Reject Shop in bargain bin?

Based on its latest results, The Reject Shop could be worth putting in the shopping trolley.

PORTFOLIO POINT: Good retail sales and profit expectations put The Reject Shop on a solid growth path.

Earnings expectations are factored into the price of every stock, so it is useful to consider which stocks have overly pessimistic expectations, relative to the probable future, and to buy when undue pessimism is already priced in. Conversely, selling stocks with overly optimistic expectations and high prices relative to value is a sound risk mitigation strategy and very useful in driving returns and avoiding unpleasant surprises.

Recently The Reject Shop reported its profit in the year to June 30 increased 35.6% to $21.9 million. Pleasingly, this was well supported by cash flow and enabled a significant reduction in debt levels, which are key items for investors to monitor. This was broadly in line with my expectations and the business retains its place in my growth portfolio.

Same-store sales were up 0.5% over the year. In the first half they were (-1.6%), which increased to 3.2% in the second half and 3.8% in the fourth quarter. Conducting channel checks, I believe the sound comparable store sales growth of the fourth quarter has strengthened into the new financial year. This is, interestingly, contrary to this week’s July retail sales number, which was heavily influenced by terrible department store sales. The recent government assistance payments had a temporary effect on consumer spending and retail sales, that appear to be subsiding. Consumer confidence remains subdued and clearly this has a meaningful impact on broad retail sales, however there is always a need for the everyday items The Reject Shop offers.

I look for 4%-5% comparable sales growth and marginally higher profit growth in 2013, followed by stronger results in the years following. Along with 20 new stores planned for 2013, the business should achieve double-digit gross sales growth.

Key operating metrics of The Reject Shop:

Return on Equity:

Up from 39.7% to 51.6%

Positive

Gross margins:

Up from 38.9% to 44.1%

Positive

Cost of Doing Business:

Up from 37.4% to 39.3%

Negative. Due to increased marketing and temporary distribution centre spend.

Earnings Before Interest and Tax Margin:

Up from 1.58% to 4.79%

Positive

Net Profit After Tax Margin:

Up from 3.2% to 3.95%

Positive

Stock Turns:

Flat at 8.9x.

Neutral. With Queensland distribution centre online from October, I expect this to improve in 2013.

Net Debt to Equity:

Down from 74% to 32.6%.

Positive

These metrics, while broadly positive, still have some flood-related distortions.

Discount retail is a tough business where competitive advantages stem from keeping costs low along with turnover, product quality and service high. Efficiency is paramount to success as retailing margins are razor thin. Barriers to entry are low and profitability high, which encourages competition.

The Reject Shop’s offer focuses on everyday needs, low price points and convenient shopping locations. It would take time for competitors to replicate brand awareness, the store network and distribution capabilities. The business thrives on the foot traffic that passes through its stores, which are ideally located near a supermarket. Fortunately the business model is not overly susceptible to internet substitution. After all, it is not really economic to buy toothpaste and toilet paper online. Should foot traffic fall as a result of online transactions taking people away from other retailers, this may cause potential customers to decline.  

The Reject Shop is one of the few retail concepts with strong store roll-out potential in today’s market, which is a key attraction. Management note a target of more than 400 stores, against the current store network of 236.

It appears the business has five-seven years of strong store growth ahead. Importantly, this growth is likely to be funded from internal cash flows rather than debt or dilutive equity raisings. The business has sunken costs into two distribution centres and a comprehensive IT infrastructure, which will enable store growth without equivalent infrastructure investment. The network effects that this enables bodes well for margins and profitability should management be able seize the opportunity. 

Management has now put the Queensland flood disruptions behind them and are focused on driving sales and store growth. The disruption was large, redirecting most of management’s time away from growing the business.

Many in the market underestimated the strength of management and extrapolated the short-term nature of the Queensland flood effects. The former allowed the business to cope with the latter and position the business for growth in the years ahead. It appears the market has given management a pat on the back for staying the course through a challenging period. 

Figure 1. Five-year financials: The Reject Shop Limited

Source: MyClime

What could affect the outlook?

Ongoing price deflation and cautious consumers continue to be headwinds. While it is futile to speculate on currency movements, I do observe the marked fall in commodity prices recently and the historic relationship with the AUD with interest. A falling currency would likely reduce the deflation impact and bring a little inflation into the retail space, which is a positive for sales and, should margins be held, the bottom line.

In summary, I see value in The Reject Shop’s shares at $13 today offering around a 10% discount. This value is likely to grow at around 10% p.a. for the next few years and will be augmented by franked dividends of around 5%.

The sound balance sheet, strong management and growth opportunities lead to my conviction this business will produce sound returns and justify its position in my growth portfolio.  

Building in expectations

Meanwhile, as the curtains closed on another reporting season, it again highlights the expectations of many market participants and their impact on share prices, which are always forward looking. The earnings outlooks for Harvey Norman and Boart Longyear provided stellar examples.

In early August Harvey Norman guided the market for 40% lower earnings, driven by falling sales and price deflation. Recently Boart Longyear reported its first-half earnings, which had increased 32% over the previous year, however it expressed caution in their outlook. At the close of trading, the Harvey Norman share price was flat and Boart Longyear was down by over 38%, and it continues to be under pressure.

An outsider must observe this activity with disbelief. How can a company displaying earnings growth experience such a sell-off, while another maintains its price after a lousy result?

The answer is purely the expectations built into the price. The market was well aware of the operating difficulties Harvey Norman is experiencing and the expectations of large profit declines were already incorporated into the price. Conversely, the market had incorporated the continuation of strong profit growth into Boart Longyear’s price and was subsequently disappointed with management’s dampening outlook.

Clime Growth Portfolio

Return since June 30, 2012: 5.81%

Returns since Inception (April 19, 2012): (-1.62%)

Average Yield: 7.49%

CompanyCodePurchase
Price 
Market PriceFY13 (f)
GU Yield
FY13
Value
Safety
Margin
Total
Return
BHP BillitonBHP$31.45$31.345.42%$47.8452.65%1.89%
Commonwealth BankCBA$53.10$54.729.09%$61.4412.28%8.73%
WestpacWBC$21.13$23.9010.28%$27.3014.23%12.58%
BlackmoresBKL$26.25$29.586.52%$29.810.78%12.09%
WoolworthsWOW$26.80$30.566.26%$33.078.21%14.55%
IressIRE$6.55$7.995.70%$7.65-4.26%21.33%
The Reject ShopTRS$9.15$12.034.99%$15.3827.85%23.92%
BrickworksBKW$10.10$10.026.27%$12.6626.35%-0.77%
McMillan ShakespeareMMS$11.82$12.276.05%$13.7912.39%7.33%
Mineral ResourcesMIN$8.95$6.8012.82%$12.6586.03%-18.27%
Rio TintoRIO$56.50$50.165.01%$82.2764.02%-8.05%
Oroton GroupORL$7.30$6.3911.40%$5.57-12.83%-10.53%

* Market prices as at close September 6, 2012.  ^ Purchase price as of close June 29, 2012


John Abernethy is the chief investment officer at Clime Investment Management. Register for a free trial to MyClime, or attend a Clime investment seminar.