What’s Next for the Reject Shop?
The Reject Shop (ASX: TRS) has previously presented as a compelling investment opportunity but the company has not been a holding of The Montgomery Fund for quite some time.
With the shares down nearly 60 per cent this financial year – an experience we are fortunate to have missed – some investors are asking whether it’s time to wade back in? It is important to keep in mind that a company’s shares are not cheap because the price has merely fallen. If the price falls but the intrinsic value falls even further, there may be no value to be found.
Back in February 2012 with the share price at $12.61, we wrote here:
“Way back in September 2009, [we] published [our] reasons for selling The Reject Shop:
“The Reject Shop still enjoys its high brand awareness but, as is typical in many store roll out stories, as the offer matures the later sites are less profitable than the early sites.
“This doesn’t fully explain the fact that during a period in the economy where one would expect a bargain offering to shine, it hasn’t. Eighty percent of Australians still know the brand but I believe consumer experience and mismanagement has done it some damage.
“According to one report, 20 per cent of the population believes the company offers rubbish – cheap Chinese junk that quickly breaks after use and fills our tips.”
So has anything changed since?
Recently, we met with Ross Sudano, the new CEO and Darren Briggs, CFO, and with the share price at $7.12, we learned of their plan to turn around the company.
In a nutshell, management understands that they operate in the value segment of the market and the best way to win here is to consistently beat the competition on prices with high quality, everyday products. Ross’s focus now lies here.
In addition, management will be developing back office capacity so that they can tailor the inventories of various stores automatically. This will enable catering to demand from different demographics and locations.
They’ll also be slowing their store rollout so that they can focus on staff training & hiring (turnover has been high and inexperienced individuals promoted to senior positions), supply chain efficiencies, marketing and other short term and medium term projects.
Management’s fresh eyes have discovered the company doesn’t really know who its customer is and they’re going to undertake studies to find out. Prices also still appear to be high, and the brand and offering somewhat confused. Meanwhile, despite the large investment in SAP, the company still cannot alter specific stores inventory to suit different demographics/geographies and the manual over-rides they do apply represents an inefficient and impermanent solution.
Every company has its issues and these can be surmounted but they do suggest a turn around may not be imminent.
With the share price down more than 60 per cent this financial year, it’s natural to wonder if this is a value opportunity or a value trap. Despite being impressed with both Ross and Darren and their plans sounding sensible, there is always risk inherent in turn around stories, especially those that take time to effect, allowing competitors to gain market share and share of mind.
We will leave it up to you and your adviser to decide what is right for you.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
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.
Rob James
:
Ever since I read this I was curious about the “on the ground” results of the new initiatives that management flagged at the AGM.
Foot traffic was high, with many people who were casually wandering past walking in, showing that the products on promotion may well be drawing in customers.
The more interesting thing was the queue at the registers: 4 people serving with between 10-15 people waiting. Most were clutching wrapping paper, cards, gift boxes and pet supplies. In my opinion this shows that management may be coming to the right conclusions with their ranging choices, which was a big reason for their like for like sales declines.
The other interesting observation was that this was a value store going very well in a middle / upper middle class setting (the new multi million dollar refurbishment of Westfield Garden City for those playing along at home) which shows that the value proposition may well be appealing to a very wide potential audience.
The other thing I found really interesting in my research was the fruits of the change in marketing from catalogues which were clearly not cutting through to the social media spend. The Facebook page has 138,000 likes and has been adding over 1000 per week for the last three weeks. The “engagement” of posts on the page (likes, comments, shares) is equal to or higher than what is arguably their nearest competitor these days, Kmart. Interestingly, Kmart has twice as many likes to begin with, which means that TRS posts are connecting better with the target audience.
Obviously all very anecdotal but thought it was interesting nonetheless, interested in other comments.
Roger Montgomery
:
Interesting indeed…stats are just formalised and aggregated anecdotes
Andrew Kong
:
Does the falling A$ also significantly negatively impact profits due to higher import costs?
Roger Montgomery
:
And that is another challenge…
Guy Davis
:
HI Roger, for what my two cents is worth I am hopping you are wrong on this one:-) I bought TRS last week at $7.50, again yesterday at $6.35 and will continue as long as it falls without new evidence that changes my mind.
I believe all the points you have made are reasons why the share price is in the doldrums for now, but provide a base for a strong turnaround. This is a company that despite the being caught out by the warm winter and smashed by the closing down sales at Retail Adventures still achieved a ROE of 18% for FY14 with almost no leverage. To me, this indicates a competitive advantage exists (one of scale largely). I also think that the aggressive roll-out of the last few years will start to pay dividends in the next year as these new stores find their feet.
For mine, Ross Sudano is the most important piece of the puzzle. Given his success at Little Creatures, I think he is a great addition and clearly very confident. When I talked to the manager at my nearest store, he was very positive about Sudano and a reinvigoration of the brand. He didn’t even seem too perturbed when he confessed he’d had to take a pay cut under the new regime, which really piqued my interest.
Imagine what the company is capable of when it actually frames a cohesive marketing and networking plan. When they achieve their stated goal of 400 stores in 5-7 years I hope we will be looking back at the last week and any further weakness as a buying opportunity, with today’s lower earnings, profit margins and confusion an obvious temporary blip.
I also just wanted to say thanks for the blog too. It is a privilege to have such a generous insight into your processes!
Roger Montgomery
:
A great deal of money can be made getting turn arounds right…getting it right is the challenge especially when operating in an environment where stronger competitors are free to respond to your attempts.
Guy Davis
:
Hi Roger, as an addition to this post I was interested to read TRS’s half year update for profit in the range of $12.7-13 mill was greeted as negative by the market.
Obviously I am holding the stock so was keen to try and find a silver lining. The headline story was that half year profit had fallen from $16 mill 1st half FY14 however when I went back to that result I saw that the EBITDA and NPAT reported were both before new store costs, whereas the most recent guidance had already taken new store costs into account.
Given that NPAT FY14 was smashed down to $14.5 mill after new store costs, onerous leases and writedowns, if the 1/2 year number already accounts for a large proportion of these negatives, would it not be reasonable to think that FY15 NPAT could look something like double the 1st half FY15 update?
Assuming I am onto something, 12.7×2=25.4 minus 5 million for a safety margin and $20 mill looks a lot better than $14.5 mill last year.
I have tried several times to call the company and ask them about it but no replies as of yet.
I would love to hear your thoughts.
Regards,
Guy
Roger Montgomery
:
I’ve sent your thoughts to our TRS analyst Russ. We’ll get back to you here shortly.
Guy Davis
:
Thanks very much, I know you are very busy.
Roger Montgomery
:
Thanks Guy for your question, it’s a good one.
When annualizing The Reject Shop’s results you need to factor in that they make most of their money in the first half of the financial year (i.e. Christmas), in fact over the last few years – all of it.
As such, doubling the first half result can present a higher forecast than may be realistic.
Below shows their historical results for the first half and full year financial periods over the last few years.
1H13/$20.1m, 1H14/$16.9m, 1H15/$12.7-$13m
FY13/$19.3 FY14/$14.5 FY15/?
TRS are currently in the execution phase of a turnaround strategy. It may be successful however there is clearly a risk that it won’t be and this is what the market is responding to.
Hope this helps
Guy Davis
:
Hi Roger, thanks for your reply.
Yes you’re right, it seems I still have a lot to learn as an equity analyst. I was too impatient to pull the trigger in a market where there is not a lot of value available. In the future I will be waiting for a noticeable turnaround in prospects.
From a broader outlook, I have really enjoyed your market analysis of late. It seems that Christopher Joye and yourself are the only two not marching to the beat of the RBA at the moment. I think the broader market doesn’t realise the current level of overvaluation in the market because the ASX 200 is still a long way off it’s pre GFC highs. However, when you consider that BHP, RIO, QBE, MQG and LEI are now all worth considerably less than then and together made up a significant chunk of the 2007 market, the current level is perhaps more alarming than first glance.
Another reason for overvaluation flying under the radar is that our index has become so bank heavy and banks tend to hold much lower PEs than growth and industrial stocks, therefore anchoring the PE of the overall market. Unfortunately, we also know that Australia’s banks are by far the most expensive in the world at present, so this resultingly reasonable seeming ASX 200 PE shouldn’t provide much comfort.
This can be coupled by the US market where record high profit margins are making PEs taken off trailing or one-year forecast numbers extremely misleading, given that we should all be aiming to hold our stocks for long periods. The Wells Capital article that Russell Muldoon posted around a month ago also pointed out that the average S&P 500 stock is more expensive than it has ever been (this is scarily without combining the record profit margins), although this seems to have been glossed over by the headline index number once again being somewhat lower.
Obviously we can never expect to correctly forecast the future. However, as Howard Marks teaches in The Most Important Thing, you can take the market’s temperature and make an approximation of where things stand on a valuation basis at any given time and make an informed decision on whether it is a time for risk-on or risk-off decisions.
I was one of the rookies leveraging up in 2006-7 and I have promised myself I will not be a fool in a rising market again or give back the capital I have built up since 2009-10. In my opinion this leaves only one conclusion. A generous cash holding is required at present, in the full knowledge that markets may move substantially higher before it all ends in tears, but knowing that preservation of capital is too important to be fully invested at current levels.
Thanks again,
Guy
Roger Montgomery
:
Thanks for that considered contribution Guy. It’s also worth looking at some of the PE ratios in Aus then and now. prior to the GFC in 2007 Dominos Pizza’s Historical PE was circa 40 times. AT the depths of the GFC the PE ratio halved. Now it’s at 68. Successful long term investing means buying when everyone is fearful. Historical PE’s of 68 for Dominos or 41 for Boral and 38 for Bega Cheese don’t sound like fearful PE’s to me.
Patrick Poke
:
An interesting insight, to use your words. I’ve had my eye on TRS for some time but always held off for essentially the same reasons you outlined (and because it hasn’t passed my valuation tests). However I’ve found recently myself wandering into their stores again and getting excited by some of the things I find (I’m a bargain shopper in businesses as well as products I guess!), which has not happened for some time. My partner has been shopping there more regularly again too, she loves shopping for craft supplies there, and we both love their American foods.
If management can pull of what’s being suggested in their comments above while they’re still in value then I think I may be very tempted to get on board.
Andrew Legget
:
“Management’s fresh eyes have discovered the company doesn’t really know who its customer is and they’re going to undertake studies to find out.”
That line is very telling, at least the new people are aware it is a problem but it is an indictment on the previous people in charge. You can be as fancy as you want with marketing, supply chain, capital strcuture etc but if you don’t know who your customers are then you are just painting a bullseye around wherever the dart may land.
I think their search to understand their customer would need to be answered before the green light of value might start showing again.