adult collectors, rather than children. He recently received an angry letter from one, who complained that a tiny fire-stocker's shovel, on the model of a historic train, only had one rivet in the handle when it should have had two.I suggest his customers aren't just enthusiasts, they are nerds. He smiles and says: "We don't like to call them that. They are consumers who recognise the true value of this wonderful collectors' range we have created for them."The nerds should have kept Hornby's profits puffing along quite nicely during the recession – not many businesses enjoy such a loyal customer base. But in recent years it has, if not hit the buffers, then certainly got stuck in the sidings. High raw material costs (plastic, zinc for the die-cast), rising labour rates in China and a difficult supplier, who consistently failed to deliver products on time, have hit profits.Martin says the issues with the supplier have been sorted and the outlook is looking far more promising. That is mostly down to Hornby securing a licence to manufacture a range of London 2012 merchandise
A difficult supplier.
Can you imagine?
Hornby is yielding 20% on 10 years average operating profit.
It’s not cheap at that price.
I also gave up on the company after 3 years of mentioning the supplier problem and slowly losing the battle against electronic games.
ReplyDeleteMaybe a strategy similar to Games Workshop will work.
Totally agree. Dumped it as it serially blamed its Chinese suppliers.
DeleteApple doesn't seem to have a problem with them...
I'd want to see totally new management. Probably one for the PE boys.
I think Field was feted for Hornby's huge stockmarket success early in the last decade when outsourcing manufacturing to China was a good idea and before it acquired its vast miscellany of brands and licenses. Funny how things change. I agree - who'd have predicted it? Which, makes me wonder about Games Workshop (to pick up Tim's point). At different times in the past both companies looked like they'd found the key to mining the enthusiasm of their hobbyist customers and then splurged the loot on games or collectibles that were in fashion momentarily but lacked the staying power of their core brands. Does history repeat itself? Or will one of these companies eventually learn? I think Games Workshop may have, but Hornby has a long, long way to go.
ReplyDeleteThanks for the comments, gents. I'd buy Hornby whole, but I wouldn't touch its shares.I've posted a follow-up.
ReplyDeleteI enjoy your posts, and this on Hornby has a couple of interesting slants, but I think it's a bit trite. Hornby wouldn't exist today had it not re-invesnted its business model and shipped manufacturing out to China, and initially this was very successful. But it has exposed the company to hard to manage challenges - manufacturing on the other side of the world, currency exposure and I'm sure high labour cost inflation.
ReplyDeleteClearly, it's major supplier has had problems, but I'm not convinced management could have made effective speedy changes in this area.
I think, too, targeting youngsters with its toys is becoming increasingly difficult. Would a youngster choose a train set or an iPad, would a parent? I'm sure parents would view the i-pad as a surer bet to keep the kids quietly occupied for longer and with far less tidying up.
Management have seemed quite savvy with their marketing, and the acquisitions they made in recent years seemed to lever their expertise in reinvigorating brands by manufacturing in China. But I think with their Olympic souvenirs and one or two other ventures outside train sets and slot cars earlier this year management seemed to be taking their eye off bedding down and marketing their acquisitions - which was surprising and perhaps suggested quiet desperation.
I also wonder to what extent they've saturated the train set and slot car market in the UK. They've been selling high quality product now for 10 years - when this shift began most households wouldn't have any stashed away. Now I suspect little brothers get to play with the sets of their older brothers.
The company is currently trading well below its last reported NAV, and if it's poor management it's attractively priced for a takeover, but I think Hornby's challenges may quite challenging to resolve. I think Mattel's model is pretty close to Hornby's, put it this way - name their competitors.
Thanks for the thoughtful comment.
Delete1. China: I have no problem with having the products made in China. China is not synonymous with poor quality. Take, to pick a name out of a hat, Coach. It's handbags are made in China -- they are well made, sold at $500, and 4 million women buy 4 of them a year, every year. Coach earns 75% to 80% gross margins, 10 points clear of Johnson & Johnson and 15 points clear of Coke. China's not the problem.
2. Single supplier: Do you think its reasonable for management to have sourced manufacturing from a single supplier? What happens if there's a glitch in the run-up to Christmas? Look at what he says about suppliers in this article:
http://www.guardian.co.uk/business/2007/dec/21/1
Would you, in his position, have allowed Hornby to remain hostage to a single supplier some 5 years and multiple supplier glitches later?
3. the marketplace: This is the question: can Hornby sell train sets to 0.064% of the population in the UK, Ireland, Australia, NZ, and Canada, and the US, at an average selling price of £250 pounds? The answer is yes: a proper mix of price points from £1,000 to £10: differentiation, segmentation, targeting & proper distribution channels -- pretty basic stuff. Consider the contrast with LEGO: what excuse does Hornby have that is not also available to LEGO?
4. Not every business is destined to grow. Not every business should grow. Some businesses are in a position to settle in as "cash cows", to convert earnings into free cash and free cash into dividends. That coul be Hornby, and that would be fine. What's not fine is value destruction.
4: NAV etc: the danger of looking at stocks below NAV is that one wants to see the underlying business in the best possible light. Management hasn't made one-time errors, they have consistently and systematically eroded the value of the business over a period of at least 8 years. Far from being "savvy", they've reinvested at a negative real return (i.e. at rates below the cost of capital) over every time period between 2003 and now.
5: Yes, Hornby's potential, under different management, may well be similar to that of Mattel, suitably adjusted for scale.
Hi,
ReplyDeleteThanks for the great articles! I am trying to understand how to look at invested capital. I think that Greenblatt mentioned in his Columbia class that he looks at it as: (Accounts receivables plus inventory less accounts payable) plus (Property, Plant, Equipment less long term debt). He calls this net working capital plus net fixed assets. Is that the method that you are using? I have looked at the Hornby annual report balance sheet on p. 30 http://online.hemscottir.com/ir/hrn/pdf/ar2012.pdf
I am having trouble figuring out how you calculated working capital and fixed operating assets. If possible, I would be interested in learning how you think about invested capital. I understand if you are too busy to respond.
Thanks again for the great articles,
Hugh
Thanks for the question. It reminds me that the purpose of this blog is to clarify some methodological issues.
ReplyDeleteI use working capital to mean "operating working capital", i.e. those items in the current account required to run the business. I therefore exclude excess cash, finance debt, tax liabilities, etc, which are financing, rather than operating, items.
In Hornby's case, that means trade receivables (NOT "trade and other receivables"), inventory + prepaid expenses - trade payables (NOT "trade and other payables").
The trade payable / trade receivable numbers are most often in the footnotes rather than in the balance sheet.
Fixed operating assets:
Property, Plant & Equipment + Operating Leases (properly capitalized) + operating intangibles (i.e. software and such, yes; trademarks and other acquired intangibles, no).
By the way "PP&E less long-term debt" is incorrect and I doubt that Greenblatt would suggest that.
So, the above, net operating working capital + operating fixed assets = Net Tangible Fixed Assets.
This year's Operating Profit / average of this year's and last year's Net Tangible Fixed Assets = what I call, for convenience, ROIC.
"Return on Incremental Capital", is calculated by:
(Change in Operating Profit) / (Change in Net Tangible Assets + Change in Acquired Intangibles & Goodwill)
Ask me a follow up if any of this is not clear or badly explained.
Thanks, that explanation clears things up for me. I mistakenly thought of net fixed assets as including long term debt. I also wondered about whether software should be included as a fixed asset. I have seen some asset managers who grow by buying other asset managers. I think that this would be part of fixed assets even though it is categorized as an intangible. The other thing I noticed was when looking at two Japanese software companies that had similar sales and earnings, one company had ppe of 1.3 billion yen, while the other had ppe of 300 million yen. Theoretically, the first company does not need 1.3 billion yen of ppe to run its business. I think that the owner operator just used the company's money to build a big headquarters. I am not sure how to look at this.
DeleteThe other question that I keep wondering about is how to think about Enterprise Value. Do you look at market cap plus long term debt less cash? Do you exclude all other current assets and all other liabilities beside long term debt? Or do you include other current assets like prepaid tax, and include other liabilities like current tax owed, and other non current liabilities besides long term debt?
I would be interested in hearing about how you think about these things.
Hugh
Enterprise Value in the way it is used most often is what it would cost to buy the whole company outright:
DeleteMarket Cap + Debt - Cash.
I use it to mean:
Market Cap + all Debt equivalents (included the capitalized value of operating leases, the unfunded pension liability, etc) - Cash - Long-term Investments - Net deferred Tax Assets
The above is usually called Total Enterprise Value (TEV).
If you have access to a library or some such, Koller et al's book "Valuation: Measuring and Managing the Value of Companies" is a good resource -- it explains things correctly & clearly.
Thanks!
DeleteHi Red
ReplyDeletejust read someone's observation that one of Hornby's problems was that the supplier that is in trouble makes all their high value and high margin trains, and that they make very little on the rest of their range, a large reason for the profit warning; suggesting quite a close replication of the Mattel body.
I think the point I was making yesterday was that you and others are blaming management, whereas I feel that the company has problems largely outside their control to contend with. If it is poor management, then at its current price it is a buying opportunity, if its more structural it's a speculative play.
Apologies too for calling your post "trite" - bit blunt, your posts are quite thought provoking and enjoyable reads.
No worries & thanks for the additional info.
DeleteHi
ReplyDeleteThanks for this post.
What is interesting is that the CEO/CFO cost the company around £750k last year. nice work if you cant get it!
What is confusing me is your calculation of return on operating assets. THus in 2003, average operating assets is 11.4 and owner earnings is 3.9 - giving a return of 34.2% - slightly different from teh 33.68%. Is this due to rounding errors?
Also - just dont get how you get to -5.58% for your return on incremental capital. Could you spell out how you get to this figure?
Many thanks
Hi --
ReplyDeleteI calculate the return on operating assets as (operating profit/(the average of operating assets in years t and t-1).
Owner earnings are calculated after non-operating (mainly financing) items, and therefore Earnings/Operating Assets would not make much sense.
I calculate return on incremental capital as the change in operating profit over the change in average operating assets over a specific time period. So, in this case, it would be
(2011 profit minus 2004 profit)/(average invested in 2010-11 minus average invested capital in 2003-4). I chose 2004 because that was the year in which Hornby decided to change its business model.
As for the CEO/CFO pay issue. The truth is that I am far more inured to greed than I am to base incompetence.
"In 1995, Hornby thought it had found the answer to its problems in Sanda Kan in China which could manufacture most of its toys. The downside was distance. “But nowhere else offered the economies of scale, the skill base and the price. And if we hadn’t [moved production] we would have gone bust,” says Mr Martin."
ReplyDeleteEconomies of scale!
On the other hand, "Hornby now only relies on Sanda Kan for a tenth of its stock, but Mr Martin is considering whether to shift toy production to India or even back to Britain."
and this:
"Mr Martin’s strategy for 2013 is to examine costs while finding new ways of exploiting the company’s brands."
Pure comedy.
“Perhaps the risks weren’t assessed as well as they could have been.”
-New Chairman