Wednesday, 23 April 2014

The Reject Shop

I've been taking a look at The Reject Shop (ASX:TRS) after its recent sell off. The discount retailer has been on a rapid store roll-out expansion and owing to the high revenue growth forecasts being factored in, the market was valuing TRS at around $460m based on a share price of $16, equating to a PER of 23x on underlying earnings of $20m for FY 2013.

The share price has fallen by around 40% to $10 per share since releasing a 1H 2014 trading update and the CEO also announced his resignation. Revenues increased as expected, however comp sales were flat and gross margins were impacted by poor performance on higher margin products. As a result NPAT fell to approximately $16.9m compared to $20.1m for 1H 2013. Underlying NPAT for 1H 2014, adjusted for insurance proceeds and new store opening costs, was marginally higher at $19.4m compared to $19.1m for the pcp. While this looks okay on an underlying basis, the result is fairly poor when considering that 40 new stores were opened in FY 2013 (1H 2013 would not have received a significant benefit from these stores) and 33 stores were opened in 1H 2014. Hence, there was no incremental benefit from the equity raised to fund the store expansion.

While the result was poor, I think the sell off was overdone and TRS now appears to be undervalued. While comp sales are flat and revenue growth is nearly entirely associated with new stores, earnings and free cash flow are being understated by new store expenses and higher capital expenditure. As store roll-outs decrease, earnings will benefit from reduced opening expenses, capex will reduce and working capital investments will moderate. There also appears to be room for margin expansion if the product mix improves and as the business matures.


Revenues have increased steadily which is not unexpected given the extent of the increased store count. Post GFC however comparable store sales have been relatively flat and therefore projected revenues will be predominately driven by new stores.

TRS is conservatively financed with virtually no debt ($481k) and has a dividend yield of 3.5%. In FY 2013 the company chose to raise $40m to fund the accelerated store expansion rather than use debt. The company should have sufficient funds to finance future stores.

Gross Margins

TRS has a high inflexible cost base and changes in margins can have a material impact on earnings as per the 1H 2014 results. Gross Margins decreased by around 1.3 percentage points as a result of issues with store product mix. TRS sells a number of low margin products such as confectionery and toiletries to get consumers in the door and relies on those consumers to then purchase higher margin products such as furniture, home wares and garden accessories. It is the product mix in these higher margin categories which performed poorly over 1H 2014 and resulted in margin pressure. Management are aware of the inventory management issues and have successfully dealt with similar issues in the past.

 Free Cash Flow

 Free Cash Flows have been affected by increased capital spend and working capital investments. Net cash from operating activities has been lumpy as you can see below. FY 2013 was depressed due to inventory stocking for new stores, although the 37% increase seems high when considering the new stores in relation to total current stores. 1H 2014 is higher than normal following a 44% increase in A/P. These tend to balance each other out. Net cash from operating activities should become less lumpy as the business matures and store expansion moderates. Free Cash flow will increase as capital expenditure for new stores slows.

Store Roll-out Assumptions
TRS accelerated the store roll-out in FY 2013 taking advantage of the collapse of competitor, Retail Adventures. 40 stores opened in FY 2013 and 33 opened in 1H 2014. A further 12 are planned for 2H 2014, taking the total number of stores at the end of FY 2014 to approximately 321. The company aims to open around 400 stores in Australia which is the stated capacity of the two distribution centres. The company has stated that it is likely new stores will moderate to around 20 stores per year from 2015 onwards, presumably until the 400 store number is reached.

Costs associated with new stores that are expensed affect earnings immediately. For example in 1H 2014 $3.6m in costs associated with new store openings were expensed. The statutory NPAT of $16.9m was therefore equivalent to $19.4m on an underlying basis (post tax).

Aside from the earnings implications, there are capex costs which are capitalised. Capital expenditures related to new stores make up a substantial proportion of total capex. Management have provided new store capex and we can therefore see what a maintenance capex might look like as the business matures (note these figures are in thousands). The new store capex also provides a basis for estimating what future growth capex should look like. It is also likely the Melbourne DC will need upgrading and I've increased maintenance capex slightly.


How capex may look as store expansion slows:

Revenue and Margin Assumptions

 Revenues will be guided by new store numbers and comparable store growth. Given the timing differences that will arise when new stores open (i.e. FY 2013 will likely be understated as most stores opened in 2H) I have estimated revenue per store as revenue divided by the average number of stores for the year and adjusted each projected year by a very modest comp sales growth (1%). Comp growth seems likely to remain soft in the near term with competitor pressures, lacklustre economic conditions and higher savings rates when compared to pre-GFC, however the valuation would benefit from an increase in spending activity.

TRS is a fairly low margin business and therefore FCF will be significantly influenced by any changes in margins. I believe the gross margins used to be reasonable (i.e a 44.5% gross margin has been used in FY 2019 compared to 44.6% in FY 2013). I have assumed no margin improvement for administration expenses and only a slight improvement in store expenses as a % of sales as the cost of new stores moderates. As TRS expands it should follow that purchasing power increases and economies of scale are realised.

Competition and other notable risks

  • The administration of Retail Adventures likely improved the competitive position of TRS, however Kmart and BigW sell similar discounted products. There are also a number of independent discount retailers.
  • TRS imports the majority of its products and therefore is exposed to fluctuations in the Australian dollar. They hedge this exposure, however in the longer term as these hedges are reset there may be some margin pressure if the dollar were to fall further.
  • Inventory management / product mix issues and the associated gross margin implications. If margins are not maintained the earnings impact would be material.
  • As the business matures and store roll-outs moderate the market will likely imply a lower multiple to TRS.
  • Appointment of successor to current CEO.

I'm betting TRS can work through their inventory management issues and slightly enhance current margins. Free cash flows should increase materially even with modest consumer spending activity. I estimate a fair value between $12-$13.

 Note: Terminal value is equivalent to a multiple of 11x.

Note: The information contained in this post is for my own purposes only.  The post should not be confused with an investment recommendation and details should not be relied upon.

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