The Reject Shop: Result 2015

Finally, some good news from The Reject Shop. And not just the odd positive number, either. As new chief executive Ross Sudano said: 'Across our whole business, momentum changed in the second half.'

After an appalling start to the 2015 financial year – marked by a plunge in the Aussie dollar, aggressive competition, heavy discounting and ultimately a 5.4% fall in same-store sales – The Reject Shop posted an impressive 4.7% increase in same-store sales for the 3 months to June and 2.3% increase for the second half. The sales result was attributed to reduced discounting and increasing the number of customer transactions per store.

When it comes to discount variety retailers, there's an important distinction between increasing same-store sales by increasing prices and the volume of transactions. Higher prices might increase sales in the short term but would undermine the company's long-term profitability as customers realised there were better bargains to be had elsewhere. That Sudano grew same-store sales by increasing the number of customers suggests that The Reject Shop's new marketing strategy is working.

The company has invested heavily in TV and online advertising. Sudano said the company's shift away from junk mail towards digital marketing is having a significant effect and that there will be 'increasing use and development' of The Reject Shop's database of 200,000 customers. The goal is to use the database of customers to track their purchases in order to tailor special offers to their individual preferences.  

Roll-out

Revenue for the year to 30 June increased 6.4% to $757m, mainly on account of the ongoing roll-out of new stores. The company opened 21 new stores in 2015 and closed nine poorly performing ones, bringing the total to 333. The Reject Shop has more than tripled the size of its network over the past 10 years.

Sudano said he would continue with a roll-out rate of 10-15 stores per year – down from a historical average of 20, and well below the 45 opened in 2014. The company is on track to reach its long-standing goal of 400 stores in 2020.

The company is trialling a new store format in Sydney's Kellyville, which is more spacious, has prominently labelled departments and an overall 'Bunnings' feel about it. Management said the new format was cheaper to fit out and that initial customer feedback has been 'overwhelmingly positive'.

The cheaper format is part of a larger plan to reduce the company's cost of doing business and simplify a complex supply chain. Management has been reducing inventory and increasing turnover, and is building a system that it intends to better balance stock between stores. Early results appear to be positive with a slight reduction in inventory, despite a larger network compared to the prior year.

Free cash flow

Fewer store openings compared to the prior year also improved the company's free cash flow, which increased to $30m from negative $7.4m a year earlier.

The turnaround in free cash flow was also helped by 'improved control over stockflow and purchase order management', which resulted in less working capital being tied up in the business. Management also expects rents to fall over the next two years as the company shifts away from large shopping centres to main streets.

The company's gross margin was ever so slightly higher at 44.5%. All things considered, that's actually pretty remarkable: the first quarter of the year saw such heavy discounting to clear the winter product range that many items were sold at a loss and a fall in the Aussie dollar meant that the company needed to purchase overseas stock at higher prices. Management said a strong Christmas period and reduced fuel prices on freight were the main offsetting factors.

It's been a bumpy ride for The Reject Shop and the stock is still down 27% since we upgraded it in Bargain hunting at The Reject Shop on 1 Apr 14 (Buy – $9.89), despite rising 9% since The Reject Shop downgraded to Hold from 19 Feb 15 (Hold – $6.61). The investment case for this stock hasn't worked out as we'd hoped. However, Sudano's first nine months at the helm have shown three quarters of consistent improvement and the turnaround is gaining momentum. The point at which we'd sell depends heavily on how the improvement develops, but at the moment we'd be looking to downgrade to Sell at about $8.50 and we're reintroducing our price guide accordingly. HOLD.