Can The Reject Shop Turn Around?
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Discount store chain, The Reject Shop ((TRS)), has signalled its marketing strategy announced late last year has not provided the turnaround expected. The company is considered unlikely to pay a final dividend in FY17.
The Reject Shop should benefit from a $2m saving in operating costs from the recent closure of its Melbourne distribution centre, but weak foot traffic and sales have overwhelmed any improvements in operations. Moreover, macro conditions are not solely to blame, with brokers noting a fall-out from a change in merchandise mix as well as strong competition.
The company reports like-for-like sales in the second half are down around -4%, with weak conditions particularly apparent in Western Australia and the ACT. Assuming this contraction continues in the fourth quarter, it will result in a net loss in the second half of around -$5m on Macquarie's estimates. While the company has reported it is compliant with debt covenants, the broker notes head room is clearly reduced.
Goldman Sachs observes there are some cost efficiency programs under way which should support earnings growth into FY18, and assumes 1% like-for-like sales growth. The broker agrees, while the company is compliant with debt covenants, if the top line deteriorates more than expected there is a risk to a very thin fixed charges cover.
On the plus side, debt levels are low and there is the flexibility to cut dividends. Goldman Sachs, not one of the eight brokers monitored daily on the FNArena database, has a Neutral rating and awaits a pick-up in consumer sentiment to take a more positive view on the stock.
The key to a turnaround will be how quickly the problems with execution can be resolved and the state of the inventory position. Macquarie observes merchandising strategy has plagued the company for several years and the question is whether this is reflecting an increasingly challenging competitive environment.
The company is working through surplus stock, the cost of which is factored into revised guidance, and aims to finish FY17 in a manageable position. Still, Macquarie observes, after a period in which profit improved under new management because of a reduction in costs, the continued inability to generate sustainable sales growth has caught up with the company and affected profitability.
While the company remains highly leveraged to any improvement in the sales trajectory, the broker needs evidence that new initiatives for merchandising are gaining traction before believing the stock is a turnaround opportunity.
UBS downgrades its long-term operating earnings (EBIT) margin estimate to 3.0% from 5.0% and considers it increasingly unlikely that the company will reach a 5% margin by FY20. The magnitude of the earnings downgrade raises questions for the broker regarding the ability of management to turn around the company's performance.
The broker had maintained a Buy rating based on the expectation of a return to positive sales growth in the second half, as supply chain disruptions subside. Instead, UBS downgrades forecasts for earnings per share by -39-45% from FY18 onwards and reduces its rating to Neutral.
UBS finds it difficult to separate the macro and competitive issues in Western Australia from the effect of merchandising decisions and supply chain disruptions.
The company is expected to have around 352 stores in operation at the end of FY17 with a long-term store target of 400. The broker still believes there is a long tail of stores that would be marginal propositions at best. Given the underperformance in FY17, UBS believes a review of the store network would be a prudent step.
The problem, in Morgan Stanley's view, is the heavy focus on variety products that did not sell well, exacerbated by a weak consumer environment. The company's intention to focus on everyday products at lower prices and reduce merchandising risk has clearly been unsuccessful and the broker is concerned about the ability to effectively compete on price and offering for everyday products.
The broker expects fourth quarter like-for-like sales will contract around -3% which, along with lower margin estimates, means net profit forecasts decline by 34.1% for FY17 and 20.8% for FY18.
Merchandise risk remains high for the short term, dampening confidence, and the broker downgrades to Equal-weight from Overweight. Despite cost savings on the horizon, Morgan Stanley does not believe the company's strategy has provided enough stability for sales and expects the stock to trade at a discount to its peers.
FNArena's database has three Hold ratings. The consensus target is $5.70, suggesting 14.0% upside to the last share price. This compares with $10.18 ahead of the announcement. The dividend yield on FY17 and FY18 estimates is 4.8% and 5.9% respectively.
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