An Investor’s Look At An Important Formula For Hour Glass Ltd

The return on equity (ROE) metric is important in investing as it measures a company’s ability to generate a profit with the shareholders’ capital it has. Generally speaking, a high ROE is preferred over a low one, all things being equal.

As you can observe in the following chart, Hour Glass Ltd (SGX: AGS) has seen its ROE fall gradually over its last five fiscal years, from 18.5% in FY2012 (fiscal year ended 31 March 2012) to just 11.8% in FY2016.

Hour Glass ROE chart - Wilson
Source: Hour Glass’ annual reports

What has happened here? Let’s breakdown Hour Glass’ ROE to have a better idea on why the metric has declined over the years. The ROE can be separated into its individual components via the formula below:

ROE = Profit Margin x Asset Turnover x Equity Multiplier

Some of you may recognise the formula as the DuPont formula, created in the 1920s by the DuPont Corporation to measure its own internal efficiency.

Before we perform a DuPont analysis on Hour Glass, it’s important to have a few words about its business for some context. The company is a luxury watch retailer. It has a network of over 40 boutiques in Australia and many countries in Asia, such as Singapore, Thailand, Hong Kong, and more.

Hour Glass profit margin chart - Wilson
Source: Hour Glass’ annual reports

The first component of the DuPont analysis is the profit margin. In the chart above, you can see that Hour Glass’s profit margin has declined over its past five fiscal years.

Revenue may have grown by S$100 million from S$607.0 million to S$707.5 million over that period, but the company has not been able to fully offset rising costs for its bricks-and-mortar retail operations. Net income actually declined from S$56.1 million in FY2012 to S$53.5 million in FY2016.

The next two components of the DuPont analysis are the asset turnover and equity multiplier and they are shown in the next chart below:

Hour Glass asset turnover and equity multiplier chart - Wilson
Source: Hour Glass’ annual reports

The asset turnover is a measure of how good Hour Glass is at utilizing its assets to generate revenue. It is calculated by dividing the company’s revenue with its assets. Generally, a higher asset turnover translates to a better performance.

In the case of our luxury watch retailer, the metric has been deteriorating despite the higher revenue. The company’s disproportionately larger asset growth indicates that it has grown less efficient at utilizing its assets.

A further glimpse into the numbers reveal that Hour Glass has been taking longer to clear its inventory over the years. Inventory turnover days (a proxy for how long the company’s inventory of luxury watches sits on its shelves before being sold) has risen from 167 days in FY2012 to 208 days in FY2016.

We’re left with the equity multiplier and it is found by dividing a company’s assets with its equity. It is a gauge for how much leverage – and thus financial risk – Hour Glass is taking on.

Hour Glass’s equity multiplier has been pretty consistently maintained at around a level of 1.2, even though total liabilities have swelled from S$55 million in FY2012 to S$114 million in FY2016. Retained earnings had helped to offset the increase in borrowings, allowing the company to maintain its equity multiplier.

A Fool’s take

To sum up what the DuPont formula has showed us, Hour Glass’s falling ROE is largely the result of its lower profit margin and asset turnover. The company has suffered from rising costs.  Its management however, has displayed prudence when it comes to taking on debt given the steady equity multiplier.

It should be noted that more work needs to be done beyond the DuPont analysis before any firm investing conclusion can be made on Hour Glass. This look at the company’s ROE should only be seen as a useful starting point for further research.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Wilson Ong doesn’t own shares in any companies mentioned.