This post is about the eleven reasons why I think Dixons Carphone trumps AO World as a good investment. Sure, both retailers are struggling as seen in the decline of their share price.
For me, what is astonishing is how investors gave AO World the benefit of the doubt while neglecting Dixons Carphone consistent performance. Because it is the one paying out a dividend, the one making cash flow earnings, the one making improvements to their business model and the one seeking to save on costs.
AO World shouldn’t be valued at over £500m.
If I had to choose a stock to invest it would be Dixons Carphone.
Below are the eleven reasons why.
Reason 1: Superior Profits
When it came to faster sales growth, I tip my hat to AO World.
since 2011, AO World has seen sales rose from £164m to £701m, but they haven’t made one penny in operating profit over this period.
In fact, it has achieved accumulative losses of over £20m.
Meanwhile, Dixons Carphone saw their share price drop 30% because it was forecasting an average profit decline of £100m to £400m (median estimates).
Reason 2: Pay high bankers’ fee for high valuation
Anyone looking at the table below would be eerily suspicious of paying to obtain a high valuation in their IPO. However, there is no evidence that suggests this is the case (apart from the numbers below). By comparing other similar IPOs such as Pets at Home and Boohoo.com we see some stark contrast.
Here is the illustration:
|Companies||Gross proceeds||Bankers’ fees|
|Pets at Home||£280m||£40m|
As you can see, AO World is paying one-third fees to raise gross proceeds of £60m, that is high and not to mention very expensive.
Below is the interpretation from the above table:
|Companies||Net proceeds||% of proceeds paid to bankers||Net proceeds/IPO valuation|
|AO World||£40m||33.3||£40m/£1,200m = 3.3%.|
|Pets at Home||£240m||14.3||£240m/£1,300m|
Look at the net proceeds to IPO Valuation for AO World, it looks like shareholders are holding a minority stake in the company. The free float is 40% traded in the market meaning 60% is held in private hands where shares can’t be traded.
Reason 3: AO World is a better place to work
Employee costs are important for service companies, especially those who rely solely on distributing brand products.
In the past three years, staff cost has exceeded £30k per employee, whereas Dixons is stringier as employee cost an average £25k. Surprisingly, wage costs for both companies account for the similar percentage of sales (roughly 10%).
However, Sales per employee at AO World has been declining since 2011, where each employee manages to turnover £348k. But, now it turnover £280.6k worth of stock. Either this is due to heavy discounting or it’s being inefficient.
It’s very hard to compare it to Dixons Carphone as they have a different mix of products and services on offer than AO World. Though I must admit it isn’t too far off the mark. Instead, I would study the trend. The sales per employee are steady at around £232k for the past three years.
Reason 4: AO World reported net earnings of £6.3m in 2013
I spoke about the high bankers’ fees in reason 2. There was another red flag and it was the booking of a profit. It stated net earnings of £6.3m in their IPO when their previous years were showing losses.
Although some would give it the benefit of the doubt, the next four years saw losses of £9.57m, £2.5m, £6.1m and £7.4m. A grand total of £24.5m of net loss.
In the end, there was zero profit potential.
Reason 5: AO World increasing operating lease
I know Dixons Carphone has a far larger operating lease, but AO World much smaller leasing expenses will become more problematic for the company to turn a profit.
The annual rent charge is up 70% to £13.3m from £8.6m. Still, a far cry from Dixons Carphone’s £350m rental charges, though this will begin to fall in the future as total operating leases have shrunk by half a billion pounds in three years.
Although, AO World annual rent represents less than 2% of sales, compared to 3% for Dixons. AO World is the business struggling to make money and requires shareholders support.
Reason 6: Market Capitalisation disparity
Dixons Carphone has a market valuation of £1.9bn and AO World comes in at £580m.
Dixons is clearly the bigger company with £10bn in sales vs. AO World’s £700m (which is growing at a rapid pace).
In terms of net earnings, AO World has zero track record, whereas Dixons makes £400m in profits.
Meaning AO world is surviving from cash in the bank of £29m representing 5% of market cap. when Dixons £209m makes up 12% of its valuation.
To justify AO World’s valuation, it needs to make £100m earnings to be on a par with Dixons, despite the latter seeing maturity in sales.
P.S. AO World recently did a placing for £50m gross. Hope the bankers’ fee is low this time around!
Reason 7: Increasing operating expenses
For the sake of fairness, Dixons Carphone has seen operating expenses, as a % of sales fall from 22% to 18%. Also, gross profit margins are no higher than 22 to 25%.
Meanwhile, AO World started with a low operating expense, as % of sales of 11% in 2008, however, this increased to 20%. Their gross margin has been in decline in recent years and stands around 17%.
Right now, Dixons has the better gross margin and an improving operating expense account giving it an edge over external and internal efficiencies.
Reason 8: Declining Net Cash, and why this is important
For the record, Dixon’s net debt is £271m but makes enough net cash flow (£364m) to pay back in one fell sweep, if the company decides to halt capex and dividends for one year.
Then you have a company that needs a “safety first” backup plan to stay as a going concern. AO World has net funds of £12m (which will increase by £40m after share proceeds) and makes zero profits. So, you get some sort of a reducing cash balance each year.
Reason 9: Problematic European Operations
AO World’s European operations only started in 2014. The strange thing it bears the brunt of their future operating losses.
For example, in 2014, AO World’s UK operation report a loss of £7.5m. In 2015, it made a profit of £8.7m, and as their European operation reported their first full year it made a loss of £11.5m, which push group losses to £3m.
In 2016 and 2017, AO World’s UK division saw profit before tax grew from £13.6m to £17.2m respectively. While their European division has seen their losses widen from £20m to £24m.
If I was AO World, I would begin to ditch their European arm because it can’t even make a gross profit let alone operating profit! Also, the weak GBP means their “Euro losses” is compounded when reported back into British Pounds.
Reason 10: The curious case of AO World capex spending
Since 2011, the company spent £31m on capex and acquisitions. It incurs depreciation and amortisation of £21m, giving it growth capex of £10m for the next six years! Meanwhile, sales have apparently increased by £565m.
That is £1 in growth capex = £56.5 in new sales.
The comparison with Dixons Carphone is unreasonable due to its merger and consolidation reasons. But let’s do it for the sake of illustration,
Dixons Carphone’s growth capex is £117m, and sales increased by £2,330m.
That is an equivalent of £1 = £19.91 in new sales.
Tip: A company that requires little capital to grow sales exponentially, should see increasing operating profits.
Reason 11: Shareholders haven’t seen a penny in return
The one thing that stands out the most is shareholders in AO World have piled over £110m in gross proceeds with no return and nursing capital losses.
Meanwhile, Dixons Carphone returned £260m of dividends in three years.
Here is the summary of why Dixons Carphone is better than AO World:
Reason 1: – Dixons has superior profitability, whereas AO World hasn’t (consistently) made a profit.
Reason 2: – AO World pays high bankers’ fees in their IPO.
Reason 3: – AO World is the place for employees to work for, but remains unfriendly to the “minority” shareholders.
Reason 4: – The odd profit reported by AO World happens during their IPO to bolster the share price amidst a high valuation attached.
Reason 5: – AO World will experience the increasing operating lease, which reduces their profitability.
Reason 6: – Despite Dixons being 10 times bigger than AO World, their market capitalisation is three times greater. Add in the consistency of cash profits and dividends, then there’s no reason why AO World is highly-valued.
Reason 7: – Despite AO World fast revenue growth, their operating expenses grew faster as it accounts for 20% of sales. Meanwhile, their gross margin has been declining and stand at 17%.
Reason 8: – When it comes to net borrowings/funds, Dixons has net borrowings which can be met from net cash flow, whereas AO World requires “cash balance” to stay as a going concern.
Reason 9: – AO World’s European division is becoming more problematic.
Reason 10: – AO World’s growth capex is £1 = £60 new sales, whereas Dixons growth capex is £1 = £20 in new sales.
Reason 11: – Shareholders in AO World has plough £110m into the company, while Dixons has returned £260m back to shareholders.
BONUS REASON: – DIXONS CARPHONE GOODWILL
For the sake of being unbiased, Dixons Carphone could write down their bludgeoning goodwill, when it downgraded their profit forecast.
And my analysis shows the goodwill created from the Dixons and Carphone Warehouse merger is huge. Here is my full explanation below:
Did Dixons Carphone use the Merger to boost their Shareholders’ Equity?
The standout asset item is the value of goodwill it totals over £3bn on its books. Also, it has £523m of intangible assets.
Untangling Goodwill and Intangibles
Tip: – Find the level of goodwill and the level of intangible before this merger and tally it together.
Goodwill: – £607.4m;
Intangible Assets: – £50.9m.
Goodwill: – £481m;
Intangible Assets: – £136m.
Together, it totals: –
Pre-merger goodwill: – £1,088.4m;
Pre-merger intangibles: – £186.9m.
(Remember the above numbers, as they will be used to calculate the fair value of goodwill and intangibles below.)
When this merger, the management of both these entities think they have created a big money tree by slapping on “EXTRA” values on their balance sheet.
Post-merger goodwill: – £2,989m;
Post-merger intangibles: – £525m.
The difference in this extra value mostly derived from: –
Goodwill: – £1.9bn;
Intangibles: – £337m.
Meaning out of £2.8bn in shareholders’ equity, £2.24bn is valued newly created by goodwill and intangibles resulting from this merger.
Unless we see the combined entity tripling their profits in an instant, this grossly overvalue the company’s assets.
Fair Value of Goodwill and Intangibles
Before we slander the company for overvaluing their assets. Let’s make several assumptions, and calculations.
Before the merger, Dixons Headline earnings comes to £115m and Carphone at £102m, giving us a total of £217m.
After the merger, their 2015’s headline earnings = £285m, but since it covers 13 months, here’s the 12-month result at £263m.
A £46m increase gives profits growth of 22%.
Taking account of this immediate synergy effect, I would upgrade Dixons Carphone goodwill and intangibles by 22% resulting in £1.3bn and £228m, respectively. It still implies a £1.8bn difference.
But, wait there’s more….
What about the synergy effect after two and half years as a combined entity? How much have profits grown?
Answer: In 2017, headline earnings grew to £389m.
Also, both goodwill and intangible grew to £3.1bn and £553m.
This growth in headline earnings implies a 48% increase. Apply that to goodwill and intangible gives it £1.61bn and £275m.
Still, it overwhelmingly overstates goodwill and intangibles by £1.768bn.
Shockingly, this could mean that Dixons Carphone shareholders’ equity should be in the region of £1.3bn to £1.4bn.
If we use (debt + pension deficits) to equity ratio, it will increase by 0.7 from 0.25.
Shockingly, I get the sense that the reason why the shares fell is the strong probability of a goodwill and intangible write down.
A 25% decline in revised profits could see management writing off 25% of £1.768bn, or £425m.
Or, 25% of £3.6bn from the balance sheet. That could mean a write-down of £900m!
The good news is any write-down will be NON-CASH IMPAIRED!
However, Dixons Carphone next annual report won’t be out for another 10 months (from the time I post this article).
P.S. You can write the full post HERE.
Forecasting Valuation on both these companies
I made my opinions clear about Dixons Carphone’s share price. The forecast I gave is between £1.20 and £1.45 per share in the next six to eight months because management came out with lower profits guidance. And when you know that over £1.5bn of asset value got created literally “OVERNIGHT” from this merger, then expect a write-down in Goodwill!
On AO World, the shares should be closer to 50 pence, rather than a £1.20 per share. This stock was once valued at £4.
If you like the 11 reasons for Dixons Carphone over AO World, then share this post and subscribe to the blog. If there are other reasons that I miss or you happen to favour AO World, then why leave your comments below.
The opinions expressed by the writer is for entertainment and research purposes. It does not constitute professional investment advice. Data is correct on available information at the time.
Finally, the writer does not own the company’s stock, unless stated otherwise.