Dead man walking

Will Specialty Fashion (ASX: SFH) follow Oroton (ASX: ORL) into administration?

Specialty Fashion (ASX:SFH), Australia's ‘largest specialty retailer of women's fashion', has intrigued value investors for years.

With over $800m in revenue from Millers, Katies, Crossroads, Autograph, City Chic and Rivers stores, Specialty Fashion offers tremendous scale. Its online business is also market leading, providing more than 10% of the company's sales.

And with a market capitalisation of just $20m, any margin improvement would create immense value for shareholders.

But the problem is that Specialty Fashion has struggled with intense competition, rising costs and integration issues for years, and October's trading update shows things are only getting worse.

Is Specialty Fashion next?

After Oroton (ASX: ORL) entered administration last month, many investors are worrying over which retail business is next. To me, the risk of Specialty Fashion going under is uncomfortably high and the success - or lack thereof - that it has over the Christmas trading period could well determine its survival.

Underlying operating earnings (before depreciation and amortisation) are expected to fall as much as 54% in the first half of 2018. And history shows Specialty Fashion rarely makes money in the second half. So after deducting depreciation, amortisation, interest, tax and one-off costs, another hefty loss is on the way.

Other industry news suggests operating conditions aren't improving either. Oroton recently entered administration and Myer (ASX: MYR) downgraded its second-quarter sales again. The latter is particularly noteworthy given the December quarter is a crucial period for a retailer.

Restructuring

To restore profitability, Specialty Fashion plans to close 30% of its stores over the next few years. Trouble is, cutting costs can be an expensive business.

Exiting leases prematurely triggers early termination fees, so Specialty Fashion plans to avoid these fees by closing its stores that have already rolled off contract. But with removalist and refurbishment costs plus margin erosion from 'store closing' sales, shutting 300 stores won't come cheaply. 

In fact, it's difficult to know how much it will cost (and the company hasn't let investors know). Specialty Fashion incurred one-off costs of $7.4m when it exited 17 City Chic stores, while Oroton expected to incur $11.3m in closing 6 GAP stores. Either way, it's likely to be 'a lot' and it comes at a time when Specialty Fashion is already strapped for cash.

On the plus side, though, fewer stores brings savings on inventory, providing a much-needed offset.

But Specialty Fashion's bank is getting worried and that only makes life more difficult. The company extended the maturity on its debt facilities to February 2019, but it must reduce the drawn amount by $20m by June 2018. This is a big drain on liquidity at the same time as its operations are bleeding red and it's embarking on an expensive downsizing program.

You might think Specialty Fashion would attract takeover attention at current prices. Al Alfia Holdings tried earlier this year and market speculation is that 20% shareholder Cotton On could be interested. But with Specialty Fashion in such a tight spot, what incentive does a buyer have to pay an on-market premium, when they could get a chance to buy the business for a song out of administration instead? That's how the Oroton administration is likely to play out.

With such a large revenue base, it's likely that shareholders will eventually make money out of Specialty Fashion. But I doubt it's going to be current shareholders.

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