Resurrecting Confidence In Dick Smith

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-Price deflation abates
-Private label underpins margin
-Better store composition
 

By Eva Brocklehurst

Consumer electronics retailer Dick Smith Holdings ((DSH)) is a familiar name but relatively new to the listed market. At a time when retailers are troubled by declining margins and profitability, Dick Smith may be better placed. CLSA thinks so and has initiated coverage on the stock with an Outperform rating and target of $2.30. On the FNArena database both CIMB Securities and Macquarie rate the stock similarly for an average target of $2.65. Other FNArena brokers are yet to initiate coverage.

Dick Smith had more than 400 stores and contributed 5-6% of earnings when it was owned by Woolworths but after being taken private this unravelled, notes CLSA. The broker expects the current salvage operations to continue and set the company up to deliver on FY14 prospectus earnings forecasts. Store numbers should head back to 400 from around 375. The severe price deflation of the past few years should abate and make sales growth achievable, in the broker's opinion. 

Can Dick Smith return to the glory days? CLSA believes the new management is up to the task. In FY07 the business contributed $71.1m in earnings to Woolworths. Subsequently, five years of mismanagement meant costs went through the roof and earnings fell to $24.6m in FY12. Lower short-term incentive payments should drive lower costs from FY15. In FY14 these payments are around double what the broker thinks should be the case on an ongoing basis, reflecting the transition of the organisation away from a private equity model. Supply chain optimisation should also result in more direct to store and direct to customer deliveries.

CLSA thinks gross margin expansion is less of a profitability lever now. Indeed, the broker expects FY15 to be flat. Private label penetration, expected to rise to 15% from the current 11%, is touted as the key support for gross margins. In Morgan Stanley's opinion, private label business has been key determinant why Dick Smith's gross margins are ahead of listed peer JB Hi-Fi ((JBH)), even though the latter has three times the turnover. CIMB also welcomes the lifting of the private label offering to include the New Zealand market. Dick Smith branded TVs have been in the Australian market for some years now and are the largest seller in the sub-40 inch category.

CLSA thinks the composition of stores will be better in FY15 and FY16. Closures have focused on stores that were the wrong size for their location or where there were onerous rents. Expansions are now based on the store-in-store format as well, such as the partnership with David Jones ((DJS)), which extends the reach to a more affluent consumer. CLSA also lauds the new MOVE format, which targets a younger consumer that may not have previously engaged with the Dick Smith brand. The broker notes customers now recognise that the company's offer has improved and thinks investors should follow suit.

What about price deflation? The Australian dollar's slide below US$1 has helped, and a reduction in discounting has alleviated the pressure across the AV/IT sector. CLSA cites the latest inflation data from the Australian Bureau of Statistics that showed price deflation is the lowest it has been in five years, supporting like-for-like sales growth. A stronger NZ dollar versus the Australian dollar will also assist Dick Smith. The sector will remain competitive and the broker does not necessarily think the Dick Smith brand is the best on offer but… the stock is cheap and should outperform.

CIMB also thinks there's a buying opportunity. Forget the negative overhang of private equity (Anchorage retains 20%) and lack of listed history. The initiatives the company has unveiled sell the story for the broker. As a one-time only provision, the company will report third quarter sales on April 16, in order to clarify the confusion around the underlying sales momentum. The broker thinks the cycling of last year's December clearance event could be concealing an improvement in like-for-like growth. CIMB is increasingly confident the re-worked staff incentive structure, a refined marketing program and category management a can deliver underlying sales growth, sustainably.

The company continues to target a working capital release as it pushes out vendor terms in New Zealand. Factoring this in, and a FY15 dividend at the top of the 60-70% target, CIMB expects a net cash balance at year-end of close to $55m. The broker thinks the pay-out ratio has potential to increase, or the company can assess acquisitions, possibly to rebuild the commercial business. CIMB notes Dick Smith has expressed a desire to maintain a conservative balance sheet and will not incur debt for acquisitions or dividends. The company has also signalled an intention to rebuild its commercial business, which could, in the broker's opinion, be supplemented by an education-based business.

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