-Well placed for AUD impact
-Small footprint advantage
-Buy case based on offshore
 

By Eva Brocklehurst

Jewellery chain Lovisa Holdings ((LOV)) is undertaking due diligence on the northern hemisphere, in the hope of establishing an initial presence in the next 12 months. The company's store roll-out, margin expansion and like-for-like sales were all robust over FY15 and brokers expect new markets will present further opportunities.

Lovisa may be experiencing a 17.8% increase in average buying currency in FY16 but, with a gross margin above 75% and average price of $9 per unit, Morgan Stanley suspects the company is better placed compared with other retailers when it comes to passing on the currency impact to consumers.

Still, the broker assumes the gross margin percentage will decrease by 100 basis points in FY16, to be offset by lower costs, as store growth is in low-cost countries and 20 underperforming Australian stores were closed over the year.

Morgan Stanley believes the brand is well positioned for international expansion with a small store footprint and low level of seasonality versus other specialty retail categories. The business model is highly scalable and suited to international expansion. Entering either the US or UK should provide significant expansion potential.

At present Lovisa operates profitably across six countries, while 11 of the top 20 stores globally by contribution are now offshore. Morgan Stanley expects a further decline in operating costs as a percentage of sales in FY16 as 20 stores begin contributing in South Africa, where rents and wages are substantially below Australia.

Further benefits should come from the Middle Eastern stores, where the group operates as a franchise and only the royalty revenue equal to 10% of sales is reflected in the accounts.

FY15 revenue beat prospectus but was slightly below Canaccord Genuity's estimates, because of the lower promotional activity over Easter. The broker expects 20% revenue growth in FY16 and a gross profit margin of 75.6% but awaits more detail on the northern hemisphere plans before adjusting its outlook to incorporate either a US or UK market opportunity.

The company also expects to add an additional franchise partner in FY16, likely to be in Asia. Canaccord Genuity, not one of the eight monitored daily on FNArena's database, retains a $3.55 target and Hold rating.

Morgans, too, bases its investment case on offshore expansion. FY16 looks to be the year of achievement and the broker envisages potential for substantial earnings and valuation upside. The broker observes like-for-like sales growth slowed substantially in the second half to just 4.2%, versus a first half result of 12.2%. This was attributed to soft April sales.

The company decided not to run its typical Easter promotion because its inventory position was clean. Management is also inclined to hold back on the April sale again in FY16.

This promotional discipline impressed Macquarie. This is why the company was able to meet prospectus margin forecasts despite a lower-than-forecast Australian dollar. Macquarie observes retailers regularly need to decide on the trade-off between like-for-like sales growth and gross margin, either discounting and selling more or holding firm on price and selling less at a higher margin. Macquarie will firm up its view as more detail on the expansion opportunity comes to light.

The South African acquisition contributed a $156,000 loss in FY16 and management continues to expect incremental earnings of $1.75m in FY16. Shares held by BB Capital and Shane Fallscheer were in escrow at the IPO last December, to be released immediately following the FY15 results. Of note, this escrowed stock is a significant share of total capital, being 48.7%.

FNArena's database contains three Buy ratings. The consensus target is $3.85, suggesting 11.9% upside to the last share price. Targets range from $3.79 to $3.91.
 

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-Dilutes Oz exposure
-Doubling of earnings forecast
-Scope for higher margins
 

By Eva Brocklehurst

Surfstitch ((SRF)), an online sports wear merchant, is confident that integrating several acquisitions onto one platform will pay off with improved market share and profile. After consolidating European business into Surfdome, from Surfstitch Europe, the company will now consolidate its assets into one global website under the Swell brand.

Surfstitch aims to become a worldwide online destination for action sports, offering its customers apparel, technology and travel products. Brokers welcome the strategy to re-brand as it should increase engagement and reduce duplication costs. The exposure to global demand is also welcomed as it dilutes the impact of a depreciating Australian dollar and slower growth in Australia.

The company has been busy in the US in re-setting its inventory since acquiring Swell.com from Billabong International ((BBG)). While growth in FY15 in that region was weakest, at 5.5%, the business is now considered better positioned as margins improve in the shift from discounted Billabong product. JP Morgan expects the re-branding to Swell should generate capex synergies by FY17 amid savings from improved scale in product sourcing and marketing benefits.

Gross margins improved in FY15 to 46.0% from 42.5%, attributable to improved terms, higher average selling prices and better merchandising. JP Morgan observes selling prices have benefitted from a larger proportion of hard goods. In Europe, the company has moved more towards action sports and away from lifestyle and outdoor products.The broker lifts its target to $2.40 from $2.10 and maintains an Overweight rating.

Outside of North America, Asia Pacific was a strong performer, with 43.4% growth in sales, despite the challenges in retailing domestically. Revenue growth in Europe was weaker, at around 18.6%. Margins improved, however, as Surfstitch Europe was consolidated into Surfdome. Further benefit is expected in FY16 as the business can leverage the simplified platform. From here, moving to single eCommerce brand should drive further upside.

Pro-forma sales were in line with prospectus, although only after a translation benefit from the weaker Australian dollar, Morgan Stanley observes. Nevertheless, sales growth remains at a level that does not provoke undue concern. The broker is looking for a clean set of numbers in FY16, as pro-forma and statutory accounts for FY15 show wide variance owing to the consolidation of the brands and acquisitions.

The clear path outlined by the company, and the apparent confidence in guiding to earnings of $15-18m - more than double FY15 - means the broker is confident the outperformance can continue. By having a very specific target market and offering a full range the company is differentiated from other online retailers. Moving to a single eCommerce brand under Swell should drive further upside and Morgan Stanley retains an Overweight rating and $2.25 target.

Bell Potter also has a $2.25 target with a Buy rating. The integration of all assets into one online global sports wear brand should deliver the expected synergies in FY17. The broker expects a 3-year compound revenue growth rate of 33%. Additional investment in marketing and IT infrastructure should underpin this growth.

The broker considered the FY15 results a positive outcome, given the company did not own Surfdome and Swell for the whole period. Importantly, in terms of the Australasian business, gross profit margins increased over 200 basis points. Similarly, in the UK, which accounts for 75% of the European segment, gross profit margins benefitted from the company taking control of the Surfdome business.

Bell Potter is encouraged by the re-positioning of the US brand and product offering and momentum is expected to build now the inventory restructuring is being finalised.The broker envisages scope for higher margins in the medium term because Surfstitch is less exposed to fast fashion and, therefore, price deflation. Moreover, this should be easier with global operations as inventory and currency fluctuations are managed more effectively.

Surfstitch is Australia's largest online retailer and the world's largest in terms of action sports and youth apparel. It acquired online action sports retailer, Surfdome, in Europe as part of its IPO. The company manages a retail platform that offers over 900 brands.
 

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-GM down on increased discounting
-But sales growth substantial
-Supported by robust housing
 

By Eva Brocklehurst

Adairs ((ADH)), a retailer of home furnishings, has reported its maiden first year result as a listed company with a flourish. Sales growth was well above prospectus, mainly from growth in the fashion/decorator category.

The gross margin was below expectations. This was explained by a decision to increase discounting in the final quarter to improve the inventory position heading into FY16. The company is undertaking due diligence in the South African and New Zealand markets with no decision yet on whether to commence operations.

Adairs remains intent on improving its product offering, adding to its range and increasing the average spend per sale. Around 8-12 new stores are to open in Australia each year for the next five years.

Discussions on a trial of three department store concessions are advanced, which will provide its Urban Home Republic brand with a CBD presence in those locations without such a store. Historically, Adairs' store footprint has been concentrated in Victoria.

Morgans has an Add rating and $3.14 target. The broker has no problem with the discounting carried out into year end, given strong sales growth. The company is seen as benefitting from significant investment over recent years. The main risks, in Morgans' view, are a softening of consumer spending or a material deterioration in the Australian dollar from current rates.

There was no upgrade to FY16 guidance, although the company stated the year has started well. Morgans expects an upgrade will come, with upside to the like-for-like sales assumptions leading to further operating leverage on costs. Despite disappointing gross margins the broker assumes 61.5% is achievable in FY16. Like-for-like sales growth is expected to moderate over the second half of FY16, given the strong comparables which will be cycled.

Sales growth would need to fall below 8.1% and gross margin below 60.0%, UBS calculates, before the company's prospectus forecasts would be at risk. The broker's forecasts for FY16 profit are 6.0% higher than prospectus, and a Buy rating and $3.30 target are in place.

UBS had some concern regarding the gross margin in FY15 but believes the slight reduction to expectations in this regard is more than offset by higher forecast sales. Moreover, sales momentum does not appear to be slowing.

Goldman Sachs believes the initiatives underway should deliver growth rates which exceed the market and this, in turn, is being supported by robust housing activity. The broker anticipates 15.0% earnings growth over the next couple of years.

Goldman Sachs, not one of the eight brokers monitored daily on FNArena's database, retains a Neutral rating on valuation grounds with the stock trading close to its $2.85 target.

See also, Brokers Highlight Potential In Adairs on August 3 2015.
 

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-Sales growth slows in recent weeks
-Potential competitors ramping up
-Is gearing too high?
 

By Eva Brocklehurst

Greencross ((GXL)) has developed a dominant position in the provision of veterinary clinics and pet care products. The market continues to grow and the company is well placed to leverage this growth, although there are some issues for brokers in terms of bedding down acquisitions from FY15.

Deutsche Bank is concerned about the pace of growth, driven as it is by acquisitions and the rolling out of stores. Risks are compounded by high gearing. The company operates Australia's largest specialist veterinary services and pet retail group, with brands such as Petbarn, City Farmers and Animates.

The market offers favourable dynamics but Deutsche Bank remains concerned about the execution of the company's strategy, preferring to witness some stability before adopting a more positive view. The broker maintains a Hold rating and $7.00 target.

The financials were generally in line with expectations in FY15. Revenue rose 45%, driven by expansion in the network. Gross margins and the New Zealand business stood out as the most positive aspects, while there are signs Australian retail growth has slowed over the last quarter. Sales growth was primarily driven by the acquisition of City Farmers as well as the roll out of stores. NZ growth, at 8.0%, was attributed to increased traffic and premium product.

The recent downgrade to the outlook and the underperformance of City Farmers - which is heavily exposed to the Western Australian economy - as well as supply chain disruptions are aspects which disturb Deutsche Bank. This may just be a result of the aggressive expansion underway, the broker acknowledges, but the supply chain is not integrated and this is compounded by high gearing and thin cover for fixed charges.

FY15 was a period of significant investment, Macquarie observes. Operating cash flow was weak but it did include acquisition costs and significant investment in new stores. Macquarie believes the company has sufficient capacity and flexibility in its existing facilities to support the current growth profile and expects FY16 to be cleaner. An Outperform rating and $7.60 target are maintained.

Revenue synergies from the original merger of the pet and vets formats should be of material benefit from FY16/17, in the broker's opinion. Macquarie does acknowledge that the listing of National Vet Care, if successful, would mean a second aggregator in the industry emerges with reasonable scale and access to future funding. Still, in isolation, that company is not expected to drive a step-change in market multiples in the near term.

The success of Greencross means the broker is not surprised new entrants are attracted to the market, with feedback indicating at least two other corporates are exploring various strategies to ramp up their presence.

The majority of pet foods are imported, typically purchased from Australian distributors in Australian dollars. This signals to Macquarie inflationary pressures are likely to be shared and price increases an industry-wide issue. In this aspect, Greencross has potential margin offsets from growth in private and exclusive brands which currently represent 13% of sales and are higher margin products.

Operating cash flow in FY15 was impacted by one-off costs and working capital issues so Canaccord Genuity is happy with the company's performance and does not have concerns around funding and gearing. The broker believes, given the strong results, that these concerns will subside as investors renew their focus on the outlook.

Strong like-for-like sales growth is expected to feature, despite the challenging conditions emerging in the second half from weather and supply chain issues.Gearing levels will plateau and at 56% in terms of net debt to equity gearing is manageable, in the broker's opinion. Canaccord Genuity has a Buy rating and $9.15 target. 
 

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-Control of vertical market
-Healthy margins
-Expansion opportunities
 

By Eva Brocklehurst

Home furnishings retailer Adairs ((ADH)) is a beneficiary of a housing cycle in an upswing, with fashion and decorator sales now making up half of its turnover. The category is outperforming the rest of the discretionary retail sector in Australia because of the strong number of housing completions.

Having recently listed on ASX, Morgans lauds the company's potential for upgrades to prospectus forecasts with strong growth versus its peers. Complete control of a vertical market is a help, as costs and pricing can be managed, which the broker considers critical in an environment of a falling Australian dollar. Morgans initiates with an Add rating and $3.11 target.

Adairs is a retailer of home furnishings with a national footprint. There are 131 stores in a number of formats and a small, but growing, online presence. Most of the product is private label brands with the company controlling design, manufacture and sales such that it can respond quickly to changes in trends while margins are maximised.

Sales growth has been around 12% per annum from FY12-14. Morgans believes this can easily continue and forecasts 18% sales growth to FY16, underpinned by store rollout and margin expansion. With more money in consumers' pockets because of low interest rates the wealth effect drives confidence, while the housing backdrop means new purchases are required to fill new homes - all upside for Adairs.

UBS is also an enthusiast, noting the company enjoys support from strong household goods spending with opportunities to expand its addressable market. The company expects to lift its store openings to 8-12 per annum over the next five years.

Risks in the near term are the rollout of a new point-of-sale system in the second half of FY16 and the FX impact on costs. UBS, in monitoring the currency sensitivity, notes every US1c fall in the Australian dollar below US75c affects FY16 pro forma earnings by a negative 1.1% without offsetting price rises. Any macro economic slowdown could magnify these risks.

Long term the risks are a maturing of the category while strong sales growth and earnings margins could attract new international entrants. There is a risk of failure in emerging formats and offshore markets but also upside if the company opens more core format stores domestically and in New Zealand or South Africa.

The broker acknowledges the latter two markets are not growing spending on household textiles as fast as overall consumer spending but there is an opportunity for Adairs to exploit, as the homewares "fashion" trend appears to be relatively immature. Moreover, the broker highlights the positives in that both are in the southern hemisphere and other brands have had some success leading the way. UBS initiates on Adairs with a Buy rating and $3.25 target.

Goldman Sachs is more circumspect. While accepting the company is a leading specialty retailer of homewares in a strong market the broker initiates coverage with a Neutral rating on valuation grounds as the stock is trading close to its 12-month target of $2.85, which is based on a 10% price/earnings premium to the small cap industrials ex finance.

Earnings margins over a two-year average are 15.8%, which the broker compares to the domestic retail median of 10.2%. The high margin and vertically integrated model supports high returns, in Goldman's view. The core driver of growth will be the vertically integrated model, design capabilities and online investments, which should enable the company to win market share. Still, Goldman Sachs also cites increased competition as a risk, particularly from international entrants and online.

The broker estimates the company has around 12% share in a relatively fragmented market. Competition, particularly in its Staples business, is price based. Moreover, the barriers to entry are moderately low, Goldman Sachs observes, and a number of large global players have recently opened in Australia. While their impact has been limited to date they may be strong competitors in the future.

The broker also considers the lower Australian dollar to be a material headwind for gross margins in FY16. In order to manage this impact the company takes out forward cover up to 12 months in advance. Goldman Sachs is also not so sure retail spending can continue at its current pace. The broker's economists forecast the current level of housing shortage should persist until 2016 before easing back as interest rates normalise and population growth slows.

While the housing sector has been robust and favourable for household goods over the past two years the broker highlights growth in retail sales and wages is below trend and consumer sentiment is fragile. If housing activity starts to slow this could negatively affect demand for the company's products.

Adairs has several different formats besides its Adairs stores, such as Adairs Homemaker, a larger format with the widest range of bulky goods, Adairs Kids, which targets children's bedroom products, and Urban Home Republic, a home decorator range which is now a store format. Clearance outlets complete the mix. The lease terms for the stores are broadly consistent with specialty retail peers.

The company also has 370,000 members in its paid loyalty program called the Linen Lovers Club. The majority of product is sourced from China but increasingly also from Vietnam, Bangladesh, India, Portugal and Turkey. Adairs is expected to focus its store roll-out in NSW and Queensland where it is relatively underweight compared with the population. The first Adairs store commenced trading in 1918 in Prahran, Victoria, and the footprint was expanded in the 1990s to include all mainland states.
 

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