Bargain hunting at The Reject Shop

With an unblemished growth history and a well respected chief executive, just two months ago The Reject Shop looked like the perfect retailing investment, especially to those that bought in at the $2 listing price in 2004.

The latest interim result put paid to that reputation. Same-store-sales growth stalled, competition intensified, a falling Aussie dollar hit margins and an accelerated store roll-out program caused net profit to fall by 15%.

Somewhat mysteriously, chief executive Chris Bryce then quit. In the space of two months, the stock price has fallen 40% and the air remains thick with uncertainty. For value investors, that spells potential opportunity.

The Reject Shop is a discount variety retailer that sells everything from homewares and snack food to seasonal decorations and wrapping paper. Customers demand variety, convenience and, above all else, a very lean price, which is why The Reject Shop imports almost everything it sells from countries with low manufacturing costs.

Whilst an appreciating dollar improves margins, the recent decline has reduced them, something the latest result made all too clear. But The Reject Shop's competitors have to deal with those same movements, too. In the grand scheme of things, the currency issue is a sideshow. Over the long term, margins will be influenced more by the competitive landscape than the exchange rate.

And there is intensifying competition, although not from the Internet. The Reject Shop’s average customer spends just $10 per visit. So why shop online and pay postage and packaging fees, which may be more than the cost of purchase, when you can take home a few plates and a salad spinner right now?

Target, Kmart and Costco pose a bigger threat, with the recent Christmas sales period a source of concern. With overall discretionary spending weak, these retailers discounted heavily, forcing The Reject Shop to follow suit. That lowered the company’s gross margin and same-store-sales growth.

Many investors see this as a permanent, structural shift in the sector but that’s unlikely; this is the first time such aggressive competition has broken out and it’s likely to be the exception rather than the rule. If so, the recent share price fall would look especially overdone.

Rapid Expansion

The third major issue worrying investors is the apparent abrupt end to growth. With a long-standing plan to reach 400 stores nationwide (opening about 20 per year), The Reject Shop now has some 300 stores, has tripled in size in the last decade and more than tripled profits in the process.

This expansion received a huge boost in late 2012 when creditors pulled the plug on The Reject Shop’s major competitor. Debt-laden Retail Adventures was owned by Jan Cameron (founder of Kathmandu) and operated the Go-Lo, Crazy Clark’s and Chickenfeed brands.

The Reject Shop’s management quickly spotted the 'unique opportunity to accelerate our long-term store expansion’. The company raised $44m at $16.20 per share and swooped on the gap left in the market. As a result, the number of store openings in 2013-14 was twice the usual rate. And here, dear reader, we find the explanation for the 15% decline in profit.

Understated Earnings

There’s a strong case that this is only a temporary, and indeed predictable and desirable, setback.

The Reject Shop expenses store opening costs immediately, which means new stores are usually loss making in their first year. Indeed, the company spent $3.5m opening and fitting out 41 new stores in 2013 (this financial year a similar amount is likely to be spent). These are one-off expenses that quickly contribute to earnings in the second year and beyond.

Many investors seem not to appreciate the fact that these store openings aren’t the source of the company’s problems but the reasons for its success. New store openings increase future earnings power because of these one-off costs. Statutory near-term profits may have fallen due to this investment but underlying long-term profits look as promising as ever.

If the viability of opening a new store were measured solely by the profit it generated in the first year, every Westfield shopping centre would be stillborn. By expanding the store network and incurring some short term costs, management is acting exactly as it should.  

Low valuation   

Two things can happen from here. If the store roll-out continues as we expect, The Reject Shop should reach its goal of 400 stores in four or five years. Even if same-store-sales growth remains flat, at least $850m in revenue would be within reach. With a slight margin improvement the company should be able to achieve a net profit of around $34m.

That would mean, on a conservative price-earnings multiple of 15, The Reject Shop would be worth around $500m, or $17 per share, in 2019, making today’s price of $10 or so a steal. With a current fully franked dividend yield of 3.5%, it looks even better.

The alternative is for the company to abandon its growth strategy and concentrate on same-store sales growth. That would reduce opening costs and immediately boost profits in 2015. With underlying earnings of around $21m in 2014, and a price-earnings ratio of 14, it’s still attractive.

So this is the pitch: if The Reject Shop curtails its store openings, it’s cheap. If it doesn’t, it’s even cheaper.

What might go wrong? Margins could contract as competition intensifies or the Aussie dollar declines. Maybe the company’s supply chain will again be disrupted, as was the case when a warehouse was damaged in the Queensland floods. And although the company has no corporate debt, its sizeable lease obligations make closing ailing stores expensive.

The company’s share price goes a very long way to offsetting these risks. Its price-to-sales ratio, arguably a more stable measure than PER, is 0.42 – the lowest in nine years. The company’s enterprise value is 10 times its three-year average earnings before interest and tax (EBIT), which is around 30% less than comparable US companies. And The Reject Shop’s historic return on incremental capital has exceeded 20%.

Opportunity

That alluring picture is only sullied by the rather odd departure of the CEO. But whether the replacement sticks to the old strategy or slows down the pace of expansions, The Reject Shop has already taken the opportunity to take market share from a failed competitor. It was inevitable that this would lead to lower profits in the short term. What is surprising is the savage market reaction to this predictable event.

We’re more than happy to take advantage of that surprise. With the stock down 35% since Which retailers will survive? Part II on 15 Jan 13 (Avoid – $15.11) The Reject Shop is priced at bargain basement levels. BUY for up to 4% of your portfolio.

Note: We're taking a position in The Reject Shop of about 3% in our model Growth portfolio, by buying 1,000 shares at $9.89, for a total consideration of $9,890.