Turnarounds Seldom Turn, The Reject Shop (ASX:TRS)

22/01/2019

Trav Mays

Follow @MaysTrav 

Today we will be continuing our search for companies at bargain prices within the retail sector, focusing on The Reject Shop.

Within my recent Shaver Shop article, I compared the large players within the Australian Retail market. The Reject Shop was hands down the winner when compared using traditional value metrics. This obviously made me eager to investigate The Reject Shop further, a company with such low value metrics is an obvious potential buy, how wrong I was.

Description

The Reject Shop (ASX:TRS) is a 30 year old variety discount retailer, predominately focusing on everyday items. Ron Hall and John Shuster founded The Rejected Shop in 1981, opening their first store in Melbourne as a factory seconds retailer. 4 years later they transitioned into the variety discount retailer they continue to be today. During the 90’s and 00’s, The Reject Shop had a number of successes, moving to the direct importation of their goods, they also expanded into NSW in 1990, SA in 1992 and reached their 100^th store by 2004. Along with opening their 100^th store, The Reject shop listed on the ASX in 2004, with an IPO price of $1.88. Post 2004, The Reject Shop’s expansion seems to have accelerated at an alarming rate. Taking 23 years to open their first 100 stores, it then took only 6 years to achieve the next 100 stores and only 3 years for the subsequent 100 stores. The expansion culture is clearly evident at The Reject Shop, with the boast “2009 - Opened 30 stores (23 opened in 22 weeks!)” proudly displayed on their website. Whilst they have always voiced their long term goal of a total of 400 stores, with such rapid expansion, it would be extremely difficult to control culture, customer experience and expenses.

Graphing the trailing 10 year Earnings Per Share (EPS) of The Reject Shop, displays a worrying sign, that The Reject Shop is clearly deteriorating. Please note that I have included a 2019 EPS of $0.36, assuming a 2019FY earnings of $10.5m and no change in the number of outstanding shares.

Diving a little deeper into the numbers shows that whilst revenue has levelled off in recent years, it did almost double over the 8 year period between 2009 and 2016. However, when we look at it on a per store basis, it’s clear that the true story, a decline in revenue, has been masked by the addition of new stores.

This graph is however heavily influenced by the addition of new stores, especially during 2013 and 2014. Therefore to try and reduce the new store impact, I have created a mature store graph, displaying both the NPAT and Revenue per mature store. To calculate the mature stores, I have simply subtracted the new stores from the total number of stores for each fiscal year (mature stores = total stores – stores opened that year). Obviously this isn’t a perfect solution, however given that stores within a mall typically reach maturity within 1 year, we are unsure of when these stores opened and we are look at general trends, any yearly misrepresentations will be smoothed out over the 10 year period.

The general trend is worse than above, showing a continued decline in Revenue per mature store and an even steeper decline in NPAT per mature store. The disconnect highlights an important point, expenses must be increasing at a faster rate than revenue. 

Looking into the expenses beginning with the gross margin shows a decline from 46% in 2009 to 43% in 2018. This is obviously considerable, especially given the revenue The Reject Shop is currently turning over, but is there anywhere else that expenses are increasing?

Below I have constructed a table showing on a per store basis, a number of The Reject Shop’s expense information. As you can see, between 2009 and 2019 the Compounded Annual Growth Rate (CAGR) of the number of stores increased by 8%, over the same time period, the number of employees per store decreased by a CAGR of 18.1%. The reduced number of employees helps to explain the slight decrease of total salary of .3% CAGR. NPAT is a real worry though, showing a CAGR of -9.1%, the bulk of which has been made up by the 6% CAGR decrease in revenue. To combat this, The Reject Shop has clearly tried to curb the growth of expenses, with store expenses increasing by only 0.8% CAGR and salary and admin costs both falling. Cost saving initiatives such as improved lighting, are having an impact on reducing store expenses, however as store expenses are so high to begin with, a 0.8% CAGR results in an additional cost of $55,000 per store. Adding this to the increase in rental expenses whilst subtracting the admin and salary savings, each Reject Shop is spending an additional $50,499 per year. In 2009 these expenses only made up 78% of the revenue per store, whilst in 2018 it has increased to 88%.

Along with the increase in expenses, The Reject Shop is now carrying an additional $65,800 of inventory per store. Some of the inventory could be explained away by the inclusion of larger stores, however I believe it is a combination of both this and The Reject Shop changing their product mix to include more expensive items. Long gone are the days where they once were trading under the name “Everything Here $2”, The Reject Shop now stocks items for well over $50.

For reference, I have also calculated the CAGR for an optimistic 2019 NPAT of $10.5m, this results in a worrying -12.8% CAGR.

Another troubling sign, is the disconnect between management’s total remuneration and the NPAT. Graphed below is the key personal’s remuneration as a percentage of NPAT. As you can see, the CEO’s and the non - executive directors’ wages have tracked consistently over the past 10 years, other key management personal however have sky rocketed, from a low of 10.4% in 2010 to 18.7% in 2018. This equates to an increase of 80.4%, whilst over that same time period, NPAT decreased by 29%. To highlight the most extreme example of the disconnect, in 2016, NPAT increased by 20%, over the same year total remuneration as a percentage of NPAT increased by 9.2%. To achieve such a high increase in total remuneration as a percentage of NPAT, despite NPAT increasing, required management to increase their total remuneration by 62%. The business did 20% better and the management was rewarded with a 62% increase in salary.

Takeover

The Reject Shop is currently being subjected to an unconditional on-market takeover, the buyer Allensford, has offered $2.7 per share. Trying to combat this, The Reject Shop recently confirmed their HY2019 results of $10.5m. They unfortunately didn’t give any further details, which in my opinion is a little suspicious. It might have been an oversight, but a little more detail would definitely be appreciated. The $2.7 offer price continues to be extended and I believe will be continued until after the HY results are out, giving Allensford an opportunity to either increase their offer if the results are good, or purchase a large portion from disgruntled investors.

Comparison

Below, I have lazily re-used the comparison table used in the Shaver Shop article, comparing the major players within the Australian Retail market. As you can see, using predominantly value metrics, The Reject Shop is the clear winner, with their nearest rival, The Shaver Shop, being 18 points higher. Not only do they have very low value metrics, but they also have a very healthy Pitroski score of 7.

Whilst not included above, below I have graphed the EBIT/Share of Wesfarmers’ Kmart alongside the EBIT/Share of The Reject Shop. The reason for this is to show the difference between two discount retailers, one with mediocre management (The Reject Shop) and the other under the superb management of Guy Russo, who has done a magnificent job of turning Kmart around. Pay less attention to the values and more to the trends, as for Kmart I have used the total outstanding shares of Wesfarmers’. When looking at the graph, two things stand out straight away, The Reject Shop’s EPS is trending downward whilst Kmart is trending upward and The Reject Shop is far more erratic. 

This graph highlights an important point, despite The Reject Shop blaming outside and macro forces for their decline, Kmart clearly shows that despite these forces a good strategy cannot only weather them, but improve results during them.  Typically when money is tight, from salaries being stagnant, bills rising etc, it drives consumers towards discount retailers as customers forgo convenience and luxury to expend their dollars further. Unfortunately for The Reject Shop, it appears that they are being pushed towards discount retailers other than The Reject Shop.

Evaluation

At first glance, it appears that The Reject shop is trading below liquidation value, with a balance sheet tangible book value per share of $5.16. However looking deeper into the balance sheet items shows a different story. Below I have calculated The Reject Shops liquidation value per share and as you can see, with a share price of $2.70 and in my opinion, optimistic recoverable values, they are currently trading well above it.

The keen eyed observer would have noticed that the recoverable ratio multiplied by the 2018 figures do not always equate to the recoverable value. This is due to me removing selected items hidden within the notes, in this case leasehold improvements. I removed $35.9m from Plant Property and Equipment as it was attributed to leasehold improvements, which are to the sole benefit of the lessor during/after liquidation.

Is liquidation value the right way to value The Reject Shop? I don’t think so, even with the current management, I don’t believe that there is a chance they will go under in the foreseeable future.

As liquidation value is not the correct value technique, below I have estimated, using the recently confirmed earnings, the share price for The Reject Shop after they have released their FY2019 annual report. Forecasted earnings are a fickle thing, terribly difficult to predict for both management and analyst alike and when they are reported, they are a delicate balancing act between best for the owners and best for the management. To combat this, I have used The Reject Shop’s recently confirmed HY2019 forecast of $10.5m (EPS $0.36), an error margin of 10% (EPS $0.32 & $0.39) and a selection of P/E values to create the following heat map.

To achieve a return that gives a safety margin of at least 30% requires The Shaver Shop to achieve a FY2019 Profit of $10.5mill and a PE of 10. This is unlikely as The Reject Shop is a cyclical business and has earned a H2 average of -$1.7m over the last 5 years. Looking at the heat map, the best most likely outcome is an 11% gain on today’s price.  I personally believe that the removal of the current bidder’s proposal, which is, in my opinion, currently artificially propping up the share price, would see a reduction in share price to between 2.68 and 2.2. This is because I see The Reject Shop’s long term prospects worse than The Shaver Shop’s, resulting in their PE hovering around if not below The Shaver Shop. If you would like to read my analysis on The Shaver Shop, click here. 

Discussion

The Reject Shop has had a number of competitors chip away at their competitive advantage. Companies such as Daiso, Aldi, Kmart, Supermarkets, Amazon, Ebay, Alibaba etc have all been improving and increasing their presence, clearly this has been at the expense of The Reject Shop.

To try and claw back some of their competitive advantage, The Reject Shop will need to slow down their current strategy of expand at any cost, shut down non-profitable stores, reduce key management’s wages, cut back on expenses and improve their gross margin. All things that are achievable, however given current management, I am doubtful. Their highly promoted lighting improvement, which would no doubt be having an effect, is clearly not large enough. It reminds me of the story Warren Buffett tells in his annual letters about the textile department of Berkshire Hathaway. Mr. Buffett describes how they continued to invest in new technology for production improvements, only to find that they didn’t offer any advantage over their competitors, but simply allowed them to keep up.   

The other thing I believe that will really have an impact on The Reject Shop is that they don’t offer online sales. They do have a shopping list that can be created on their website, deceptively disguised as online sales, but the customer will still need to physically travel to a store to purchase their desired products, all the while, hoping that this particular store has the items. This is because, unlike many other retailers, you currently cannot sign into a location, allowing the website to show if it is available at a particular store; if you are not going to offer online sales, this is a must. A cheaper and quicker way to improve their online presence is to introduce the “Buy online, pickup in store” option. This way, customers are able to purchase online and then simply pick their items up at the counter. Not only will this increase the convenience for consumers, but will also have the positive outcome of a boosting in store traffic.

By not focusing on their online presence, I believe that The Reject Shop has stopped focusing on their customers. An excellent article by Jess Huang, Sajal Kohli, and Shruti Lal at McKinsey titled “Winning in an era of unprecedented disruption: A perspective on US retail“, describes how 17% of all retail sales within the US will be online by 2020 and that the consumer of today are very different from consumers of yesteryear. They state that “Gone are the days when a retailer could rely on brand loyalty..... Being an older, well-established brand name—once a major asset—is now something of a liability.” They go on to describe that “In our view... the US retail industry, far from being moribund, is experiencing disruption—and reinvention—at unprecedented speed. It’s not a story about the malaise of an entire sector but rather a tale of two worlds. A confluence of trends has changed the playing field, forcing retailers either to adapt and innovate or to suffer painful losses or imminent demise”.

Conclusion

The Reject Shop, in my opinion, is a shell of what it once was the direct result of continual managerial mistakes. They have blamed the reduction of earnings on reduced consumer spending and general macro conditions. However as Kmart has shown, these negative forces could have been overcome. My belief is that The Reject Shop has failed to keep up with the changing consumer; they are neither adapting nor innovating.

Whilst some may say that this analysis has been somewhat harsh on The Reject Shop, I do believe that over the long run, they have the making of being a turnaround company. They do however need to make some changes, starting with management. I’m going to watch how the current situation with the takeover offer plays out and wait for some signs of trends turning before I consider buying. Especially as I believe Allensford is offering a premium on FY2019’s results and as Warren Buffett says “Turnarounds Seldom Turn”.

If you are looking to purchase a business within the retail industry, The Shaver Shop and Cellnet both, in my opinion, offer far better value.

Thanks for reading

Just Culture Investor

Trav Mays

Subscribe to Just Culture Investor by Email 

The author is a current owner of a portion of The Reject Shop, given this, they may be subject to one or a number of biases, more specifically anchoring and/or confirmation bias. This article is neither general nor personal advice and in no way constitutes specific or individual advice. The website and author do not guarantee, and accept no legal liability whatsoever arising from or connected to, the accuracy, reliability, currency or completeness of any material contained on this website or on any linked site. This website is not a substitute for independent professional advice and users should obtain any appropriate professional advice relevant to their particular circumstances. The material on this website may include the views or recommendations of third parties, which do not necessarily reflect the views of the website or author, or indicate its commitment to a particular course of action  

Does Shaver shop offer value? (ASX:SSG)

06/01/2019

Trav Mays

Follow @MaysTrav 

The recent large decline of the ASX, especially within the retail sector, could provide an opportunity to purchase excellent companies at bargain prices. Today we will be evaluating Shaver Shop, the speciality grooming retailer, to try and determine if they offer value.

Description

Shaver Shop (ASX:SSG) is a 30 year old speciality retailer, who up until recently focused primarily on male grooming products but have expanded their product offering to include female products as well. This move towards targeting female customers, while some might say a little late, is especially important for Shaver Shop, as a large percentage of their customers have traditionally been women purchasing for men.

Shaver Shop IPO’d (Initial Public Offering) on the ASX in 2016 with a plan to move away from the franchise model and with a goal to expand to a total of 145 stores. As you can see below, in 2013, of the total 72 stores, 80% were franchised, whereas of FY2018, they have expanded to a total of 115 stores, 92% of which are owned by Shaver Shop.

Along with their expansion of brick and mortar stores, Shaver Shop has been increasing their online store presence. The results of which saw a FY2018 increase in online sales of 45%, 10% of total revenue. Whilst their online presence is increasing, their total Like for Like (L4L) store sales growth has been decreasing. Shaver Shop has attributed this decrease to a reduction in Daigou (Surrogate Chinese purchasers, who ship products that are unavailable in China to China to then be sold on) sales, when excluding their Daigou sales, they have actually increased their L4L sales quarter by quarter. It is this number that should be focused on, Daigou sales can be sporadic and unpredictable and therefore should be seen as a bonus to revenue when evaluating businesses, not as repeat or ongoing business.

Evaluation

Comparison

Ranking the large players in the retail industry using traditional value metrics has the Shaver Shop ranked second behind The Reject Shop. A quick look at the most common metric’s formula reveals why this is the case. As with most of the metrics, PE has the price as the numerator, Price/Earnings, therefore a reduction in the price has a large impact on the PE value. The PE for both the Shaver Shop and the Reject Shop are a lot lower than the rest of the retail companies listed below, average retail PE was 10.98 in FY2018, this means that the value metrics should be used with caution. The underlying reason for the disproportionate reduction in Shaver Shop’s share price compared to the industry average needs to be investigated thoroughly, before a conclusion can be drawn. The Dividend Yield is quite high, again this is related to the price of the share (Dividend yield = Dividend / Price) so it should be compared with caution as well.

Other evaluation metrics such as the Pitroski score and the Z-score which are not affected by price offer more insights at this stage of the evaluation. Shaver Shop’s Pitroski score was equal second in FY2018, showing that as a business, Shaver Shop has improved over the year, scoring 6 out of a possible 9. Shaver Shop’s Z–Score is however the lowest, whilst it is still above the recommended safe zone of 2.6, be it slightly, it’s well below its peers. Other comparisons within the list are the profit and gross margin where Shaver Shop scored 5^th and 6^th respectively. Shaver Shop’s DEBT/Equity score was a respectable 19%, ranking 4^th amongst its peers. This score in my opinion sums up Shaver Shop as a business perfectly, average. The real question is, is average good enough, especially given current economic conditions and with increasing competition? 

Future Earnings

A quick and dirty way to estimate next year’s earnings is to multiply the historical average NPAT (Net Profit After Tax) to EBITDA (Earnings Before Interest, Tax, Depreciation and Amortisation) margin (NPAT/EBITDA) with that of the recently confirmed FY2019 EBITDA guidance. I have excluded 2015 from the average due to the misleading result this outlier will create. As you can see on the table below, the average NPAT - EBITDA margin was 56%. Multiplying this value with the Low and High EBITDA guidance of $12 and $14.5mill results in an EPS (Earnings Per Share) of $0.055 and $0.066 respectively (For those who disagree with removing 2015’s value, the average increases to 65% with a Low and High EPS of $0.062 & $0.072).

Another quick way to value Shaver Shops’ 2019 EPS is by calculating the historical NPAT per store and then multiplying this by the FY2019 guide. For this analysis I have again excluded 2015’s results from the average, helping to mitigate any one off effects. 

Both the low guidance of 112 and high guidance of 116 stores gives a figure around the lower end of the analysis calculated above, helping to validate these results and stressing the need to put more emphasis on the lower EPS (including 2015 increases the average to $0.061mill/store and the Low and High EPS’s to $0.062 & $0.072). As I have a conservative nature when investing, I will typically use the lower end of the analysis when making final decisions, that way, if the 2019FY result ends up being towards the higher end, then it is all an additional gain. When doing this however, it is paramount that the analysis doesn’t have too many or too high a safety margin, conservative is key, but over conservative results in unrealistic and useless forecasts.  

Within the table above, I have also included their long term goal of 145 stores within Australia and New Zealand. Using the analysis outlined in the previous paragraph and assuming everything stays equal, Shaver Shop will have an EPS in the range of $0.063 when they have reached this goal. I have assumed 2 franchise stores at this point, the makeup of the 145 stores is however irrelevant, the total is all that matters for this calculation. It is also worth noting, that as this analysis uses NPAT which includes online sales as well, as online sales increase, assuming the shift from in store to online isn’t the cause for all of the online growth, will cause the average NPAT/store to increase further. Therefore the $0.063 is somewhat conservative, but given the unknowns and increased competition from both online and actual stores, I believe it offers a value that is approximately right.

Share Price

In calculating the share price below, I have again used a quick and dirty method, whereby I use average PE ratios to calculate the potential share price. To calculate the compounded annual growth rate, I have assumed Shaver Shop will grow by a slower rate than historically, 6 stores per year as opposed to the historical average of 9. The reason for this is due to the possibility of a reduction in revenue over the coming years, failed stores and the increasing difficulty of finding suitable locations. At a rate of 6 per year, it will take 4 years to increase their number of stores from 112 to 145.

To calculate the share price I have used the current average PE of the companies listed above (9.52) and Shaver Shops’ 4 year trailing PE (10.07), which when multiplied with the 2023 EPS of $0.063, results in a share price of $0.60 and $0.64. Keep in mind that Shaver Shops’ 4 year trailing PE is heavily influenced by 2016’s PE of 16.39, removing this from the average, brings the PE down to 7.97 and a share price of $0.50. If the share price does increase to $0.50 in 2023, that would result in a total gain of 35.14% or a compounded annual growth rate of 6.21%. If however the share price increases to $0.60 it would result in a total gain of 62% or a 10.15% compounded annual growth rate. The higher gain would require that Shaver Shops’ PE ratio to increase to levels equal to the other companies within the industry. One of the main requirements for this would be sustainable and constant dividend.

Dividend

Shaver shop paid out a dividend of $0.042 in 2018 a 5% increase on 2017 levels. This required a payout ratio of 79%, 9% higher than the 2017 and 2018 industry averages. The payout ratio calculates the percentage of NPAT paid out in dividends, in other words, 79% of Shaver Shops’ 2018 profit was paid to the shareholders in the form of dividends.

If Shaver Shop chooses to continue the 5% dividend increase in 2019, they will need to increase the dividend to $0.0441 and assuming the estimated EPS stated above are correct (EPS .054 & .063), would require a payout ratio of between 82% and 70%. Whilst a payout ratio of 82% is not unprecedented, it is far from sustainable; Shaver Shop will therefore need to either increase earnings or reduced expenses to continue the trend further. Failing this, the long term dividend will need to reduce to average levels, freeing up ample cash for Shaver Shop to spend on growth opportunities, buybacks etc. If Shaver shop was to reduce the payout ratio to 70% in 2019, using the range of EPS of .054 - .063 will result in a dividend between $0.0378 and $0.0441. A dividend of $0.0378 at today’s prices is still an extremely high 10.35% dividend yield and a fact we should keep in our minds when making our final decision.

Discussion

It’s my belief that Shaver Shop will achieve an EPS towards the lower end of the calculated values. This will put a lot of downward pressure on the dividend, I don’t believe they will necessarily lower it in 2019, especially given the huge sell off seen recently when other companies have done it, Telstra for example. They will however need to reduce it in the future if they are unable to increase sales or reduce their expenses.

Shaver Shop has been reducing their business expenses over the last 6 years, the majority of which has come from the marketing and advertising, see below. They are also decreasing their cost of sales, predicting a gross margin of between 42 – 42.5% as opposed to 2018’s gross margin of 41.4%. As Shaver Shop expands, their purchasing power will increase, allowing them to further decrease their expenses, however as their expenses as a percentage of revenue are similar to their competitors, the difficultly of reducing them further will increase disproportionally.

Shaver Shop therefore will need to increase their revenue and this, I believe, is the reason for their low share price. Similar to Cellnet (read more about that here) and the rest of the retail industry, shaver shop is feeling the pressure from a range of sources, an aging bull market, low AUS/US exchange rate, low household savings rates, low wage growth, high household debt, house prices falling sharply (mostly in the east coast capitals), reduced Chinese demand for Australian resources and online behemoths such as Amazon, Alibaba etc are all having an effect on Shaver Shop. How will they fair when Amazon really starts to attack the Australian market is anyone’s guess. Australian retailers do however have the added advantage of seeing Amazon’s effect on America and other countries. Many, including Shaver Shop, have been expanding their online presence helping to mitigate Amazon’s affect, this along with the well run business of Shaver Shop, will help them to weather the storm. 

Recommendation

In doing this analysis, I have employed more crude analysis techniques allowing me to complete the evaluation rather quickly. Whilst they may be crude, I believe the results are in the ball park and as Warren Buffet says “It’s better to be approximately right, than completely wrong”.

Whilst Shaver Shop has increasing L4L sales growth and are well positioned to weather Amazon and others, the combination of the uncertainties stated above will likely result in a reduction in growth of future earnings. The calculated 2023 EPS of $0.063 is in my opinion, approximately right, which achieves a total gain, not including gains from future dividends and buybacks, of 35.14% or a compounded annual growth rate of 6.21%. The high dividend yield even if Shaver Shop lowers their payout ratio to 70% is definitely a positive, especially when calculating potential total returns. I do however believe they are nearing the top of their growth potential and a large percentage of any future gains will arise from dividends and buybacks as opposed to share price movements, unless they diversify and grow through acquisitions, similar to Cellnet. Shaver Shop therefore could offer adequate return, depending on the investor’s personal belief in the likelihood of this analysis and when compared against other possible returns in alternative investments.

*Updated on the 10/01/2019, I mistakenly entered the wrong EBIT for the reject shop, updated comparison image and corresponding sentences.

Image Source: http://investors.shavershop.com.au/Investors/

Thanks for reading

Just Culture Investor

Trav Mays

Subscribe to Just Culture Investor by Email 

The author is a current owner of a portion of Shaver Shop, given this, they may be subject to one or a number of biases, more specifically anchoring and/or confirmation bias. This article is neither general nor personal advice and in no way constitutes specific or individual advice. The website and author do not guarantee, and accept no legal liability whatsoever arising from or connected to, the accuracy, reliability, currency or completeness of any material contained on this website or on any linked site. This website is not a substitute for independent professional advice and users should obtain any appropriate professional advice relevant to their particular circumstances. The material on this website may include the views or recommendations of third parties, which do not necessarily reflect the views of the website or author, or indicate its commitment to a particular course of action  

Trav Mays 19:22 ASX, Retail, SSG Read More →