Specialty Fashion’s Rivers of gold

For SFH, it’s not really about belt tightening … it’s about the Rivers purchase.

Specialty Fashion Group (SFH) looks like a bargain, but recent reports that Australian households’ newfound fiscal conservatism would give the women’s apparel retailer a nice sales boost this year are probably off the mark.

Don’t get me wrong. The stock is a good “buy” at current levels, but it’s the Rivers acquisition last year that is the name of the game for Specialty Fashion – not the rebound in consumer spending.

Indeed, I am not expecting much of a pick-up in spending from the group’s primary target demographics, which is middle-lower to low-income consumers, despite speculation that the latest federal budget will drive more people to tighten up the family budget by trading down.

The “trading-down” theory is sound for some product categories, but I doubt it applies to fashion, especially not women’s fashion. If you are used to shopping at Country Road (CTY), I suspect you wouldn’t be caught dead looking through the racks at a cheaper fashion outlet. Such consumers are instead more likely to shop less at the more prestigious fashion houses.

The unseasonably warm weather is also posing a risk to sales as it may prompt consumers to defer purchasing warmer clothing. I won’t be surprised to see the stock come under some pressure from the “mild May” phenomenon.  

The good news is that there’s a better reason to be excited about Specialty Fashion, and this has to do with the Rivers brand it bought at the end of the last calendar year. The market acknowledges that the group has picked up the asset for a song, but has yet to fully appreciate how transformative the acquisition could potentially be for earnings.

Specialty Fashion paid $5 million for Rivers, which is expected to generate annual sales of around $180 million and earnings before interest, tax, depreciation and amortisation (EBITDA) of $9 million. I can’t think of a cheaper acquisition made by a listed Australian company in the sector.

There is plenty of room to grow the brand too, as Specialty Fashion believes the number of Rivers outlets can expand by 37.5% to 220 stores and estimates that it can squeeze $10 million in cost savings (before reinvestments) due to economies of scale.

But cost is not the only synergies Specialty Fashion can potentially extract. Management claims that many of Millers’ (Specialty Fashion’s largest chain in its brand portfolio) customers buy their footwear at Rivers, which also sell clothes and accessories to men and kids.

What’s more, given that female shoppers often buy clothing for their kids and partners, having Rivers under the group umbrella should give Specialty Fashion some exciting cross-selling opportunities that the Millers franchise was unable to reach before.

The interesting thing is that analysts have ascribed very little, if any, of these synergies in their forecasts. Consensus estimates on Bloomberg show sales rising by $92 million to $659.3 million for 2013-14, which is largely due to the half-year contribution from Rivers.

Revenue is then expected to grow to $784 million by 2015-16, which appears to indicate a material deterioration in the underlying business. While I am only anticipating modest organic growth across the group’s portfolio of brands (which also includes Katies, Crossroads, Autograph and City Chic), a big backward slide is improbable in my opinion.

Besides the Rivers integration, the group’s top-line is likely to be bolstered by its ongoing store rollout program and the much-needed refurbishment of its tired-looking Millers chain.

However, I am expecting operating EBITDA and margin to drop in the current financial year due to the costs of bedding down the Rivers acquisition, although the stock should have plenty of appeal to both income and growth investors.

Specialty Fashion has enough firepower to maintain the 4 cent a share dividend it paid in 2012-13, and this puts its yield at a little over 6% once franking credits are included.

Earnings are expected to grow by double-digits over the next two to three years, even if consumers remain cautious, because of new store openings and an expansion in margins (thanks to better economies of scale with Rivers under its belt). This in turn should lead to increasing dividend payments, even as management spends around $75 million over three years to grow the business.

Steady growth in its dividend would prompt a re-rating of the stock, as the group has a poor history of paying dividends.

Specialty Fashion has twice stopped paying annual dividends in the past five years. But if everything goes according to plan, the stock could be yielding around 12% on a gross-up basis in 2015-16.

For these reasons, I am reiterating my “Buy” recommendation on the stock, with a 12-month price target of $1.35 a share.

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