The Reject Shop: Bright future or burn-out?
Despite the media talking up a very positive sales period over Christmas for our retailers, a mixed bag of trading results reported by the likes of JB Hi-Fi Limited (JBH), Super Retail Group Limited (SUL) and The Reject Shop Limited (TRS), have left many investors scratching their heads.
With downgrades currently outweighing upgrades, there’s little wonder why many are confused.
Focusing on those who have downgraded, it seems that not all retailers can be tarred with the same brush. Looking beyond the headlines, what we find is that the reasons for the downgrades thus far vary from business to business, and they can’t be attributed to soft sales alone.
Looking specifically at The Reject Shop – who effectively downgraded their forward earnings expectations by 30 per cent compared to consensus in their Half Year 2014 Trading Update – the business’ focus on rapid expansion appears to have resulted in a slight quantification issue.
Higher margin product lines such as recreation, home decor, gifts, furniture, photography and gardening, appear to have sold poorly; requiring heavy discounting to move stock. This stands in contrast to the sales of confectionery and everyday items – much lower margin product lines – that sold well above budget. Put simply, it appears that focusing on their aggressive store roll-out – with frequent yet inconsistent opening rates (at almost one new store per week) – seems to have created issues elsewhere.
As we see it, these issues predominantly surround inventory management. Rather, getting it wrong during such an important period of sales. The quarter ending December 31 is a key period for a group that relies on generating a large proportion of their annual sales, and the last quarter has impacted profitability – resulting in a significantly lower share price.
Net to net, margins over the past 6 months have reduced by approximately 150 basis points, and given how operationally-leveraged the business is (with a high inflexible cost base), the impact on the company’s bottom line has been material.
To put the downgrade of expectations into context, the market previously valued TRS at approximately $17-$20 per share, on the basis that they would earn $25 million in the 2014 financial year, and $34 million in 2015.
As those numbers stand today, we can now conservatively estimate that, on a normalised basis, NPAT will rebase to $21.5 million in 2014, and up into the “mid-twenties” – or $26 million – in 2015.
Indeed, modeling these expectations results in a valuation of approximately $11.60. If the shares overshoot by a wide margin, such behavior can, and often will, lead to an opportunity to acquire a business with a well-established household name and a store roll-out program that is growing, while the legal proceedings from the creditors of Retail Adventures’ – a competitor of TRS – continue.
Focusing on the business in a few years’ time and not the current share price reaction – and TRS will have cemented themselves as a market leader, with significantly larger buying power, and efficiencies of scale flowing from its investment in both IT and distribution systems. And, as it has shown in prior years, it will adjust and better manage its growth and inventory levels.
All of this should ultimately lead to improved business performance in the future. And determining whether an investment case in TRS at lower share prices makes sense, is precisely what we are doing at Montgomery Investment Management.
The Montgomery [Private] Fund owns shares in The Reject Shop Limited (TRS).
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
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Tom Hunt
:
Roger and Team.
Over reading the chairmans report from 2009 to current he places a large emphasis on store expansion, foregoing short term returns, borrowing when required (Ipswich floods) and capital raising.
They keep talking about this “400 stores” number.
This is where my mind starts asking questions.
When they hit this number, then what happens?
1. Are they going to increase the dividends to keep shareholders happy? “and our ongoing moderated dividend payout ratio” (Chairmans address 2013)
2. Do they look to expand into overseas markets with their business model? A growth strategy to keep or gain shareholders interested in those aspects of a company/stock.
Can a business survive the market if it just continues to have a great return on equity with no or little plans on growth? (If they hit the magic number of 400 and stop that is?)
Or is it always going to be a story of chasing growth? Currently its here in AUS, then will it be the UK, US or even Asia?
I guess I ask this is because they seem to be focussed on growing at any means possible, and when does this stop.
This blog teaches us about owning top quality companies with little to no debt, but they did have quite a bit of debt (during the Ipswich floods mainly) and were comfortable borrowing more and seeking capital of its shareholders (Apr 2013).
This to me seems like a company that goes against that model we are looking for, even though they are a well run company.
These questions just leave me scratching my head to wonder if they are indeed a long term (10 year) investment.
Roger Montgomery
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Business is dynamic and often cannot escape the influence of the business cycle. If a company takes on debt to do something impactful (e.g. taking market share when the competitors are on the deck) and it has the cash flow and returns on its investment to quickly repay that debt, there should be little concern about that method of financing affecting the definition of quality. It is important to be consistent but not necessarily prescriptive.
Chris B
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Hi Roger,
Thanks. Wow. I was having a look at it again before you mentioned the margins and there is a noticeable deterioration in the margins.
I actually haven’t looked at the financial statements for about 3 years, I had a good look at it 4 years ago and was impressed. This is a big lesson for me. I bought without looking at the new figures. I still think it is a great business but it has deteriorated since 2010. My valuation of the company has dropped a little.
The deterioration was evident in the last annual report released September last year.
I thought they were getting more efficient as their supply chain was getting better and their SAP system would lead to better inventory management but this is not the case at all.
The industry is more competitive than I thought.
Sales/Assets has been deteriorating over the last 5 years
Profit per store is falling.
Despite a poor performance before Christmas, they have not fixed the problem in the busiest part of the year. And this happened a few years ago too.
Profit per store has dropped over the last 3 years.
One year they were affected by the flooding in their Ipswich warehouse.
Inventory has built up a lot in the last year. There is also the concern of later stores they open not being in prime positions and not doing so well. Perhaps the stores they are opening now are not as profitable. They said they have 4 stores they want to close.
I think they can turn it around.
They are in no risk of losing money, they are still in a strong position.
Chris B
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Hi Nick, that was good information.
TRS have some high fixed costs eg rents and wages so if they don’t sell as much, it really hits them. And they had the store rollouts which cost a lot.
They’ve had inventory management issues before, nothing too serious and it is easily fixable.
I agree that it is inventory issues and I also think it is easily fixed. So I bought at $10.50.
Last financial year they went from $9 to $18 and so did JBH. Yes that’s right, a 100% return in one financial year. Check that fact yourselves.
I value TRS at about $18. I believe they can have about 400 stores max and that is one way I evaluated them. They are actually a very simple business to evaluate. You just need some common sense and a spreadsheet and work out some calculations such as how much money they make per store.
You need to consider how long it will take for them to open the 400 stores ie achieve that maximum value.
Also, you need to consider the risk. I’ve evaluated this. Their competitors are Kmart, Big W, Target, Bins and independents. If you look in all the stores, the product mixes are different. Bins sells stuff TRS doesn’t. Kmart have a good range of stationary, they also sell cleaning products and the other categories but they don’t sell a mop and bucket for $5 like TRS. Target and Big W sell some good stuff but it is different to Bins and TRS. You can buy a remote control from TRS which is not sold in Kmart, Target and Big W. Go into the stores and look at the product mix. Sure there is some overlap but people will go to 2 stores to find what they really want.
As Roger said, Kmart may be hurting TRS in shopping centres but TRS are selective about where they open. I’ve seen TRS do very well in a shopping centre that has Big W.
If you want to find something that sells in a department store, you will go to maybe Kmart and somewhere else. But you won’t go to Kmart, Big W and Target, not all 3 because Kmart keeps away from Big W, the stores are not together. And in a fast paced society, people won’t go to all 3 because it is a long drive. They will go to Target and TRS and compare.
The independents don’t have the pricing power so they are already running at a disadvantage. They carry lots of stock so some of the stock sits in the store for a year, so the shop owner doesn’t get a return on that stock for a year (a bad way to use your money). The store formats are usually cluttered and badly organised. And the independents have been disappearing.
Aldi have Wednesday and Saturday specials on merchandise. People love it. You see them early Wednesday morning trying to be the first ones into Aldi. I see queues in TRS on a normal day. I like TRS, a lot of people do.
The aggressive store expansion just widens the moat because with more stores TRS then have more pricing power (ie buying in bigger quantities and getting the products cheaper and can sell cheaper) to drain competitors out of money if they try to compete. Top Dollar and Bins are some competitors that are trying to compete and they are pretty good. TRS does have risks, anyone with a lot of money can break TRS down but it may cost them a lot of money to take them on and they may fail. Bad management can be a risk to the business. And retail companies must stay fresh and reinvigorate at least every decade to stay fresh.
Roger Montgomery
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Hi Chris,
We know the people and like them at TRS. The big issue for us has been the margin. The company is still delivering and selling the stock that was responsible for the margin compression so we aren’t sure there’s a rush to jump back in. Of course that’s just our view and yours may prove to align better with the subsequent share price performance…Seek and take personal professional advice.
rob barnett
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Roger,
Can you please help me understand your analysis of TRS. This company appears to generate very little Free Cash. There appears to be insufficient Free Cash from Operations to fund their expansion hence the need to raise capital (either debt or equity).
Will the expansion improve this situation or does the lack of Free Cash not matter?
Best regards, Rob
Roger Montgomery
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You’re spot on Rob. The cash will improve when the massive store roll out stops but by then there may be other factors such as maturity to which the price may be influenced.
Nick Buckley
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Recent research from Roy Morgan indicates that about 36% of Australians have shopped at TRS in the last 12 months and that purchases have grown from 30mln to 39mln per 12 months over the previous 4 years. In contrast, BigW, Sam’s Warehouse and Harris Scarfe all had declines in purchases per year. It seems TRS younger families and seniors largely drove this growth and that it wasn’t limited to the “penny pinchers” (which is important considering recent arguments about no one but the later shopping at TRS during “better” economic times). Reduced performance in shopping malls could be a short term effect (product mix, margins, people not wanting to add “one more” store to their Christmas shop) or a reflection of a stronger K-mart/Big-W. I’m inclined to think it’s a mix of both. A lot can be learned from visiting stores and even in K-mart laden high traffic malls in Perth, TRS appeared to have a lot of in store visits and long-ish queues over Christmas. If management can right the ship, I reckon there is still scope for sustained profits and growth.
Roger Montgomery
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Thanks for sharing. Comments like that make this blog a value.able place for investors to visit! Pun intended of course.
Charlie Dalziell
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What is your view on the falling $A and the effect it will have on TRS’ gross margin? I know they hedge, but eventually they will wear the impact of a lower $A on purchased inventory, and I wonder if they can pass that higher cost on? Has the high $A given the business a free kick in the past that will be ultimately unsustainable?
Roger Montgomery
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Hi Charlie,
Thanks for your comment. The company does hedge their currency position which gives them a certain relief period to do the only things an importer can do when faced with a declining currency and higher inventory costs.
They can put pressure on their suppliers to lower their costs, cease stocking those items which they cannot pass on a price rise, pass on the price rise completely to their customers, or absorb the cost increases and take a hit to their gross margin. More likely is that they will do a number of these things in an attempt to avoid price inflation.
TRS is in a slightly favourable position given small average basket sizes – many products are less than $5/$10, hence a price rise is unlikely to detract from volumes.
Russell
Michael Leslie
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Andrew, I note your comment about taking your wife for a walk through a shopping centre. A week ago I did just that with my own wife in Singapore. The shop that was of great interest was a Harvey Norman store in the business district. It was small and crowded and the shop assistant followed us around closely. We were the only potential customers in the shop. Nothing else moved.
Adam Novek
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Be greedy when others are fearful and be fearful when others are greedy Russel.
Ian Hammond
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I remember wrong product mix and poor sales of higher margin products given as a reason for poor performance of TRS only a few years ago. Have they made the same mistake again of having the wrong product mix?
Roger Montgomery
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Hi Ian,
Thanks for your comment. That’s exactly what happened, and reading between the lines, a “quantification” issue just means a “product mix” issue – ie. not having the right stock in the rights stores at the right time at the right price to keep customers happy and buying. They did learn from their previous error, and I’m sure that the learning process will again be applied this time round.
Russell
grant.rogers.94
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Kmart with its new strategy is killing TRS. Surely its worth a mention in the above?
Roger Montgomery
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Hi Grant,
Thanks for your comment. From everything we have researched, the K-Mart effect is largely quarantined to major shopping centres. Neighbourhood and shopping strip comparable store growth numbers are in the mid-high single digits (impressive), which is where the bulk of TRS revenue and earnings are derived.
Russell
Andrew Legget
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Hi Russell,
You couldn’t be more correct in your comment about retailers cannot be tarred with the same brush. I am happy for the most part that many do as it can create great opportunities.
I have said it many times, the good thing about retail businesses is that you can get a pretty decent view of their potential by simply taking a walk with your wife through a shopping centre. Over the past “difficult” couple of years it has been clear that some sections would do well and some not so.
TRS is always interesting but never quite was able to convince myself on them. They appear, to myself at least, to get a bit lost in their products they offer sometimes. This is particularly in the way of their high margin devices so i am not surprised that this was flagged as an issue especially with brands like Kmart especially and BigW to an extent looking at these same areas all without the word “reject” in their shop title.
“Reject” and high margin just doesn’t make sense to me at least.
I think there is a great business there, and if they can better manage their inventory and make better decisions on item to stock then they should see the potential come through.
Going to a more big picture level.
I think Retail will be an interesting story during reporting season. Many a looking for a sign that the segment is recovering but i expect it to be a very mixed bag. The introduction of ABS reporting the extent of online sales is also an interesting side story, my only wish is that they broke it down further into how much is being spent online in specific sub-segments of the retail industry.
I think JBH as i have mentioned previously will have a good result. In a HY where there have been big new releases in phones, games, consoles, tablets etc took place i think that was a given and the World Cup in Rio (i am not convinced winter olympics will have much of an impact in Aus) coming up in the second half then this should help move a few TV’s as well.
I have always seen Myer as an average or lower company, it think David Jones, whilst slightly better, have joined them. I also turned off Oroton as a company a while ago due to increased competition and perhaps a shift in the demographic buying oroton items from what i hear.