Adairs Hangs On By A Thread: 2023 Moment Of Truth

On the morning of August 21st, a notable downturn struck Adairs’ share price following the release of their earnings report. In the span since my previous update a few months ago, Adairs’ stock seemed to have made a partial recovery. Regrettably, the recent earnings disclosure didn’t manage to garner favor among investors.

Unfortunately, certain events lie beyond the control of most enterprises. The macroeconomic landscape stands as one such fluid phenomenon, ceaselessly evolving. The company’s adeptness in navigating these circumstances serves as my basis for appraisal.

To paraphrase the wise words of Howard Marks, “If a piece of knowledge, while intriguing, remains elusive, it’s best left unpondered.” Nonetheless, prudence dictates preparing for the enigmatic scenarios ahead. Attempting to prophesy macro occurrences amounts to a futile pursuit, given that certainties evade even the keenest insights.

In the context of the majority of non-essential retailers, the existing environment of heightened inflation doesn’t stand as their closest ally. Considering the financial strain faced by the Australian populace due to escalating costs across vital necessities, it’s hardly astonishing that many have scaled back on expenditures.

Commonwealth Bank of Australia, which concurrently unveiled its earnings report, brought to light that those below the age of 45 bore the brunt of this impact. This demographic bracket typically constitutes the primary customer base for these retail entities.

An auspicious outlook for the immediate future doesn’t appear to be on the horizon. Anticipating that sales will continue to languish due to elevated inflation seems to be a reasonable projection.

Nonetheless, it would be judicious to appraise a business not solely on macro factors, but rather on the strategies the business intends to pursue henceforth.

Adairs Faces Higher Costs

Considering the overarching trends in macroeconomic activity, Adairs results were not surprising. Admittedly, the reported figures didn’t paint an overly positive picture. Yet they didn’t plunge into unfavorable territory either. Consequently, the stock price experiencing a nearly 15% drop in a single trading day may be unduly pessimistic.

Adairs, akin to its retail counterparts, grapples with the escalating costs of conducting business. The tandem surge in inflation coupled with the turbulence in supply chains amid the pandemic hasn’t done any favors either.

While the company has indicated that supply chain hindrances have been resolved, the reverberations of heightened expenses will persist as they navigate through their existing inventory.

On a more encouraging note, the resolution of the supply chain woes is poised to yield positive effects from 2024. This implies that costs are likely to be lower compared to the fiscal year 2023 reporting cycle.

Furthermore, there was a notable 36.7% increase in third-party warehousing costs. This amounted to $30.4 million in FY23, in contrast to $22.3 million in FY22. The chief rationale behind this surge is the dissatisfaction stemming from the National Distribution Centre (NDC) arrangement with DHL, which failed to meet performance expectations.

In response, Adairs has invoked their prerogative to assume control of the NDC, a transition set for September 6th, 2023. This transition entails Adairs’ investment of $20 million in capital expenditure. Though it might be disappointing, the board of directors’ decision to forgo a final dividend appears astute, given the expected financial outlay by Adairs.

Being entrenched in a fiercely competitive industry, even slight fluctuations can have significant implications on bottom-line margins. Considering the ongoing state of the economy and external factors beyond their influence, Adairs results held their ground fairly well.

Adairs Looks To The Future

In the world of business, there’s a saying that goes, “You can’t trim your way to expansion.” In simpler terms, slashing costs and cutting back on spending won’t necessarily make a business grow. When delving into Adairs’ annual report, it’s evident that Adairs doesn’t have any intention of following that path.

Adairs appears to be quite resolute and purposeful about fostering growth in their operations. To start, their decision to assume control over the NDC (National Distribution Centre) carries significant promise. Leveraging their warehousing expertise, the company aims to realize cost savings of $4 million within the first year alone.

What’s more encouraging is that this endeavor is expected to produce increasingly improved cost savings yearly. Ultimately recouping the initial investment within a span of four years. With this in mind, I’m inclined to support Adairs retaining their final dividend, considering that the capital can potentially generate a favorable internal return.

As Australia emerged from the pandemic there was yet again a shift in consumer habits. A substantial number of customers gravitated back to physical stores instead of exclusively shopping online. Focus On Furniture, along with Adairs as an omni-channel retailer, managed to maintain robust sales performance.

Adairs

Adairs experienced a modest 2.9% increase in revenue. Despite the broader uncertainties within the macroeconomic landscape, Adairs has ambitious blueprints to expand the size of their stores. The growth in physical store space has been identified as a pivotal catalyst for increased sales volume, a trend they intend to capitalize on.

Focus on Furniture

Focus on Furniture enjoyed a remarkable 73% surge in revenue with a first full year contribution. Likewise, their plans to refurbish Focus on Furniture stores, with a proven track record of boosting sales, also bodes well for growth.

Mocka

On the other hand, Mocka, functioning as a dedicated online retailer, faced a disappointing sales decrease of 24%. Recognizing the low brand awareness of Mocka, the company is determined to address this challenge, and even mulls the prospect of establishing a brick-and-mortar Mocka store in the future.

It’s indeed heartening to witness Adairs’ unflinching commitment to making strategic investments even during times of uncertainty.

Adair’s Valuation

The earnings result from Adairs Limited is not complete without a valuation. Taking higher inflation and interest rates into consideration, a higher discount rate is to be expected.

In the short term, we can expect margins to be slightly lower that previous years, but once consumers start spending again, we can expect these margins to have significant improvement.

Considering Adairs have remained profitable the last decade, we can expect management to maintain some semblance of profitability through these tough times.

PE Valuation

This share price is not far-fetched if you consider the market capitalisation of $580 million. Back in 2021 during the peak of sales growth during the pandemic, Adairs had a market capitalisation of nearly $700 million.

Discounted Cash Flow

Despite macro economic uncertainties, certain educated assumptions can be made regarding Adairs margins. The company has proven itself to manage capital appropriately and also maintain a profitable business economics.

By incorporating our assumptions into data cells, we can generate forecasts for the forthcoming years. However, it is important to note, that discounted cash flow models are inherently imperfect. This is due to the likelihood of assumptions being more wrong than accurate.

Therefore, it is crucial to avoid overly optimistic or excessively conservative assumptions. When presented with the same dataset, two individuals are likely to arrive at divergent conclusions regarding fair values.

Nevertheless, employing the unlevered discounted cash flow model has yielded a fair value estimate of $4.84 for Adairs.

While this estimate does not align with the projected fair value derived from the PE Valuation Method, you have a sense of a rough valuation.

Reverse DCF

As far as I know, making predictions is quite impossible, since no one can accurately foresee the future. Despite their imperfections, using PE Valuations and DCFs can be a useful exercise. Going through this process can help you ponder about what a business requires.

Another approach you might consider is the reverse DCF. This method aims to gauge whether the stock is priced accurately by working the other way around. It begins with the current share price and calculates what conditions need to be met for the valuation to hold true.

At the time of writing, Adairs’ share price stands at $1.44. For this valuation to be justified, the revenue would have to decrease by 50% over 10 years while keeping profit margins steady. Alternatively, the business would need to be in a state of unprofitability for 5 years.

Personally, the scenarios listed seem quite improbable to me, which is why I believe that Adairs is currently undervalued.

Key Takeaways

• Adairs results, aligned with macroeconomic trends, weren’t shocking. Though figures weren’t overly positive, they avoided significant decline.
• In business, the adage “You can’t cut your way to expansion” holds true. Adairs annual report reveals their determination to foster growth. Despite challenges, Adairs unwavering investment commitment is commendable.
• Despite uncertainties, Adairs’ past profitability hints at resilience. Current valuation of Adairs hints a side of caution despite it being undervalued.

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*Disclaimer – Incognito Wealth currently holds shares in the companies mentioned in this post. This material should be used for research and entertainment purposes only. Incognito Wealth in no way shape or form intends this blog post as financial advice. Please consult your own professional financial adviser or accountant for investment decisions.