The Reject Shop (Still) Requires A Leap Of Faith

This story features REJECT SHOP LIMITED. For more info SHARE ANALYSIS: TRS

While freight costs/delays, lockdowns and consumer behaviour continue to shadow progress, brokers are looking beyond the short-term pain to a continuation of The Reject Shop’s turnaround story beyond 2022

-Sales revenue expected to decline by around -11% in the second half
-Freight costs expected to remain elevated for 6 to 12 months
-Positive investment view relies on headwinds being transitory and further cost reductions

By Mark Story

Looking back at its humble origins from a solitary store in South Yarra back in 1981 selling discontinued crockery, it’s easy to conclude the last 40 years have been kind to The Reject Shop ((TRS)). Fast forward to 2021 and the company is a household name with more than 337 sites locations nationwide.

While the discount variety store chain has had its fair share of challenges over the last four decades, the company’s biggest challenge arrived along with covid. Before the pandemic hit the company had already embarked on repositioning the business to better compete with its traditional rivals such as Big W and Target, and relative newcomers such as Aldi.

Management recognised its business was a numbers game that required it to be a lot savvier than in the past. As a result, the company embarked on a turnaround strategy which saw it take a knife to the sheer volume of stock items lining its shelves, and this resulted in stock keeping units, or SKU numbers, being slashed.

Management knew that in light of a more intensely competitive environment, The Reject Shop’s survival relied on recalibrating its offering around the dynamics of large volume, low margin on a limited range of fast moving stock items.

During the initial turnaround phase the company made efforts to stabilise the business by strengthening its balance sheet and reducing costs. Around -$12m of underlying cost were removed from the business in the first half FY21.

In addition to re-engineering of The Reject Shop’s store network, and re-setting its product range, the company has also started to renegotiate leases, although this will take time to bear fruit.

When the pandemic hit, The Reject Shop’s turnaround was still very much in its infancy and the company’s sales activity fell sharply. But it was the tail of two distinctly different narratives: modest sales increases across its broader portfolio were being pulled down by stores in the inner-city and large shopping centres.

CBD lockdowns and supply headwinds

In short, the CBD lockdowns Australia-wide started to take their toll on trading. Additional trading headwinds came in the form of freight delays/costs on high margin inventory through to early March, and a channel shift from metro to regional areas.

Impacted by the cycling of 7.1% comparable-store sales growth in the previous period, plus lower foot traffic in its 47 shopping centre and CBD store locations, The Reject Shop’s sales revenue is expected to decline by around -11% in second half FY21. Then there are lingering stock availability issues due to delays in international shipping, while freight costs are expected to remain elevated for 6 to 12 months.

Impacted by lockdowns, the 47 stores in metropolitan CBD locations and major retail centres delivered a -12% drop in sales from the same period in FY19, and continue trading well below pre-covid levels. By comparison, the balance of the company stores have seen a 0.9% increase in sales.

Management expects FY21 earnings (EBIT) of between $8 to 10m — up from $4.5m last financial year — which infers a second half FY21 earnings loss of between -$13.3m and -$15.3m.

Given that sales trends are expected to remain volatile, and in light of gross profit margin pressure due largely to higher international shipping and supply chain costs, Ord Minnett cannot see a quick fix for the business.

With recent developments having undermined the company’s initial progress in lowering store labour costs and administrative costs, the broker has downgraded the The Reject Shop to Hold from Buy and slashed its target price to $5.70 from $10.34.

Ord Minnett notes the decline in gross profit margins has been exacerbated in the second half following prior management locking in its USD exposure at disadvantageous levels.

While Ord Minnett acknowledges the turnaround story remains in its infancy, the broker expect sales to remain volatile as the company continues to focus on lowering inventory levels, reducing the number of suppliers and lowering the number of SKUs.

Tailwinds coming

Having concluded that the headwinds are short term and the long-term prospects are continuing to improve, Jarden maintains a Buy rating on The Reject Shop. While Jarden has lowered the target price to $10.00 from $11.00 in light of short-term headwinds, the broker believes the proposition on offer is a long-term margin accretion story.

While headwinds are now forecast to last longer than initially expected, Jarden is encouraged by the company’s underlying cost-out efforts.

The broker also expects the company to benefit from a material cost of goods sold tailwind in the key first half FY22 trading period. Equally encouraging, adds Jarden, are further rent reductions – with 35 of 47 CBD leases expiring in 18 months – plus a growing store network. It’s understood around 9 stores are planned for first quarter FY22 (2.5% network growth).

The broker believes management’s proven ability to consistently rollout stores and reduce the cost base, reaffirms underlying strength on executing internal factors.

Given that Jarden doesn’t view headwinds as structural, the broker’s long-term forecasts remain relatively unchanged. However, the broker has cut its FY21 earnings forecast by -26% and FY22 by a similar amount to reflect higher supply chain costs persisting into next year.

A slower normalisation of consumer spending patterns is also expected, and Jarden suspects it may take some time for customers to return to store in pre-covid numbers. Despite current USD exposures, Jarden expects the company to start benefiting from a 20%-plus forex tailwind in first half of FY22.

Meantime, Morgans has some lingering concerns about The Reject Shop’s ability to deliver positive sales momentum for sustained periods in the long term. However, the broker also thinks the company can resolve/offset current headwinds reasonably quickly. Morgans is also encouraged that the underlying cost reduction strategy remains on track.

The broker sees scope for most of problem stores to swing back to profitability reasonably quickly, and maintains an Add rating but has lowered its price target to $6.80 from $8.91.

Morgans notes 10 of the 47 impacted stores contributed 50% of the decline, with 7 of these 10 stores now coming up for lease contract renewal. The broker expects landlords to come to the table with reasonable reductions. However, if not the broker understands the company has a reasonable pipeline with which to replaced troubled city stores in more suitable and cheaper locations.

Morgans has lowered earnings per share forecasts by -25%, -17%, and -11% in FY21-23. However, Morgans original investment view centres around the requirement for patience on the sales front, while inventory reduces and product is optimised, with cost-out the key area of upside.

Having concluded that business model sustainability and structural rollout far outweighs near-term transitory headwinds, Morgan Stanley maintains an Overweight rating on the company with a price target of $10.00.

The consensus target, which combines targets set by Morgans, Morgan Stanley and Ord Minnett, is $7.50 which suggests 32.5% upside to the current share price. Jarden is not one of the seven stockbrokers monitored daily by FNArena.

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