Unraveled Linens: Adairs Share Price in A Tailspin

Adairs Limited (ASX:ADH) is Australia’s largest omni-channel retailer specialising in home furniture, furnishings and decoration products. The Adairs Group features three vertically integrated brands – Adairs, Mocka and Focus on Furniture.

The roller coaster journey of specialty retail stocks over the past three years is no secret. Adairs, too, has witnessed a descending trajectory in its stock price since April 2021. However, with the recent trading update on 02/06/23, the share price plummeted precipitously, seemingly plunging off a metaphorical precipice.

Nevertheless, as I have consistently emphasized, the price of a stock does not invariably align with its intrinsic value. The true potential lies in procuring a stock at a mere $0.50 when its actual worth stands at $1, allowing for the possibility of exponential wealth accumulation.

Thus, the question lingers: Has the fabric of Adairs’ linens genuinely begun to unravel, or does this present a case of unwarranted pessimism overshadowing the true essence?

Reflecting on Adairs: Insights and Impressions

The initial half of the financial year 2022 witnessed a robust surge in Adairs’ business momentum. It was during the August 2022 FY22 results presentation that the market received forward guidance from the company.

	FY23 Guidance
Group Sales ($m)	625 – 665
Group EBIT ($m)	75 – 85
Capital Investment ($m)	12 – 15

This guidance coincided with the gradual rise of interest rates in May 2022. At that time, the extent of the rate increase was unforeseeable. Merely a year prior, the Reserve Bank of Australia’s governor had indicated that interest rates were not anticipated to increase until 2024. That is assuming all things remained as they were.

However, as we now know, circumstances did not remain unchanged, and we find ourselves amidst the swiftest surge in interest rates.

The recent trading update has thrown Adairs “investors” into a state of turmoil, as shares experienced an 18% decline within a single hour of trading. The outcomes appear to have been met with dissatisfaction by many.

	Updated FY23 Guidance	Previous Guidance
Group Sales ($m)	616 – 622	625 – 665
Group EBIT ($m)	62 – 65	75 – 85
Capital Investment ($m)	12 – 13	12 – 15

Given the recent economic developments, I personally harbored modest expectations for the second half of numerous retailers, and Adairs was no exception. Yet, does this justify the market’s reaction witnessed today?

Will Adairs Threads Hold?

There is widespread concern surrounding inflation in the global economy, which is generating negative sentiment regarding consumer spending. The uncertain trajectory of rate hikes has led many individuals to prudently accumulate savings as a precautionary measure.

It is foreseeable that discretionary spending will adopt a cautious approach. This reamins true until there is clarity on the duration of interest rate increases. Retrospectively, during the pandemic, Australians bolstered their rainy day funds by 50%.

As the pandemic prompted shifts in Australians’ spending habits, the reopening of the economy witnessed a resurgence of expenditure from accumulated savings. However, this occurred before the impact of interest rate increases began to strain household incomes.

I expect to experience softer spending in the near-term in the retail space. But also confident that Australian’s will begin to loosen wallets when economic impacts become more certain.

With Adairs Linen Lovers boasting a total of 1 million paid-up members in FY22 (up 32% for 3 years prior), I expect sales growth to increase with the upgrade of total gross lettable area of upsized stores.

Shifting focus to the performance of Mocka, the investment in this brand has left Adairs cautiously vigilant. The business performance of Mocka has been undeniably disappointing. Despite the acquisition cost of $85 million, the brand has failed to meet the expected value.

If Mocka fails to regain substantial growth in terms of top line revenue and profitability, you can expect a write-down of goodwill. Such an event would undoubtedly impact the earnings per share.

We can expect the execution of Adairs growth strategy to be put under scrunity during these tough times.

Adair’s Valuation

Discounting the accelerated growth in Adairs top line revenue during the pandemic, they have on average grown revenue at 15% for 7 years. Net margin on average has been 10% and gross margins of between 57-60%.

The Group Sales guidance reflects a decline of approximately 6%, while the Group EBIT guidance shows a significant decrease of around 23%. Although these figures may not be remarkable, the company has managed to achieve a year-on-year top line sales growth of 9% and maintain a flat Group EBIT growth.

Considering Adairs’ average company tax rate of 30%, it can be estimated that the net profit for the group falls within the range of $44 million. This compares to the FY22 net profit of $44.8 million, indicating a relatively positive outlook for Adairs’ future.

PE Valuation

Using the PE Valuation method we can estimate a value for Adairs. A 10% revenue growth has been applied in line with Adair’s FY23 forward guidance of $616-622 million. I expect growth in 2024 to be in line with the inflation and pick back up after 2025.

With an earnings per share of $0.53 and an assumed PE of 12, we derive a fair value for Adairs to be $3.61.

This share price is not far-fetched if you consider the market capitalisation of $618 million. Back in 2021 during the peak of sales growth during the pandemic, Adairs had a market capitalisation of nearly $700 million.

If the market assigns a higher PE ratio to this stock, you get an additional boost with earnings growth. With a PE of 15, the share price will be $4.51. The specialty retail industry has a weighted average PE of 20.96.

Discounted Cash Flow

Based on the consistent nature of Adairs’ business, certain educated assumptions can be made regarding their margins. The FY23 guidance provided by the company indicates an anticipated revenue of $620 million, EBIT of $63 million, and Capex of $12 million.

By incorporating these figures into the FY23 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 $3.50 for Adairs.

Interestingly, this estimate closely aligns with the projected fair value derived from the PE Valuation Method, amounting to $3.61.

Key Takeaways

• Inflationary pressure are likely to impact retail sales in the short to mid term. This will result in subdued sales growth in Adairs.
• Adairs have a proven track record of consistent growth in revenues over the last 10 years. I expect these to continue once consumers have adapted recent economic developments
• Based on conservative assumptions, Adairs appears to be trading at a discount to its fair value of $3.50

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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.