Undervalued stock of the week: The Reject Shop

April 24, 2014, 11:41 am John Abernethy Yahoo7

The discount retailer has seen its share price plummet by 48 per cent this year, a massive fall by any standards but especially given its context.

Company: The Reject Shop (TRS)

Price: $10.04

Forecast future value: $11.59

Potential upside: 15.4%

Value investing is all about spotting opportunities for buying undervalued shares that have great potential. One of the most common causes for shares to become undervalued is when, for sometimes inexplicable reasons, the market over-reacts to some disappointing news and ditches stock in a wave of panic-struck selling.

There is hardly a better example of this phenomenon today than The Reject Shop, and I have been busily buying the shares at what I believe is a big discount to its true value.

This discount retailer, which has 309 stores around the country, has seen its share price plummet by 48% this year, a massive fall by any standards but especially given its context. It announced in its results in February that profits were down by 15.9%, but this was largely due to the cost of opening new stores throughout the year and a poor Christmas trading period.

Excluding the cost of 33 new stores, underlying profits increased 1.6% to $19.4 million and profit margins across the group were not nearly as badly hit as people seem to have interpreted. Earnings were also hit by expansion into more upmarket products which has narrowed its profit margin a little.

While the group intends to open a further 12 stores this year, its rapid expansion and investment in store openings has been somewhat forced upon it by the demise of a competitor. This gave TRS the opportunity to accelerate its growth plans but this rapid expansion added costs to the business ahead of increased sales and profits. In that sense, it was a year of opportunity and transition; future years should not be impacted by this “one off” scale of expenditure.

However, as TRS is priced off its earnings power, the key question it must answer is around future profitability. Half year profits of $17.5 million implies profit per store of $55,000, substantially below the 5 year average of $94,000. But we expect that, in time, TRS’s profits per share can normalise towards this five year average due to scale benefits, a less onerous store expansion program, more cost effective marketing strategies, as well as other internal efficiencies.

Remember, too, that it has recently seen the departure of its CEO and the exit of CBA as a major investor – both events have added to the downwards pressure on its share price.

History suggests, however, that management has been good at extracting a healthy return on its investments and we think it will return to doing the same thing in the coming couple of years.

At the current price, we believe TRS presents a buying opportunity for investors to add to a well- diversified portfolio, especially as the economy picks up more broadly.

Disclosure: Clime Investment Management Ltd recently disclosed a 6.4% holding in TRS shares.

++Fair or forecast value is the price placed on the share after calculating a range of factors including profitability, assets, debt and, most importantly, Return on Equity – the same measure used by Warren Buffett to assess long-term value.

Shares are assessed by Clime Asset Management to calculate which companies are undervalued or over-valued based on their return on equity. History has shown that the most successful companies are those that produce the highest returns per dollar of shareholders' equity, yet this is not typically how shares are valued. This system highlights shares that are undervalued on this key measure. Shares are expected to reach this value in 3-5 years, as price tends to follow value in time.

Information is intended as a guide only. For specific advice contact your financial services professional.

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