The Reject Shop – a reject or a buy?

Founder and Chief Investment Officer of Montgomery Investment Management
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The Reject Shop (TRS) is a discount-variety retailer that has been a standout performer since it listed on the ASX in 2004 and a standout performer for The Montgomery Fund. We know that buying retailers early in their roll out and holding until 80% of the rollout is complete can be a very rewarding investment experience. The shares alone have increased by nearly 800% in less than a decade since listing. Add dividends to the return and you’ve trounced the broader market. As owners of the Reject Shop and as believers that consumer sentiment in Australia is currently improving, it’s worth understanding this business.

As you know, The Montgomery Fund is an investor in businesses rather than a trader of ‘stocks’ and so rather than chat to you about ‘rotation out of defensives into cyclicals’, or some other nonsense, we’d rather highlight two past investments made by The Reject Shop to illustrate their impact on the business and the resultant investment returns.

In order to achieve its (entirely justified) popularity in the market, the company has made critical investments over the years in order to build (and protect) what we believe have been sound competitive advantages.

Capital investments are generally designed to increase the earnings potential of a business, be it through lower costs or increased sales, but they can also be a necessary requirement to protect a company from significant loss.

All about the brand

The Reject Shop has managed to build a successful market position as a result of high brand awareness, which it leveraged with an unrivalled distribution network that is highly automated. In 2009, the company spent a reported $6 million to convert to SAP infrastructure, which integrated its merchandising, finance, management, IT, marketing, logistics and property departments. That’s no small achievement! The investment has allowed the company to critically track its stock, allowing for efficient inventory management, and has also provided the scalability to increase its store count from its current number of 247 to a target of 400 (it’s 61% of the way there).

Sometimes sound allocation of capital also provides the ability to take advantage of unanticipated opportunities too. Business success also comes from a little bit of good fortune and timing. One direct outcome from this investment has been the ability for The Reject Shop to nimbly respond to the recent failure of a rival. Retail Adventures, which sold homewares, apparel, stationery and groceries under the Sam’s Warehouse, Go-Lo, Chickenfeed and Crazy Clarke’s stores, went into voluntary administration in October 2012. By November, management at The Reject Shop announced an increase to their store rollout projections to 20 openings in the second half of FY2013, after reportedly being able to secure some of the former sites that Retail Adventures occupied. The benefits from large fixed investments are maximized when the business can scale its operations, as greater margins will flow through to the bottom line with any additional turnover.

Emergency response

Fixed investment can also be required to protect the underlying earnings of the business. The Reject Shop has a distribution centre in Ipswich, which was significantly damaged in the Queensland floods of January 2011. The base level of the centre was under several metres of water, resulting in a considerable loss of stock and damage to equipment. The loss of stock loss was covered by insurance, but the company has struggled to claim lost earnings. While the Ipswich distribution centre was out of operation for nine months, its remaining distribution centre in Melbourne had to carry the shortfall, resulting in higher costs and lower sales. The single DC was ill-equipped to handle the number of stores and its geographical location meant that filling stores with stock was incredibly expensive.

In response to this dramatic event, management prudently determined that a Flood Mitigation Plan was required. Part of the plan was the erection of a Flood Barrier System at a cost of $1.45 million, which would physically protect the site in the event of flooding. Unfortunately, two years on, the state was flooded again, though this time management was prepared to respond. While some stores in Ipswich did close due to localized flooding, there was no damage to the distribution centre, though road and rail closures will temporarily impact stock delivery.

Look at the returns

We prefer to invest in companies that require minimal capital expenditure to maintain and grow earnings. And short-term set backs, that are treated by the market as permanent, provide an opportunity to buy great businesses cheaply. The key consideration for any investment, however, is the ability to generate sufficient returns. The Reject Shop is a prime example of a quality business that is enjoying superior returns on owners equity as a result of prudent investments made in the past. As long as any additional capital investments can preserve (or enhance) its high return on equity, we are quite happy with our investment in the business.

As an investor, you should be seeking companies that generate high rates of return on equity, with little or no debt, and have the ability to maintain those high returns as the companies equity base grows. Essentially, we are after big equity and big returns on equity. Thus far, The Reject Shop is playing our song.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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