The Reject Shop: Result 2014

Want to know how buy recommendation The Reject Shop is fairing? Then throw out the headline numbers in the latest result, sullied by a string of one-off expenses, and dig a little deeper. When you do that the answer becomes clearer: the original investment case is on track (see Bargain hunting at The Reject Shop from 1 Apr 14 (Buy – $9.89)).

A poor general retail environment, tight margins, large store opening costs and flat same-store sales growth sums up The Reject Shop’s 2014. But we’d already built those factors into our valuation. Should they improve, we’ll get a free kicker. There is one clear possibility, however, that could derail this recommendation – a management stuff up.

Previous chief executive Chris Bryce mysteriously quit in March. He’d done everything right but as chairman Bill Stevens said in The Australian, ‘He was in charge of a massive store rollout and a capital raising — it all takes its toll.’ That no doubt is true but one wonders whether there’s anything else to the story.

Ross Sudano joins the company in September as the new chief executive (see The Reject Shop names new chief from 8 Jul 14 (Buy – $9.50)). Previously CEO of craft beer and hospitality company Little World Beverages, Sudano has also worked for Anaconda Adventure Stores, Foodland Associated, Coles and BP.

That’s not a bad background but there’s something odd about it. Why would the board hand over control of Australia’s largest discount variety retailer to a man with no experience in discount variety retailing?

The answer, we suspect, is that Sudano knows how to build a brand. The Reject Shop already has the scale, infrastructure and executive team to keep things ticking along. What Sudano brings is marketing skill.

During his three years at Little World, revenue increased 70% and profits jumped more than 160% due to clever marketing that took the Little Creatures brand of craft beer from a tiny niche to a mainstream product selling 10m litres a year.

Sudano neglected the traditional mass advertising route, focusing instead on engaging customers through community events, building the brand from the ground up. This may blend well with The Reject Shop’s shift away from major shopping centres to smaller regional or high street malls (more on that later). Sudano could be a good fit.

To top it off, he oversaw the buyout of Little World by Lion Nathan at a price of 40 times earnings. Given its clean balance sheet and potential for margin improvement and cost reduction, The Reject Shop would make a prime target for a private equity takeover. If Sudano can extract anything like the price he achieved at Little World, members following this recommendation will do great.

Same-store sales

His real challenge, however, is reviving same-store sales. Although revenue increased 15% this year, that was down to an increase in store count. Same-store sales fell 0.5% due to a weak Christmas and Easter period and an unusually warm May-June.

These same factors hurt The Reject Shop’s competitors, which led to heavy discounting and a decline in gross margin from 45% to 44.3%. Given The Reject Shop’s wafer thin profit margin that shaved about 15% off the bottom line.

Sudano may get some help at cost cutting from lower rental expense. The company has been opening a greater proportion of new stores outside shopping centres – sensible given the power wielded by Westfield during rent negotiations. Sales from stores outside major centres now account for more than 80% of the total and with nearly a fifth of the company’s stores up for rent renewals in 2015, management expects them to be renewed on better terms. That should improve operating margins.

Roll-out to continue

The company opened 46 new stores in 2014, bringing the total to 321. The Reject Shop has now more than tripled in size over the past 10 years, and more than tripled profits in the process.

The company spent $4.8m opening and fitting out new stores in 2014 – the main reason statutory net profit fell 25%. But this is a short term effect due to an accelerated store roll-out to fill the gap left in the market when creditors pulled the plug on The Reject Shop’s major competitor, Retail Adventures (see Bargain hunting at The Reject Shop from 1 Apr 14 (Buy – $9.89)).

It was satisfying to hear the company flag a return to its normal roll-out rate of 20 stores per year, putting it on track to reach the longstanding goal of 400 stores in 2018. Even if same-store-sales growth remains flat, at least $850m in revenue would be within reach at that time.

As store openings slow, so too will capital expenditure and if the company can eke out a 1% margin improvement a net profit of around $34m is within reach. That would mean, on a conservative price-earnings multiple of 15, The Reject Shop would be worth around $500m, or $17 per share.

Comparing The Reject Shop to its American counterparts, as we have in Table 2, also suggests that The Reject Shop remains cheap. Still, discretionary retail is a tough game and a lot can go wrong. But the board has positioned the company well and a lot could go right, too.

This recommendation has a wide range of potential outcomes which is why we have a strict portfolio limit of 4%. But with the stock flat since 8 Jul 14 (Buy – $9.50), we’re sticking with BUY.

Note: The model Growth Portfolio owns shares in The Reject Shop.