The Reject Shop’s (ASX: TRS) 3rd Quarter trading update in April, the one that crashed its share price, announced that the company expect a 4% decline in sales from FY2016’s $799.9M, or about $768M for the year, if “tough market conditions continue”.
Retail is a tough business, so currently tough(er) condition continuing or not, for a retailer with profit margin around the 2%, a $32M sales reduction should not really reduce its bottom line by $5M to $12.5M.
That is, industry changes could be afoot, everything but sales is (possibly) not being equal, and so it is perfectly understandable that the Market was alarmed. But is this another case of being more alarm and not being alert enough?
With some 29 million shares outstanding, TRS current price of $4 to $5 a share put its market capitalisation between $120M to $150M.
If we do a simple normalised sales and earnings estimate – or just simply take last year’s as the average of things to come – at $800M and $16M take home profit, Sales to Price ratio of 6.7 to 5.3; PE ratio between 7.5 to 9.4… TRS at $4 or $5 a share is a pretty interesting looking bargain.
If we are to be more conservative and put earning at 2% of the next two year’s expected declining sales to $750, that’s net profit of about $15M, putting the current price at about 10 times that expected earnings. With the retail sector’s average PE of 17 (Morningstar), TRS’s market share of the discount variety business at 30% (IbisWorld), this is quite interesting.
Interesting for a retailer that is. I mean, retailing is a low two to four percent margin kind of business that leave very little margin (ahem) for error. To do well, retailers must somehow be able to turn over their inventory quickly, lower that cash conversion cycle (down to preferably a couple of days) or else put the cost of inventory onto the suppliers – such as paying them later than the usual 30 days, or by having them holding onto their stocks etc.
As we all know, low margin dissuade competitors, and so low margin business where you are the major player with a lot of clout and no shame in pushing that weight onto any business’s limit of bankruptcy… then you might OK.
Is The Reject Shop that kind of business worth buying into at almost any reasonable price? Or is it one of those average operation whose current bargain basement prices are just too good to pass on for a short term punt.
I guess the answer depends on whether you have to “diversify” into a retailer; have found little opportunity elsewhere at the moment; or you know a whole lot more than the average armchair warrior when it comes to retailing and the variety discount stores TRS dominates.
I aim to answer the above questions through a general analysis of TRS, its business and operations. Then compare its performance metrics against other more successful retailers, and also Dick Smith, to get a sense of the industry’s general standards and expectation.
First will review the recent quarterly update and its aftermaths. Then moving back to 2010 to get a sense of TRS history and performance to see if the these kind of disappointment is just a normal part of its operations or the worst is yet to come.
April 7th – Q3 Update
The Reject Shop’s share price opened at $8 a share on Thursday 6th April 2017. Following a third quarter trading update on Friday the 7th, the share price opened at $5.50 and closed at $5.11. That’s a 36% drop in a single day.
Just in case we think this is an over-reaction to an estimated $5M loss in the second half if things goes as badly in the remaining fourth quarter as it did in the third – thus bringing the 2017 full year net profit after tax down to $12.5M instead of around the $23M ($17.5M NPAT in H1, assumed H2 to be historically around 20% to 30% of H1) – the weekend gave the market some time to think things over and on the following Monday, TRS shares opened slightly over a buck under ($4.09), reaching a low of $4.01 but managed to close at $4.45.
With about 30 million shares currently outstanding, a company with $800M in sales and $17.1M in NPAT last year (FY2016) now disappoint the market by 27% on last year’s results (maybe, if things goes badly enough in Q4); and some 45% on the current year’s expectation ($12.5 instead of around $23M), got its market value halved over two trading days to around $120M. I’m guessing the extra few percent on top of the disappointment was for a likely cut in dividends.
From that proportionate downgrade alone, it seem the that market thought its $8 (or $240M) market capitalisation of TRS is pretty spot on. Maybe any further disappointment in the remainder of the financial year will see it knocked down a whole lot further.
But that’s what I think the market thinks. Since I don’t really know who is this Mr. Market, and nobody beside myself really care for what I think anyway… so… let’s try to analyse and value TRS. See if we could put some serious rationale behind what a company like this is worth.
THE REJECT BUSINESS MODEL
TRS operates a “discount variety” business – basically a “highly seasonal” (Barry Saunders, MD, FY2004 Annual Report) business selling household items mainly during the first half (end of calendar year), with the second half generally not making much profit.
TRS’s 6,202 shares were split into 23,449,328 shares on 28th May 2004. On June 1st, it further issued 625,782 shares at $2.00 each, valuing the company at $48.15M ($2 x 24,075,110) as it list on the ASX.
The company paid $2.5M to cancel the options and a further $2M were promised in 2003 but paid once the sales operation is done (listed during FY2004) – you know private equity was involved. But compare those to the stuff that was pulled on Dick Smith and Asaleo in recent years, it’s not half as bad as it is. But with sales for the first ASX year growing 10.4% to $180.6M and net profit grew 20.9% to $5.6M on the 100 stores – or 3% net margin on $1.86M sales per store – and a first step into Queensland with more rollout expected, things could be promising.
Fast forward to 2016FY, with some $800M in sales from 324 stores (average $2.34M per store) and reported net profit of $17M. However, due to the one-off Melbourne Distribution exit and redundancy costs (some $9M), normalised profit would otherwise have been $26M, or about 3.3%. With about 60M transactions totalling $800M in sales (was 50M for $618M in 2013), TRS shoppers spent an average of $12 to $13 per trip… TRS might very well be a business that does generally well with store expansion.
In its FY2016 Director’s Report (p.26), TRS restate its estimate back in FY2013 that Australia’s demographics should only allow it 400 stores. With 324 stores operational in FY2016, another new 8 stores opened during H1FY2017, TRS would make its target of 350 stores by the end of FY2017.
Assumes the current difficult trading environment will mean stores opening would reduced from the current 16-20, and definitely won’t return to the 40 stores per year of 2013 and 2014 where additional $45M was raised – at a very nice price for existing shareholders of some $16 per share… say bringing the average net opening to 10 per year, going for another 5 year to that demographic limit of 400.
With average sales currently at $2.34M per store, another 50 stores would bring total sales to about $800 + (50×2.34) = $917M by 2022. Let’s pick assumptions out of thin air and say growth in revenue per store bring total sales at 400 stores to $1Billion… making our maths easier as we assume margin at 2 to 3 percent, or $20M to $30M net profit.
What would the earning multiple be for a company that grows with population growth, contracts drastically when property market, economic activities and simple taste change could seriously hit the bottom line.
We’ll first see what the market generally pay them at; then use a more sensible approach just to show that even if we’re at the mercy of the market, we’re a lot smarter.
PRICE & VALUE
WHAT THE MARKET HISTORICALLY PAID AT
From DangInvestor’s valuation dashboard below, we can see that the market has historically paid about 15 to 17 times TRS’ reported earnings [shown in ruby red]. Implying an annual growth expectation of about 3% to 5% over the next decade. Though there are years where the prices turned out to be a bit too much exuberance (2013, 2014) – shown quite awesomely, if I say so myself, in the chart where the year’s share price ranges imply growth expectation of some 7%p.a. to 10%p.a.
Perhaps the market had more hope in TRS before and much less in the coming years, but historically speaking, the market generally priced TRS at quite a reasonably high ratio. But let us take that previous multiples of some 15 to 17 times reported earnings down to 10 or 12 once TRS normalises its operations, batten down the kinks at its new distribution centre.
At $20M earnings, TRS could be valued at some $200M to $240M; at the more optimistic assumption of $30M normalised earning, the enterprise value could be $300M to $360M ($10 to $12 per share).
At the current price of $4.10 with 30M shares outstanding, or $120M market cap… a purchase now, holding over the medium term of three to five years could return the investor some 70% to 300%, excluding dividends.