Strategy: Greg Hoffman Retail opportunities

Online retailers are hot, traditional retailers are not. There may be an opportunity here ...

The arrival of amazon.com in Australia has been making plenty of headlines recently. And shares in kogan.com have doubled over the past 12 months. At today’s price, investors are valuing each $1 of Kogan’s sales at $1 in the sharemarket. By contrast, each $1 of sales registered by “old world” retailer Myer is valued at less than 30¢ by investors.

And earlier this year fashion company OrotonGroup paid $4.5 million for 30% of The Daily Edited, a website that sells embossed and personalised leather goods, stationery and accessories. Oroton was valuing The Daily Edited at almost $15 million, or about as much as its expected total sales for the financial year. In other words, a similar valuation yardstick to Kogan’s.

So what might the sales figures (below) from another Australian online retailer imply for its valuation?

Now what if I told you that investors were recently valuing this business at around $68 million? That might seem reasonable – or even attractive – in the context of the valuations being placed on the likes of Kogan and The Daily Edited. So what’s the name of this mystery online success story?

The figures are from Specialty Fashion Group (ASX: SFH), which owns a number of fashion chains including Millers, Katies, Crossroads, Autograph, City Chic and Rivers. Those mightn’t sound like hot online retail propositions. And their degree of success in selling online varies from 3.9% of total sales for Millers (which targets more mature consumers, like my 75-year-old

mum) up to an impressive 29.4% of total sales for City Chic (bold fashion items for plus-sized women at higher price points).

Throw it all in the mix, though, and Specialty Fashion has a nicely growing online retail operation. And for a valuation of $68 million (at 30¢ a share), today’s investor receives not only the online business but a network of more than 1000 stores. In fact, online sales represented just 10.4% of total sales last financial year.

Now, I am not drawing a straight line between the likes of Specialty Fashion, which has deep roots as a traditional retailer, and Kogan, which has been online-only from the get-go. The former faces many challenges while the latter seems to be in a growth “sweet spot”. But the difference in valuation per dollar of sales serves to highlight a yawning gulf between online retailers that are currently popular with investors and most traditional retailers, which are deeply out of favour.

Such wild distinctions are always worthy of further investigation for investors seeking value. So let’s go back to the start.

The first two Miller’s Retail (as it was then known) stores opened back in March 1993. The chain grew quickly to 147 stores by the time it listed on the ASX in May 1998 and its valuation at listing was about $66 million. Here we are almost 20 years later and the valuation is roughly the same. And that fact highlights both the opportunity and the risk.

You can see in the table below a comparison of a few key statistics from the year of listing with this year. You can see that the company now has more than six times as many stores and almost eight-and-a-half times the total sales. The problem comes when we hit the bottom line.

Despite a far larger top line, the company’s operating profit has almost halved since it first listed. Put in terms of the profit margin, it has fallen from 8.6% to 0.6%. That razor-thin number is probably not sustainable. It needs to increase or the company could fall into the financial danger zone.

The opportunity is for management to improve the profit margin. Specialty Fashion may never see a margin of 8.6% again because the retail landscape has become much more competitive. But at today’s price, investors don’t need a full return to the glory days to do well.

At a 3% profit margin, based on last year’s sales, Specialty Fashion would be making an operating profit of $24 million. At 4% (less than half of 1998’s profit margin), the figure would be $32 million. And numbers of that magnitude could justify a valuation of double the current share price or more.

What chance a turnaround?

So what is the likelihood of the company delivering those kind of profit margins over the next three years? I think it has a decent shot, perhaps 50% or so, with a roughly 30% chance of bumbling along at closer to current meagre levels of profit and perhaps a 20% chance of getting into serious trouble, resulting in nasty or total losses for investors.

A key part of achieving better margins will be improving results from Rivers, the rural-focused clothing and footwear chain that started as a shoe manufacturing business in the mid-1980s. Specialty Fashion acquired it in late 2013 when Rivers was struggling and the purchase price looked cheap. But it turned out to be a case of you get what you pay for.

A three-year turnaround plan was put in place but now, four years on from its acquisition, Rivers is yet to make a meaningful contribution to Specialty Fashion’s bottom line. At the time of acquisition, Rivers had 160 stores and management estimated annual sales at $180 million. The latest store count is 148 and I estimate sales at around $155 million (management doesn’t provide much chain-by-chain information, so I could be off by $10 million or so here). I believe those sales are made at an operating loss.

I think the turnaround potential in Rivers alone is $5 million or more per year. I arrive at that by assuming that Rivers is making an operating loss of $2 million or $3 million at the moment and that management could achieve perhaps a 2% profit margin on $155 million in sales.

It might take a couple more years but, if it were achieved, it would make a nice impact on the bottom line by converting a current seven-figure loss into a profit of the same or greater magnitude. Closing unprofitable stores and warehouses and growing online sales should all help.

The recent strong Aussie dollar should improve margins, too. Most of the products sold by Specialty Fashion come from China and are effectively paid for in US dollars. But I’m not starry-eyed about the situation. Management has said that the current financial year has begun with “challenging trading conditions”.

I consider this a risky turnaround and, as such, have invested less than 2% of the portfolios I manage in the stock. A total wipeout is possible but, if all goes to plan, I’ll be selling out for more than double my entry price in three years.