A post-mortem for Thorn Group Ltd

A post-mortem for Thorn Group Ltd

I previously bought and sold Thorn Group Ltd (ASX: TGA) shares for the 10foot portfolio. I lost about 8% of the investment or about 0.4% of capital on the transaction, but I avoided the blow up that came following the recent market announcement.

I believe that the Thorn purchase was a mistake as I was too vague and had poor thought process. The sale decision however was correct, because the risks outweighed the rewards, and this was true even before the subsequent downgrade + collapse in the share price. I thought it would be useful, if uncomfortable, to revisit several of the implicit assumptions I made in my Thorn thesis.

For reference, a combination of increased competition and these posts from Dawney & Co about Thorn led to my selling my shares in the company. I will tackle a few of the comments made variously by Dawney, management, and myself regarding Thorn, and how my thinking has evolved today:

• Thorn will hit the limit on its warehouse facility and will be unable to secure additional finance

I thought this was unlikely as NAB has been really keen to grow its business lending volumes recently and I thought it was highly likely that the warehouse facility could be sold off + replaced, or the cap increased. However, it was announced that the corporate cap was kept flat and will actually be stepped down in coming years, which means I was wrong about NAB’s appetite for Thorn.

To be honest, if I had not spotted the additional competition, I likely would have held Thorn and been stung by the finance issue instead:

“However, the total of both facility limits has remained capped at $355m and the corporate facility rollover includes progressive step-downs.”

• Competition would decrease due to the caps making smaller competitors unviable

Possibly this would happen but it will happen over a period of years, not instantly. This means that a Thorn investment was being driven by the company’s access to credit, not the consolidation and cost advantage I highlighted in my investment thesis. This is another good example of a ‘factor mis-match’ which I wrote about here. Unfortunately while I was able to identify one in RNY Property Trust, I missed it in Thorn by prioritising several factors (industry consolidation, continued originations, roll-off of regulatory penalty) over a shorter-term, more important factor (access to finance). And since I was wrong about access to finance, I could have potentially wrecked the whole investment.

Also, consolidation missed the point that perhaps smaller competitors like Rent The Roo would seize the opportunity to launch a big push for market share, which they appear to have done.

• Competition

I mis-read Thorn’s competitive position. I thought that as one of the larger rental providers in Aus, and one that was already priced close to the newly imposed leasing caps, Thorn would suffer the least. I expected other competitors to struggle to reprice their leases, leaving Thorn (with a cost advantage) in the lead. Fortunately this is an area that I kept an eye on and increasing competition led to me selling.

• Afterpay?

I couldn’t say for sure if Afterpay Touch Group Ltd (ASX: APT) had any impact as it is not intentionally a direct competitor. However it’s necessary to consider the niche that this business occupies in the market. For no cost, Afterpay allows customers to repay purchases over a 2mth (?) period with 4 fortnightly payments. This effectively makes Thorn’s value proposition at the cheaper end of the market obsolete.

Depending on the product, an $800 fridge becomes 4 x $200 fortnightly, instead of $15/wk for 3-4 years (~3-4x the price of an outright purchase) or whatever it is with Thorn. I don’t know for sure the precise point at which Afterpay becomes viable for Centrelink/poorer customers, but there is clearly a price below which Thorn is totally obsolete – if the product is available via an Afterpay retailer. Larger purchases, say above $1000, are probably still unviable to most Thorn customers via Afterpay.

**Edit**: I haven’t seen Afterpay disclose its limits on its transactions. Probably an $800 fridge is beyond the limit. However some cheaper items like a Dyson vacuum (~$300) would probably be more viable with Afterpay compared to Thorn.

• Franchises

Fairly or unfairly I thought a recent boom in leasing to franchises was a blossoming risk, and it was a key element in my decision to sell. I get the appeal of a lease because it allows a business to match lease payments to cash flow instead of taking a big capital expenditure hit – especially difficult in low-profit businesses like franchises. I think this is definitely a growth market. However, the sheer scale of the growth Thorn reported and the fact that it was attributed to franchisees made me uncomfortable. (With the benefit of hindsight – was Thorn aiming to pivot away from a weakening lease market?)

Tangentially in my looks at other businesses I saw what I thought were programs encouraging people to buy franchises irresponsibly, e.g. by helping fund the start-up costs via loans, and so on, and franchising is a business model that – while I quite like its economics as an investor – I don’t have a lot of confidence in.

Find The Moat has done a considerable amount of work on this where he points out that Domino’s is predominantly in the business of selling franchises, not pizza. Overall I couldn’t get comfortable with the booming leases to franchisees and I felt that at least this part of the decision was well-reasoned, although again it is probably a longer-term concern.

• Switch from 3-year to 4-year leases lowered origination volumes

I didn’t really think this was a problem, even though Thorn’s finance lease origination is important for profit. The 4-year lease in reality should be more valuable because you’re getting another year’s worth of cashflow out of the leased item. However, this definitely could impact headline profit, and in my buy thesis I was focused on profit as the driver of value. So this is another example of a mis-match I fell for – I focused on the overall ‘value’ of the 4-year lease, even though Thorn’s originations + profit – the thing that was key to the thesis – could have been lower under the 4-year lease arrangement.

While the financing was the biggest single mistake of the original thesis, I’ve uncovered several of these factor mismatches in my post-mortem of my decision-making, and the investment was clearly poorly thought out.

As a side note, if it was that obvious that the switch to 4-year leases would lead to a year of lower originations (mgmt keeps pointing it out), Thorn should have guided for this years ago instead of letting the share price run up to $3. I wasn’t interested in Thorn then so that is no skin off my nose, but I thought – and still think – that this is an excuse for competitive threats.

With the cap in the financing facilities, limited corporate cash and high corporate debt, it’s hard to see Thorn maintaining even the current pace of originations, so I could see profits and dividends falling further.

Is it an opportunity yet?

I wrote when I sold that I’d want a fatter pitch for Thorn in the future, something like if it was trading below NTA at the bottom of the cycle. Thorn shares are now below their NTA. First, I’m definitely once-(almost)-bitten, twice-shy on this one so it’s pretty hard to see 10foot heading back into Thorn in the future.

However, because of what I wrote above about the financing and competition, it’s also hard to see profits recovering in the near future, and they may decline further. I will likely be much more cautious, looking to get a price that basically ascribes no value to the business or the NTA. As a result I’ll be watching from the sideline for now.

The bottom line

In summary, one mistaken premise – a belief in the accessibility of finance – lead to a mistaken Thorn purchase. One probably correct premise – fears over increased competition – lead to a correct Thorn sale.

It’s important to note that this post is for my own accountability, to see what I could learn from my mistakes. Given how Thorn turned out, I would suggest you don’t use my writings to inform your own thinking on the company.

I have no financial interest in any of the companies mentioned in this article. This is a disclosure and not a recommendation. I formerly owned shares of RNY Property Trust and Thorn Group, but sold them all.

10footinvestor

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