The Reject Shop (ASX: TRS) – Value Stock or Value Trap?

The Reject Shop, founded in 1981 currently operates 351 stores with a turnover of $800.3m. The group has more than half of its stores located in Victoria and Sydney. Within these states, the brand is defiantly recognisable and has always been associated with cheap products and thrifty buyers.

New South Wales 110
Victoria 83
Queensland 69
South Australia 28
Western Australia 32
Tasmania 21
ACT 5

The story of The Reject Shop, like many retailers is around their business model, low-cost & high volume, coinciding with a competitive rivalry between incumbents adding more pressure on already low prices. However, other retailers, such as Kmart, have carved their own market share and benefited from the fragmentation and the consumers demand for cheap products.

When I think about The Reject Shop, its the operating leverage, which is how changes in sales, relative to changes in the costs structure impacts the cash flow that worries me. The 2018 earnings call highlighted that 2% comparable sales in the second half would ensure a breakeven position for the six months to June 19, not leaving much margin of safety.

Putting aside that profitability is sensitive to the top line, the group has done well to produce free cash flows, an impressive ~$62m over 5 years, this is half the groups current enterprise value.

FY18 FY17 FY16 FY15 FY14
Free Cash Flow $19m $12m $8.8m $30m ($7m)

Looking to the future, the narrative for this business will be around its growth and importantly, its comparable sales. Future growth will be either from new stores, which is limited & capital dependent, or increased transactions within each store. The latter is the tricky one, and has plagued TRS.

More transactions and a increased turnover of products per store is the missing jewel in TRS’s crown. This is measured by comparable sales / LFL sales (or samestore sales, a term which refers to the difference in revenue generated by a retail chain’s existing outlets over a certain period). Any improvement in comparable sales will always flow to the bottom line, and would trigger a revaluation in market value.

In addition to the above, the group has confirmed their strategy as follows;

  1. New markets via new stores
  2. Increase same store sales growth via increased transactions
  3. Improving efficiency / Cost of Doing Business (CODB)

The first point, new store openings has been for the most part achieved, with the four new stores opened in FY18 which contributed to all of the growth in revenue over FY17 – 18. See below changes in revenue each year, aswell as the new stores.

2018 2017 2016 2015
Stores 351 345 341 333
Revenue 800,300 $794,036 $799,958 $756,800

Valuation

Please note, this is an arbitrary, quick & dirty discounted cash flow calculation and serves  more as a mental guide in viewing its current market value.

The following assumptions are based on the past four year averages of Cap Ex, Deprecation, & Working Capital. Additionally, I have assumed 1.1% sales growth in FY19.

2015A 2016A 2017A 2018A 2019E
EBIT $21,700 $30,400 $18,600 $24,000 $24,270
Less: Provision for Taxes -$6,510 -$9,120 -$5,580 -$7,200 -$7,281
Net Income $15,190 $21,280 $13,020 $16,800 $16,989
Plus: D&A $19,100 $19,400 $19,700 $19,200 $19,350
Less: Capital Expenditures -$16,900 -$16,800 -$25,000 -$17,400 -$19,025
Less: Inc Net Working Capital $14,200 -$8,300 $5,000 -$3 $2,500
Free Cash Flow $31,590 $15,580 $12,720 $18,597 $19,814

Sensitivity assumptions as follows – discount / required rate ranges from 11% – 13% and the perpetual growth rate is assumed at 0.5% – 1.5%.

Total Equity Value – Terminal Perpetuity Growth
0.50% 1.00% 1.50%
11.00% $185,455 $194,891 $205,319
12.00% $169,205 $177,037 $185,615
13.00% $155,578 $162,183 $169,362

Catalyst

Even though I’m not a current holder of TRS, I’m watching the stock carefully in anticipation for any changes in its organic sales or product mix.

And the obvious catalyst here is a market revaluation; at current the group has a P/E 7.97x and a cash flow yield of 15%.

The risk and return for this stock is starting to weigh on the investors side with the market fully discounting the future expectation of declining sales in the price.

If this isn’t the case, the group will enjoy another $19m in cash flow and have a net cash position of $35m, with a market cap of $100m. And with its cash, what comes next, buybacks? or a Special dividend?

The groups AGM is this month on the 17th October and will provide further guidance, a stock definitely worth watching.

Thanks for reading and more to come!

 

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