Small Caps | Oct 29 2015
-October extremely soft, guidance lowered
-Promotions ramped up to tackle inventory
-Issues may be more structural
By Eva Brocklehurst
Electronics retailer Dick Smith Holdings ((DSH)) has experienced a sharp downturn in sales performance, prompting a substantial downgrade to guidance at its AGM.
Sales growth on the surface was strong enough in the September quarter, up 6.9%, but was delivered on the back of some hefty discounting. October trading was extremely soft. Brokers have downgraded ratings and target prices accordingly.
The company's commentary suggests to Macquarie that like-for-like sales in the month were down 5.0%, with poor marketing decisions seen producing a large reduction in foot traffic. Stock levels are elevated and promotional activity will now be ramped up to arrest the sales declines and protect market share, as well as reduce inventory levels and improve cash flow. Such activity, the broker highlights, will undoubtedly impact profitability.
Dick Smith now expects FY16 profit to be $5-8m below prior guidance of $45-48m, which represents a 14% downgrade. Macquarie observes the balance sheet is not yet overly stretched, so earnings trajectory and operating leverage are the main issues.
The company is cautious about the outlook for Christmas and maintains it will prioritise sales growth. Still, the magnitude of the downgrade is of concern so early in the financial year, as the broker believes it raises doubts about the underlying capacity of the business. Macquarie suspects there is a brand and price perception issue which needs to be addressed. The broker downgrades to Neutral from Outperform, lowering the target to $1.00 from $2.10.
Improving the company's share of voice product could be a short term solution to drive traffic, but Credit Suisse emphasises that this is short term. The company needs to differentiate itself from competitors and improve returns on invested capital to sustain medium term growth, the broker asserts. Moreover, operating leverage is being compromised, in the broker's opinion, as the company continues with its store roll out.
Margin headwinds are being driven by higher promotional intensity and the cost of obtaining growth is rising. There is also the risk of online cannibalisation as marketing is redirected to stores. Credit Suisse continues to believe the medium-term earnings risk is skewed to the downside, despite a seemingly attractive valuation, and retains an Underperform rating.
Deutsche Bank struggles to understand how just one month can play havoc with earnings forecasts and result in such a sharp downgrade. There must be deeper issues, the broker contends, such as a format which faces difficulty in generating traffic without aggressive discounting and help from lower-margin online sales. The inventory build-up is also likely to require even deeper discounting to rectify the problem, the broker suspects.
One aspect of the inventory issue is private label accessories, mainly sold in store and recommended as an extra by sales staff to complement a primary purchase. The shift in channels to online results in a lower rate of attachment for these products, making this private label inventory an issue.
Private label products may have margins of more than 80% but it is difficult to generate sales growth on the strength of these accessories alone. The broker understands this means foot traffic has now been emphasised as a priority in coming months but, in turn, that relies on promotional activity.
There is also a bigger structural issue in consumer electronics, in Deutsche Bank's opinion. Homogenous products such as phones and tablets, and some TVs, are being sold widely by manufacturers as well, and price competition is fierce. Discounting is often led by one business and routinely followed by others to protect their market share, which means improving foot traffic may not be easy.
Were there any positives in the update? Deutsche Bank notes the strong phone sales in September following the launch of the new iPhone, although these are low-margin sales. New Zealand also reported the best quarterly sale performance since acquisition of the business, although base comparables are low.
All up, the trading multiple is low but there is little confidence that both sales growth and stable margins can be delivered simultaneously, particularly when the benefit of cost cutting realised in FY16 passes through. Hence, Deutsche Bank makes downgrades of 20-30% to estimates and expects a significant deterioration in gross margin. The broker downgrades to Hold from Buy, cutting its target to $1.00 from $2.30.
FNArena's database has two Hold ratings and one Sell for Dick Smith. The consensus target is 92c, suggesting 17.6% upside to the last share price. This compares with $2.00 ahead of the news. The dividend yield on FY16 and FY17 forecasts is 13.4% and 12.5% respectively.
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