Why excessive goodwill causes Dixons Carphone shares to fall and why a recovery could bet underway?

Shares in Dixon Carphone has collapsed from £5 to £1.60 in the space of two years. The shares debut at £3.20-£3.30 per share (my estimate, based on the first day of trading) back in 7TH of August 2014, and rose on the back of cost savings and synergy.  

What fascinating is before this merger, Carphone Warehouse has a market value of £1.8bn and Dixons has a market value of £1.89bn.

Today, the market is valuing the combined entity below £1.9bn!

 

Understanding why the share price collapse

Before explaining if this drop signals an entry point, you need to look back at the financial data before it became one entity.

Doing this is a little difficult because the Carphone Warehouse Group accounts have been discontinued from 2013, so I’m using Carphone Warehouse Limited accounts.

For the purpose of reference, the difference between Carphone Warehouse Limited and Carphone Warehouse Group PLC REVENUE is £1.78bn vs. £2.5bn for the group. 

 

Financial data in Carphone Warehouse and Dixon Retail PLC

Before the merger

(N.B.: Remember the above data represent Carphone Warehouse Limited, which is a subsidiary of the Carphone Warehouse Group PLC.)

 

From the numbers, Dixon is the bigger company, but Carphone is that “breadwinner.” Using 2014’s accounts, underlying earnings see Dixons Retail records net profit of £115.7m, while Carphone made £102m.

That quickly explains the Dixons Carphone’s share price reaction (down 30%), as changes to roaming charges in the EU affect the more profitable Carphone’s division.

Overall, the company revised profits of £360m-£400m, down from a forecast of £465m-£495m, a median difference of £100m, also affected sentiment.

Fun Fact

The market capitalisation wiped out on that day was £730m meaning the market is valuing a £100m loss in profit as 7.3 times earnings! (Weird observation, I know!)

 

Why holding your handsets longer is a good thing for shareholders?

One reason for the profits warning is due to Brexit, which saw the British Pound collapse in value against major currencies that force the company to raise prices. And forcing customers on hold on to their handsets for longer.

While 2017 will be a washout, it gives us, the investors an opportunity to buy into Dixons shares knowing that demand for handsets will pick up in 2018. And with Apple’s new iPhone coming out late this year, then 2018 is looking like a turnaround year.

 

Is Dixons and Carphone achieving Synergy?

Their target of achieving £80m in cost savings represent less than 1% of revenue, which is small. Given the low margin, this actually boosts net profit by over 35% from £285m to £389m. Also, the company’s inventory turnover, capital turnover and asset turnover saw steady improvements.

Dixons carphone asset and capital

The above chart shows this improvement and indicates strong synergies taking effect as both entities are working in harmony with one another.

For me, these are slight improvements.

 

Debt and Pension deficit is Okay

Both total borrowings and pension deficits have hovered around £950m to £1bn for the past three years. While equity has increased by £300m to total £3bn, giving a (debt + pension deficit) to equity ratio of 0.25.

That is pretty low.

Also, capex spending is small and the business was able to produce free cash flow of £150m per annum, which covers 15% of total borrowings and pension deficit and 3 times the level of interest costs.

On top of that, it has cash of £200m.

 

If the debt is low, then some would point to the use of operating lease. But that suggestion is dispelled when the net rental expense is stable at £350m per year, as total operating lease fell by £600m to £2bn.

So, given the positive factors along with minor setbacks, why did the shares fell sharply?

The answer lies 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 intangibles assets.

Untangling Goodwill and Intangibles

Tip: – Find the level of goodwill and the level of intangible before this merger and tally it together.

Dixons

Goodwill: – £607.4m;

Intangible Assets: – £50.9m.

 

Carphone

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).

 

 

 

DIXONS CARPHONE – MARKET EVALUATION

Given the downgrade in profits by £100m on average for 2017/18 period. I decided to mark down EBIT to £360m from £431m last year and post-tax normalised profits to £310m from £386m.

Also, I changed the enterprise value to £2.8bn from £3bn, while the remaining data is left unchanged.  

Using market’s metrics of EBIT Yield and EV/Sales, as well as Earnings Power Value, we get the following:  

Table 2: Market Valuation and forward forecast

Dixons Carphone market valuation

Even with the downgrade in profits and the excessive value placed in goodwill and intangibles, the market is pricing in disaster for Dixons Carphone.

Forward EBIT Yield of 13% and EV/EBIT of 8X multiples imply a ridiculous bargain. Even on a fundamental basis, the shares are 38% undervalued meaning to reach fair value it will need to rise to £2.61.

Like I said, I got a sneaky feeling that the write-down from assets will overshadow the company’s fundamental performance, which isn’t too bad and will likely pick up as new phones hit the market.

 

Timing Your Entry

With the weakness in retailing continuing, it gives you ample time to make your investment in Dixons Carphone.

Yes, I’m bullish on the company, if it wasn’t for the “excessive” goodwill.

Using the Stockchart.com website, the Dixons Carphone’s share price conforms to technical analysis really well. This could imply a lot of technical traders in Dixons Carphone.

N.B.: Below the chart covers from 2011 to present, even though the merger happened in 2014. The website “recalculate” Dixons Carphone by combining both as one entity going back to 2010.

Illustration 1: Dixons Weekly Chart

There are two periods, where technical analysis could have saved you money, these are: –

Between 2015 and 2016; – when the shares peaked at £5.10. The share price was making new highs with each peak, but both the momentum indicators (MACD and RSI) made lower highs with each peak. 

Between mid-2016 to present; – this is a role reversal when the share price was making lower highs from each peak and the momentum indicators signalling higher high for each peak.

On both these occasions, the share price fell.

TIP: – The momentum indicators making higher highs don’t always mean a rising share price when doing so on “NEGATIVE” Territory (see the drawn balloons above). 

 

Even on a long-term basis, the technical analysis of selling Dixons Carphone looks accurate.

 

Illustration 2: Dixons Weekly Chart 2

With the shares tumbling, is it the right time to buy?

For the convergence and divergence to happen the shares need to breaks below £1.20. A confirmation of a strong buy. 

Now, onto the monthly chart for further confirmation.

Illustration 3: Dixons Monthly chart

The monthly indicator strongly indicates that the momentum line has to start rising before the share price moves higher. And right now, the MACD hasn’t bottomed which could lead to further weakness in the share price. Another indication is the MACD volume (see red bar chart above) needs to revert back to equilibrium before the shares can reverse their downtrend.

 

Summary

Wow, this one colossal company is a story of two halves. One is the obvious undervaluation when investors see manageable debt levels, stable profits (despite, tough competition from AO World and Argos), and improvement in asset utilisation.

On the other hand, you discover that management has put a huge value from this merger which resulted in overstating their assets by £1.768bn (mainly goodwill and intangibles).

From a market viewpoint, the reduced profits of £100m still present a dirt cheap valuation, such as the EBIT yield at 13% and the Earnings Power Value showing a 37% discount to the current share price.

Using technical analysis, Dixons Carphone’s share price is near their lows. For some reasons, the share price correlates well with their technical indicators in MACD and RSI. Look at the monthly chart for timing your entry. 

 

My Final Thoughts

Despite management revising profits down to £360m-£400m from £465m-£495m. I still very much like this company and valuation looks too low.

However, something is dragging the share price and could go lower. That’s because most investors ignore the excessive goodwill and intangible assets (though mostly goodwill). With the profits downgrade, don’t be surprised if the write down in assets value range from to £400m to £900m. The good news is this won’t affect the company’s cash flow and cash balance.

It’s a revaluation problem, but it will shock investors.

This pains me to say that as much as I like Dixons Carphone, it doesn’t surprise me if the shares fell below £1.20. (see technical analysis) However, I have confidence (as much as 75%), the shares will recover.

My recommended entry price for Dixons Carphone is £1.40 per share within the next six to eight months.

 

Okay, this has been a long, but fruitful piece to write. I hope this gives you some interesting insight into where Dixons Carphone shares are heading.

Don’t forget to subscribe to the blog and share the post because it helps me to gain some new audience.

Disclosure

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.