A Diamond in the Retail Rough? | The Reject Shop (TRS.ASX)

This week we examine the turnaround happening at The Reject Shop (TRS.ASX). We are quite confident that the business will thrive going forward in an environment where consumers become increasingly frugal and look to save money. Under a new management team and with 25% of the current valuation backed by net cash, we believe TRS is an attractive investment for uncertain times. Read more.

The Reject Shop (TRS.ASX) is the largest discount variety store in Australia with 356 stores nationwide. The business was founded thirty years ago and listed on the ASX around ten years ago. In its first five years as a listed company TRS thrived by growing sales and opening stores. At its peak the stock reached $18 a share and had EBIT margins of 6%.

Source: CommSec

Over the ensuing five years and up until recently, TRS lost its identity. They opened unprofitable stores, increased their cost base, tried different strategies under different CEOs, and were close to breaching their debt covenants. Yet, with all these difficulties, TRS maintained sales of about $800m p.a. and underlying profitability. All this is about to change in our view.

At the beginning of 2020 TRS appointed new management in Andre Reich, previously GM at Target and Kmart. Along with newly appointed and ex private equity group CFO Clinton Cahn, the company is embarking on a new strategy that makes sense and is resonating with investors. The strategy mainly includes:
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• Focus on everyday low prices of household consumables like cleaning products, pet food, toiletries, and non-perishable food.
• Reduce stock keeping units (SKUs) from the current 13,000 to around 4,000 over the next 3-5 years.
• Renegotiate store leases on more favourable terms and close unprofitable stores.
• Increase stock turns from 4x closer to an industry leading 6-8x.
• Reduce shrinkage (theft).
• Reduce overheads and manage staff rostering more efficiently.
• Improve warehouse logistics.
• Open stores in regional areas where TRS’s small store format (500-600 sqm) suits and has an advantage over its larger competitors, Kmart and Aldi.

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So far, early traction is encouraging. Like for like (LFL) sales growth in 2H 2020 is showing growth at 5%+ and, in the short term, TRS is a pure beneficiary of the Covid-19 pandemic as shoppers look to both save money and stock up on household essentials during the crisis. TRS has 1m shoppers visit their stores every week.

The company strategy is now very similar to the one current TRS MD, Andre Reich, implemented at Kmart Group during their successful turnaround over the last five years (Kmart’s LFL sales growth was 7%+ 1H20). By reducing the number of SKUs the company can increase economies of scale and reinvest those savings into even lower prices on everyday essentials. In turn, this can drive sales of higher margin general merchandise items such as birthday cards, arts and crafts, etc.

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​In addition, TRS has close to 200 stores coming up for lease renewals over the next 12-18 months. The current retail environment is quite favourable for a retailer wanting to negotiate improved terms and lower rents on their leases. With the recent announcement of Target store closures, we see the timing of lease renewals as very fortunate for TRS (lease liabilities are currently $121m p.a.).

TRS reported flat 1HFY20 revenue of $435m with EBIT of $16m and NPAT of $11m. The balance sheet is borderline bullet proof with $75m in cash following the February equity raise of $25m. We see the company finishing FY20 with a $50m net cash position following favourable working capital movements in 1H. EBIT margins should hit around 2-2.5% this year but should improve over the next few years.

The upside for TRS is quite substantial. Both Kmart and Dollar General (a US-listed comparable business) have shown that a well-run discount chain can reach EBIT margins of 6-7.5%. If TRS can reach even 5% margins and grow LFL sales at 2% p.a. (remember, Kmart is currently growing at 7% p.a.), we believe TRS can make $45m EBIT in three years. In this scenario we see TRS trading at $15 a share. That being said, for now, we value TRS at around $7.00.

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​Disclaimer: TRS is held in the TAMIM Australia All Cap portfolios.