Specialty Fashion yet to deliver the goods

A lot of work remains to turnaround the underperforming Rivers business.

You can expect another big lift in revenue this year from Specialty Fashion Group (SFH) but the apparel retailer will need to show improving margins if it wants to win a market re-rating from investors.

While sales and earnings before interest, tax, depreciation and amortisation (EBITDA) were 0.5% over and 2.3% under my estimates, respectively, the market had expected quite a different result.

Management posted a 20% uplift in operating revenue of $683.2 million but a 4.8% drop in EBITDA to $39.2 million for the year ended June 30, 2014. In contrast, consensus was tipping revenue to come at $632 million and EBITDA of around $40 million.

The big beat in the top line should have triggered a rally in the share price, but the news had the opposite effect with Specialty Fashion suffering its worst one-day fall of nearly 8% last Tuesday when its results were released.

Never mind that the stock had inexplicably jumped from 93 cents to $1.01 the week before, investors were taking the “glass half-empty” attitude towards the group with many fretting over the pretty significant margin compression.

Ironically, gross margins for 2013-14 hit a record high of 63.1% but the integration of underperforming Rivers chain, which the group acquired for a song in November last year, is one of the key contributors to the margin squeeze.

This in itself hadn’t surprised me and I had factored the digestion issue into my forecasts, as you can see in the table above, but the larger than expected drop in cash flow and management’s warning that margins are likely to stay under pressure in the first half of this financial year are big negatives.

I knew cash flows would come under some pressure, but the net cash outflow of $21.5 million is twice what I had expected. The big drawdown is largely due to an increase in working capital required for Rivers, and the issue doesn’t end there.

Management explained that margin will be negatively impacted as it sells off the remaining stock that was bought by the previous managers of Rivers at a heavy discount.

Given the high operating leverage in the business, a small change in margin assumptions will have an exponential impact on group’s profit. For instance, a 0.5% increase in the operating EBITDA margin will change EBITDA by around 10%.

It also didn’t help that Specialty Fashion’s online sales were under my estimates. I was predicting that online sales would account for 5% of profit (or $32.4 million) but sales made through the internet only accounted for 4.6% of revenue in 2013-14. This is a bigger deal than it seems because this division has the largest operating leverage.

Full year FY14 earnings results vs. Eureka Report's expectations

ActualExpectedChange in FY15 forecastNew FY15 forecast
Op revenue ($m)683.2679.5-4.3%788.9
Adj EBITDA ($m)33.935.0-32.8%38.4
Adj earnings per share (cents)4.75.05-56.0%5.07
Source: Eureka Report, Company accounts

This has prompted me to cut forecasts over the next few years. I have lowered my sales forecast by about 4% both 2014-15 and 2015-16 and decided to be more conservative on the margin forecast for the current year. Operating EBITDA margin is now expected to fall 0.1% instead of rising 1.8%.

The result is a sharp 56% decline in my forecast adjusted earnings per share (EPS) number to 5.1 cents and a downgrade in the discounted cash flow (DCF) based price target to $1.15 (using a 12% discount rate) from $1.35 a share.

The question is whether we should give management the benefit of the doubt. I think there is enough upside to reiterate my “buy” call on the stock, particularly given that the group is still capable of delivering an increase in dividend this financial year. I am expecting a fully franked 4.5 cents a share payout, which would give Specialty Fashion a grossed-up yield of around 7%. You’re essentially getting paid to wait, as long as you believe management will deliver the goods.

There are also other positives from the result that investors shouldn’t gloss over. The stock had been under pressure earlier this year as the mild start to winter prompted a number of retailers such as Kathmandu Holdings and The Reject Shop to issue profit warnings. There was speculation that Specialty Fashion would fall victim to this trend, but its second-half performance has been very encouraging.

Comparable store sales grew 5% in the six months to June despite the challenging retail environment, and management said that the momentum is carrying through into the new financial year. The group’s attempt to rejuvenate its tired Millers brand is finally paying off.

Further, the Rivers acquisition holds great promise for the group. As I wrote on May 28, Specialty Fashion has probably picked up the best bargain in the sector by paying just $5.3 million for a business that is expected to add $180 million in annualised sales.

No doubt there is a lot of work to do to turn around the underperforming Rivers business, but the deal could help Specialty Fashion become an $800 million revenue retailer in two years. This would make it the 12th largest retailer by revenue out of its 39 listed peers on the ASX, according to data from Bloomberg.

That is not too bad a feat for a group with a market cap of around $180 million.

To see Specialty Fashion’s financial summary and forecasts, click here.

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