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 100th store by 2004. Along with opening their 100th
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
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
