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Date : 19/07/2023

Adairs

ASX :

ADH

Market Cap : $284.66 Million

Dividend Per Share : $0.18

Dividend Yield : 10.84 %

Buy

52 Week Range : $1.300 - $2.970

Share Price : $1.66

A high dividend stock that also offers good growth prospects. At current levels, we recommend a 'Buy'

Company Analysis

Adairs (ASX: ADH) is one of Australia’s largest omnichannel specialty retailers of home furnishings, home furniture and home decoration products with three vertically integrated brands – Adairs, Mocka and Focus on Furniture (Focus).

The Adairs share price has been subject to a high degree of investor pessimism. Shares have tumbled ~27% this year as interest rate hikes have sapped sentiment around retail stocks. Adairs’ recent trading update contained earnings downgrades as reduced demand for discretionary retail products has had its say. Additionally, the company encountered operational headwinds, which are now subsiding.

On the back of this sell-off, we think ADH shares are prime for long-term investors. We think they hold deep value and have considerably high dividend payouts. Adairs is a high-quality brand in ANZ, and once the cycle eventually turns, investor sentiment should follow. To put things into perspective, ADH is now trading at just 7.1x FY23 P/E and 6x FY25 P/E, less than the 10-year historical Price/Forward EPS average of 10.6x.


Source: Tradingview.com

Revised Guidance for FY23 is now Priced-in

Customers faced with the rising cost of living and higher interest rates are spending less. Last month, the company warned that there had been a slowdown in sales in the third quarter, which will affect its full-year performance. The company announced that they have been seeing less traffic in-store and online since April, and this resulted in the following downgrades:

  • Sales revised from $625 – $665 million range to $616 – $622 million,
  • EBIT revised from $70 – $80 million to $62 – $65 million, and
  • Capex reduced from $12 – $15 million to $12 – $13 million.

Adairs’ sales fell 3.4% from the previous year over weeks 27 to 48. Year-to-date sales growth is 5.2%, measured from weeks 1 to 48.

Focus on Furniture was down 10.9% on the previous year’s sales for weeks 27 to 48. Its year-to-date sales are still in growth territory: up 5.4% from the previous year.

Sales for online furniture shop Mocka slumped 23.8% since April compared to the previous year, but the division hadn’t been performing as strongly – its year-to-date sales growth is down 25.5% from the previous year.

Overall, group sales are down 7% from the previous year’s week 27 to 48. Year to date, group sales were down 1.9%, that is, weeks 1 to 48.

The company had said earlier that the online-only homewares business was normalising as shoppers returned to its bricks and mortar stores.

It is worth noting that despite the downgrade, ADH is on track to beat the record $564.5 million achieved in 2022. Adairs also said that gross margins for 2H FY23 are expected to be ahead of 2H FY22, and group inventory has been well managed and will finish below December 2022 levels.

Gross Margins show this is a good Business

Adairs is more of a brick-and-mortar retailer than an online retailer. The company only really began pushing for an online presence when the pandemic hit. As we moved past the pandemic, store sales quickly rebounded, and online sales growth slumped. This indicates that there is still quite a bit of e-commerce infrastructure for Adairs to set up, which will enable them to reach more consumers and grow its top line.

As of 1H23, online made up just 26% of Adairs sales, 25% of Mocka sales, and just 6% of furniture for future sales. However, despite the high fixed costs related to brick & mortar retail, Adairs has a robust gross profit margin of 58%. The margins were also temporarily impacted by 350 basis points compared to pcp by elevated import costs and domestic store distribution rates, which are now declining.

According to IBIS World, the average gross profit margin for homewares discretionary retailers in Australia is 43.1%. Adairs’ numbers eclipse the average as they are able to leverage their brand and sell high-margin products. In the long term, this is a highly desirable characteristic to have. As Adairs increases its online presence and once we start to see a higher contribution from the online channel, the gross margins will improve further as product costs reduce.

When we break down the group’s businesses and look at their gross margins, Adairs has a higher margin of 61.5%, and Focus with 51.4%. However, Mocka has witnessed a steady decline in gross margin from 53% in 1H21 to 47.7% in 1H23 as a result of extensive clearance activities of discontinued ranges in Q1, higher delivery costs as a result of a change in Australian domestic delivery partners and higher inbound shipping costs.

The Mocka acquisition has still not delivered everything that Adairs hoped for. The challenging operating conditions of the past 12 months did not help either. Now, margin performance in Q2 and into early 2H FY23 has significantly improved and reflects an improving product mix. Management is focusing on stabilising the operating platform, restoring customer confidence, growing GM% and reducing the range width and depth is progressing. The work done to date, combined with materially lower inbound shipping costs, is improving the delivered gross margin, which will aid future profitability.

The underperformance following an acquisition is nothing new. Businesses typically take time to integrate, especially when it is a different vertical, albeit a complementary one. As retail sector operating conditions improve in the following years, we think it will make it easier for the management to better integrate Mocka into the Adairs Group, as originally intended.

This Retail cycle is all about Inventory Management

The bullwhip effect is a supply chain phenomenon describing how small fluctuations in demand at the retail level can cause progressively larger fluctuations in demand at the wholesale, distributor, manufacturer, and raw material supplier levels.

If it seems like there are now more sales than ever, it is simply because retailers are holding on to more inventory than before. They have too much stuff, and it has been the talk on many earnings calls, not just here on the ASX but globally.

Inventory levels have increased significantly from 2020 to 2022 across the entire sector. Historically, several retailers have been pretty good at keeping just a bit more inventory than sales. It is a good balance of keeping enough stock on hand not to have bare shelves but not wasting money to store too much extra inventory. And then, of course, Covid happened. But after a year of supply chain issues, the economy began recovering, and inventories returned slightly to normal.

With the rising demand, retailers placed more orders with the wholesalers, who then placed more orders with the manufacturers, who then placed more orders with their suppliers. The further down the line this chain went, the larger the demand. By the time the products could be passed back down the line and fill the racks at the stores, the demand was not there. Now, retailers have to take on more inventory costs or sell products quickly at marked-down prices. Both of these can weigh on profit margins in the short term.

Identifying stocks by looking at their inventory management is a good way to pick the retail stocks in the current environment. They will recover their margins and profitability quicker than their peers. On the ASX, JB Hi-Fi has been one of the best at managing inventory, but Adairs is not too far behind.

Adairs’ Sales to Inventory ratio chart shows the bullwhip effect. We can quite clearly see how inventory declined in FY20 and then shot up in the following two years. With inventory being managed well, we can now expect the ratio to begin moderating. The FY23 full-year result should show evidence of this.

In fact, Inventory across all three brands closed in line with business expectations. Mocka reduced its previously elevated inventory holdings by ~20% over 1H FY23, with excess and underperforming inventory being cleared. Supply chain volatility has reduced; however, the group has retained inventory buffers to manage the risk of unforeseen interruptions. The majority of Adairs’ inventory across all brands is in core category lines with lower fashion/seasonal risk. Group inventory levels are also expected to continue reducing through 2H FY23.

Cross-Selling Growth Opportunity

Currently, Focus makes up for 24% of group revenues. Only 6% of Focus sales are derived from the online channel. There is an opportunity here to leverage Adairs’ expertise to deliver growth. The same goes for Mocka. Mocka makes up for just 8% of group revenues, and online sales makeup ~25% of total revenues. Therefore, these opportunities are fairly substantial.

On the brick-and-mortar front, Adairs already has a substantial national footprint with 172 stores. The group is also constantly increasing its floor space and adding to its store network. In 1H23, Adairs brand store floorspace increased +2.4% with 2 new stores, 4 stores upsized, and 2 stores closed. A further 2-4 new stores are expected to be opened in 2H FY23.

Focus has 23 large stores with a store size of 1,500-2,000 square metres each. These large spaces will enable Adairs to cross-sell while maintaining its unique branding. The group has also been vocal about its strategy to increase Adairs and Focus stores. Adairs also has low capex, $6.7 million as of 1H23. Given the acquisitions, cross-selling opportunities, and store footprint, we expect the capex to remain low in subsequent years. We think with complementary brands, the opportunity to cross-sell is significant and one that Adairs will definitely take advantage of – benefitting the top line from additional sales and the bottom line from synergies and reduced costs.


Source: ADH, Focus Store Sizes

A High Dividend Play this Reporting Season and Beyond

Adairs paid a fully franked interim dividend of $0.08 a share in 1H22, unchanged from the previous corresponding period. The EPS did increase during the first half, and the dividend payout ratio was a healthy 63%.

Cash flow improved through the half, with stronger sales and offshore supply chains stabilising, leading to improved stock turns. Group net debt fell by $12.2 million over the half to close at $81.0 million. The group has total finance facilities of $135 million available until January 2025 ($45 million) and January 2026 ($90 million) with substantial covenant headroom.

As such, we think Adairs will keep its dividend policy unchanged for the full year FY23. Following the revised guidance, market consensus has priced ADH to deliver an EPS of $0.234 a share in FY23. Considering Adairs maintains their ~60% payout ratio, as they have done so in the past, this will mean a full-year dividend of $0.06, bringing full-year dividends to $0.1404, at an implied annual yield of ~8.5% at current prices.

Extrapolating for FY24 based on market consensus forecasts, ADH is expected to deliver an EPS of $0.197 and full-year dividends of $0.13 (65% payout ratio). At current prices, this represents a forward yield of ~8% for FY24. These are very healthy dividends, particularly for a stock that has a challenging operating environment priced in for the next year.

How does Adairs rank Relatively?

ADH has underperformed, and we have already discussed why. Currently, based on the consensus earnings estimates we just discussed, ADH is trading at very low forward multiples:

  • FY23: P/E of 7.1x, EV/EBIT of 8.4x
  • FY24: P/E of 8.2x, EV/EBIT of 9.6x
  • FY25: P/E of 6.4x, EV/EBIT of 7.7x

What do these numbers tell us? The trend in multiples rising in FY24 and then declining a year later to lower than FY23 multiples suggest that the market expects Adairs’ sales and earnings to weaken in FY24. The broader retail industry is facing a number of well-publicised macroeconomic headwinds that mean the medium-term outlook is less certain. The multiples closely reflect the market consensus for economic growth, and the expectation is that FY25 will be the year when the economy returns to the growth phase following the easing of macroeconomic headwinds such as high-interest rates and inflation returning to RBA’s target range.

Adairs has built a reputable brand, and we think it is in a good position to navigate the short and medium-term challenges. A more challenging retail environment also provides opportunities for category-leading companies such as Adairs to strengthen their market positioning through execution excellence. We think the integration of Focus and Mocka into the group will improve, and there will be added synergies, as we discussed earlier.

All three businesses are already vertical retail models with in-house design, exclusive and differentiated products, healthy levels of innovation in the product department, supply chain control, and good pricing power that has been demonstrated with high-margin discretionary retail products. Optimal integration and execution can therefore bring substantial synergies to the Adairs Group.

The national distribution network (NDC) that Adairs established has also not transpired as originally intended. This has impacted customer experiences and resulted in significantly higher costs of operations, including additional temporary warehousing. However, since the interim result, productivity at the NDC has improved, delivering better cost and customer outcomes. The new pricing agreement with DHL, which applies from January 2023, will see average variable costs per unit despatched reduced by approximately 20% over 1H FY23 levels. The execution here is starting to improve – again, suggesting that things are looking bright for Adairs.

Considering the growth opportunities ahead and the improving operations, we think Adairs represents excellent value at the above trading multiples. In the past 5-years, ADH shares have, on average, traded with a forward P/E of 9.5x and have gone as high as 16x at the height of the covid rebound in 2020. The current multiple of 7.1x is ~32% lower than the average. Retail stocks are cyclical and, in our opinion, entering positions so far away from the average in a quality company is a bargain.


Source: S&P Capital IQ

Adairs is also trading at much lower multiples on a relative basis. Comparing ADH to its 4 homewares peers, on a rolling 12-month basis, it is the cheapest of the bunch:

  • JB Hi-Fi (ASX: JBH) – 11.3x
  • Baby Bunting (ASX: BBN) – 16.1x
  • Temple & Webster (ASX: TPW) – 90.3x
  • Nick Scali (ASX: NCK) – 9.4x
  • Adairs (ASX: ADH) – 7.1x

While the news flow out of Adairs regarding the operational challenges and earnings downgrades have warranted price drops, the operating environment is improving, and we think Adairs at these prices represent a good opportunity. Given the low multiple, we can also expect the market to turn back in favour of Adairs once the cycle changes and retail stocks are once again back in consideration. However, waiting until then may result in losing the opportunity.

Recommendation

Amidst a challenging operating environment for retailers, Adairs encountered operational headwinds and slowing demand – leading to earnings downgrades. During this period, there has been no love loss between investors and ADH shares. Adairs’ operations have improved since then, and the slowing demand is an industry-wide phenomenon that is now well-priced into earnings estimates.

Despite the earnings downgrades, Adairs’ dividends have remained elevated at a payout ratio of ~60% – well within what the company can afford. Consensus indicates that ADH trades with an implied dividend yield of over 8% for FY23 and FY24.

Looking ahead towards the recovery, we see Adairs being able to integrate its Focus and Mocka businesses – which will enable cross-selling opportunities and a better online marketplace that will help the company’s top-line and bottom-line with higher sales and lower cost of doing business.

Despite these handsome dividends and growth opportunities, ADH shares are trading cheaper than its peers. The current FY23 P/E of 7.1x is ~32% off the average that ADH shares are usually available at. We think this is a fantastic opportunity for long-term investors to gain exposure and hold the stock in their portfolios for the next 3-5 years. As such, we recommend a ‘Buy.

 

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