Join our community of smart investors
OPINION

The wrong model

The wrong model
June 28, 2017
The wrong model

The latest episode is the weird story of the takeover that wasn't (or, technically, 'isn't' since it's still in progress). Hornby's controlling shareholders - a concert party revolving around an activist fund manager, Phoenix Asset Management - are obliged to make an offer for Hornby because their shareholding has passed the 30 per cent trigger level. In fact - following the acquisition of a 21 per cent stake in Hornby from another activist, New Pistoia Income - Phoenix now owns 55 per cent of Hornby's 85m shares. So the outcome of the offer isn't in doubt - it will go unconditional and close on 14 July.

UK takeover rules dictate that Phoenix must offer remaining shareholders the price that it paid New Pistoia - 32.4p. True, that amount is now available for sellers in the market, although Phoenix's offer comes commission-free. The point, however, is that the offer concentrates investors' minds. Do they want to follow the lead suggested by New Pistoia - and by a far better-known name in fund management, Ruffer - which seems to be giving up Hornby as a bad job, or do they stick with Hornby's existing management team?

It's fair - albeit coarse - to say that New Pistoia were pistoia-ed off with the failed attempts to put Hornby on track. When Phoenix's chairman, Roger Canham, became Hornby's chairman in February 2013, the models maker's share price was 81p, so it has fallen 60 per cent since then. In the same period, Hornby's bosses have raised £23m of new equity only to see the market value of the enlarged equity drop to £28m. So what was a market value of £32m when Mr Canham became chairman is now implicitly valued at £5m - value destruction almost on a heroic scale.

Small wonder New Pistoia was part of a putative coup to remove Mr Canham earlier this year. That coup was bought off by Phoenix's offer last week. Also last week, Hornby's bosses claimed that results for the year to end-March "provide solid evidence of our delivery in phase one of our turnaround plan". That sounded smug when contrition would have gone down better. All the figures really showed was that further re-structuring costs brought cumulative pre-tax losses for the past five years to £31m, while inventories were at their lowest level for six years and operating cash flow was only just negative, bringing the cumulative free cash outflow for the past five years to £15m - hardly a reason for self-congratulation.

Yet, of course, it may be that Hornby's recovery is in train. Looking on from the outside, one just does not know. Do we follow the course suggested by New Pistoia and Ruffer and exit, even with losses? Or do we take the view implied by management that one day Hornby must come right?

Fifteen months ago, I ran a metaphorical slide rule over Hornby and believed there could be theoretical value of 67p a share. That was based on the idea that Hornby was capable of generating £3.3m of net cash profit each year, capitalising it at an estimated cost of capital and deducting net debt. Use the same base figures today and per share value drops to 47p per share, chiefly because Hornby had another share issue in the past 12 months. Yet, even that amount is 45 per cent above Phoenix's offer, which must tempt some outside shareholders to stick around, especially as Phoenix has pledged to maintain Hornby's Alternative Investment Market (Aim) quotation.

However, those who do keep their Hornby shares must understand one thing. Hornby has well-known brands in niche markets, of that there is no doubt - Airfix, Scalextric, Humbrol and, chiefly, Hornby itself. So that makes Hornby a brand-name company. Yet, it's still a million miles from making it an intellectual property company, and the distinction is vital.

I suspect many shareholders nurture the thought that there is another HIT Entertainment - creator of Bob the Builder and Angelina Ballerina - lurking inside Hornby. Not so. HIT owns cartoon characters that can be used for lots of revenue-generating products, not least Thomas the Tank Engine and his friends, which are top-selling lines for Hornby. For HIT - now owned by US toys maker Mattel (US:MAT) - that offers the power of a franchise; the ability to dictate prices and generate additional revenues with little effort. It works beautifully so long as its characters are in demand.

Hornby isn't - and won't be - in that happy position, although it has much going for it. In particular, there is the loyalty of committed hobbyists who will pay well for bits and pieces they simply must have. Yet that does not translate into growth potential while it does bring all the logistical hassles of being a manufacturer. These factors have dogged Hornby for years and, I suspect, will continue to do so for years to come. Great for producing easy copy. Not so nice if you're a shareholder.