Adairs: Not time to throw in the towel

About the author:

Alexander Mees
Author name:
By Alexander Mees
Job title:
Co-Head of Research and Senior Analyst
Date posted:
25 January 2022, 10:30 AM
Sectors Covered:
Gaming and Retail

  • We have reduced our EBIT estimate for FY22 by 9% following today’s 1H22 trading update that indicated additional costs, notably around the distribution centre, had impacted margins more than we had expected. 1H22 EBIT is now expected to be in the range $32-33m, 8-10% below our previous estimate.
  • The FY23F P/E of 7.6x and dividend yield of 8.7% are attractive enough for us to retain an ADD rating, but with a reduced target price of (login to view).
  • We expect investors will want to see the full 1H22 results and Adairs' (ASX:ADH) trading performance in the first few weeks of 2H22 before rushing in, but we believe there could now be a potentially compelling value opportunity.

Event

Adairs' (ASX:ADH) 1H22 trading update disappointed on operating margins. The company now expects 1H22 EBIT to be in the range $32-33m (pre-AASB 16), which is 8-10% below our previous estimate of $35.7m (pre-AASB 16).

1H22 sales of $242m were 4% higher than our previous estimate of $232m, suggesting to us that the disappointment at the EBIT line was about cost and gross margins and not about an unexpected shortfall in post-lockdown revenue.

Analysis

EBIT in the first half will be down significantly from the $60.2m exceptional result of 1H21. In itself, this is not a surprise given the effect of extended lockdowns in ADH’s two largest markets of NSW and Victoria, but the quantum of the decline was more than forecast.

ADH called out a $14-18m impact on EBIT from the lockdowns, which is broadly as we had expected. What we hadn’t factored in was the cost of running a legacy distribution centre in parallel with the new national distribution centre (NDC), which became operational during 1H22.

The effect of COVID-related illness and isolation on staffing availability meant ADH found it necessary to continue running one of its legacy DCs to ensure stock availability. This was achieved, but at the expense of elevated operating costs.

We expect this duplication of costs to be gradually removed over the course of 2H22, but the lingering effect will, in our opinion, weigh on earnings in that period too.

Other pressures on operating costs in 1H22 includes lower rent rebates, although we expect ADH to focus on negotiations with its landlords in 2H22 and may extract some gains there. The lack of JobKeeper benefits in 1H22 also had an effect.

We think it is important not to overlook a resilient topline performance in 1H22. Sales were flat yoy at $242m with positive group level LFLs of +2.7%, or +30.5% against 1H20. Store LFLs were (3.4)%, which was better than expected, although this was offset slightly by a softer Adairs online growth rate of +1.6%.

It appears online sales fell away post-lockdown more than we’d thought, perhaps exacerbated by the delivery issues surrounding ecommerce at Christmas time and the timing of revenue recognition.

Forecast and valuation update

We have lowered our EPS estimate for the current year by 10% to 32.2c. Our EBIT estimate falls by 9% to $85.9m post-AASB 16 ($81.9m pre-AASB 16).

Our price target, which is based on DCF and EV/EBIT valuation methodologies, falls (login to view) due to our lower earnings estimates and reduced peer company multiples.

Investment view

Today’s trading update was a disappointment and has led us to lower expectations for full year earnings. The share price reaction to the statement was, however, greater than we had thought appropriate.

The FY23F P/E of 7.6x with a dividend yield of 8.7% are attractive enough for us to retain an ADD rating.

Price catalysts

The full 1H22 results will be released on 21 February. The trading performance over the first few weeks of 2H22 will be of particular interest.

Group LFLs in the first 7 weeks of 2H21 were +5.2%.

Risks

Further margin pressures; an expected decline in consumer demand; failure to achieve the growth plan for Focus on Furniture.

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Solid top-line outcome: BAP’s 1Q22 revenue was flat on the pcp, an extremely resilient result given the extent of lockdowns in the period (~70% of stores impacted) and the strength of the pcp (cycling 27% growth). Composition comprised: Trade +2%; NZ -10%; Retail -12%; and Specialist Wholesale +7%. Overall, BAP stated that non-lockdown areas are outperforming expectations. ▪ 1Q22 trade & retail: Trade/Burson revenue was up +2% on the pcp (LFL sales - 1%; cycling 8% pcp); NZ/BNT revenue was down -10% (LFL sales -15%; cycling +4%); and Retail/Autobarn revenue was down -12% (LFL sales -16%; cycling +36%). Within the Retail segment, online sales were +80% on the pcp. Stores percentages impacted by lockdown were: Trade 70%; NZ 100%; and Retail 50%. ▪ Specialist segment results: Specialist wholesale revenue is up 7% on pcp, with Auto electrical/Truckline divisions ‘performing strongly’; and WANO underperforming. ▪ GM pressure expected to be temporary: BAP stated GM was stable across Wholesale and NZ (45% of FY21 revenue); and down ~50bps Trade and Retail (~55% of FY21 revenue), driven by promotional and online pricing in lockdown areas (we assume no margin pressure witnessed in non-lockdown areas). BAP expect margins to revert once lockdowns ease. ▪ The cost base has increased vs pcp, a function of duplicated DC costs (commencement of new VIC DC), and higher group and team member support (covid related) costs. BAP noted FY22 store rollouts and refurbs are on track.

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