Baby Bunting Group: Margin expectations reset and fundamentals intact
About the author:
- Author name:
- By Alexander Mees
- Job title:
- Co-Head of Research and Senior Analyst
- Date posted:
- 14 October 2022, 7:00 AM
- Sectors Covered:
- Gaming and Retail
- The 230 bps fall in Q1 gross margins reported at the AGM was a surprise. Some of the elements of margin decline are likely to alleviate as FY23 progresses, but we expect ongoing pressure from FX and the maintenance of entry level pricing.
- Our NPAT forecast falls by 19% in FY23 and 13% in FY24 as we pull back our gross margin assumptions.
- Shares are down nearly 30% since the AGM, which we see as an overreaction and a buying opportunity.
We have updated our model following Baby Bunting Group’s (ASX:BBN) AGM trading update.
Some (but not all) elements of the Q1 margin pressure are transitory. The key question arising from the surprising 230 bps decline in Q1 FY23 gross margins reported at the AGM was the extent to which the margin pressure will or will not alleviate as the year goes on.
Certain elements of the Q1 decline look likely to improve over the rest of FY23, including international freight rates, loyalty program redemptions and the domestic diesel levy surcharge. Counteracting this, however, we expect to see margin pressures from FX increase as hedging mechanisms reset.
The effect of the broader use of Every Day Low Pricing (EDLP) structures is likely to persist, although there are signs competitor pricing is starting to rise in certain categories, which will allow BBN to follow.
Why sell at entry level pricing? Another key question to arise was why BBN, the leading specialist baby goods retailer in Australia, feels compelled to price a significant proportion of its product range at EDLP entry levels. To answer this, we need to consider the nature of the products that now sit in EDLP.
They are primarily the high ticket, low frequency purchases such as prams, carriers and cots that expectant parents have the time and the motivation to shop around for, transacting where they see the best value. BBN cannot, in our view, afford to be ‘out of the money’ on these products.
By remaining price competitive, BBN should be able to grow volume as it builds market share, which will give it an opportunity to negotiate better COGS prices from its suppliers in due course.
We are disappointed, perhaps, that BBN’s extensive portfolio of exclusive and private label items does not appear to allow it to command a more consistent premium on pricing – at least, not yet – but the overall strategy of maintaining competitive pricing structures does make sense to us.
A stepped, partial recovery in margins expected as FY23 progresses. BBN has said it is confident in getting gross margins back up to FY22 levels (38.6%) by Q4 FY23.
If this happens, it is likely to be a stepped progression from the 37.2% reported in Q1 FY23 rather than an immediate snapback. We’re taking a more cautious approach, forecasting BBN to recover to around 38.0% by Q4, leading to a FY23 estimate of 37.4%.
We forecast 38.0% for FY24, which, for context, is 300 bps higher than the pre-COVID year of FY19, a consequence of improving operational efficiencies, especially around logistics, and a greater proportion of private label products in the sales mix.
Forecast and valuation update
We have lowered our post-AASB 16 NPAT forecast for FY23 from $32.3m to $26.2m (down 19%). Our FY24 forecast declines 13% to $30.9m. Our target price drops from (login to view).
The expectedly sharp decline in Q1 margins was an unwelcome surprise, coming just two months after BBN expressed an ambition to hold or increase its gross margins in FY23. Some of the pressures on the margin are transitory, but it is now clear that holding margins steady on a full year basis is unlikely.
With the shares nearly 30% lower than they were before the AGM, there has, in our view, been an overreaction to the update. BBN is still the largest specialist in a comparatively defensive retail segment.
It still has compelling opportunities to grow its share of a growing market through store rollout, entry into New Zealand, range expansion and the launch of an online marketplace. It’s trading on 12x FY24 P/E. ADD.
Further unexpected margin surprises or a failure to achieve sales growth.
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