Adairs sheets home the blame for its poor HY23 result

If you needed more convincing that Australia’s retailers are doing it tough, take a look at the HY23 result from manchester and homewares retailer Adairs (ASX: ADH). ‘Weak’, ‘disappointing’, ‘a miss’. That’s how various commentators described the result. But with the share price already in the doldrums, and the company paying an attractive dividend, the market seemed none too concerned.

While group sales were up 34 per cent to $324.2 million revenue – beating consensus estimates by around five per cent – net profit after tax (NPAT) came in approximately 10 per cent below consensus estimates. In-store sales were up 65 per cent thanks to the prior corresponding period (Jul-Dec 21) being impacted by lockdowns. Online sales were down 10 per cent, for the same reason.

The company’s cost of doing business (CODB) was higher for the core brand, while sales at pure-play online furniture and homewares retailer, Mocka, declined in the first half, with slowing sales continuing in the current half.

Adairs missed analyst EBIT estimates by as much as 20 per cent, with the company citing issues with its new distribution centre relationship with the operator, DHL. The hit to the CODB from warehousing-related costs was about $5 million. Group EBIT was up eight per cent to $35.5 million but missed analyst expectations due to the additional $5 million in distribution centre costs. Excluding these ‘one-off’ DC costs, the company would have beaten consensus group EBIT estimate by 2 per cent.

Net debt of $81 million sits at one-and-a-quarter times EBITDA, which is higher than many analysts had expected. The aforementioned weaker cash conversion can possibly be blamed. Operating cash flow (post-lease payments) was $34.3 million, well down on estimates.

Meanwhile, gross margins were softer at Adairs and Mocka, missing analyst estimates due to higher freight costs and “clearance” activity early in the year’s first half.

Sales for the Adairs brand were up 13 per cent year-on-year and delivery-impacted gross margins were 57.5 per cent – well below expectations. EBIT was just $18.7 million and the EBIT margin was 8.5 per cent. Adairs’s Focus on Furniture business (Focus) enjoyed a better-than-expected half with sales up 20 per cent to $78.6 million. The company noted disciplined pricing and improved product availability, which shortened lead times.

Sales at Mocka were down 27 per cent (much worse than analysts expected) and EBIT was just $300,000 for the first half. Again, this can probably be attributed to post-COVID reopening and lower consequent online consumption, as well as discounting to clear stock.

For history buffs, Mocka was purchased by Adairs in December 2019, for between $85-$91 million in cash and shares. About $43.4 million in cash and $5.7 million in escrowed Adairs shares were paid upfront. The remainder represented deferred payments based on Mocka’s earnings over the subsequent three years. According to Adair’s CEO the acquisition would differentiate Adairs’s product range, boost New Zealand sales, and accelerate Adairs’s online sales growth.

Like Adairs, Mocka designs and develops products in-house, enabling it to market value-for-money differentiated products and give “significant control of the vertical supply chain and in-market pricing” according to the CEO, at the time.

Back to Adairs, group revenue and margins during the first seven weeks of the second half are tracking ahead of estimates, the latter thanks in part to a cost-out programme. Growth at Focus has continued in the first seven weeks of 2H23 and is up 14 per cent. Sales at Adairs in the first seven weeks are up 3.1 per cent. Conditions at Mocka, however, continue to suffer, with sales down 31.7 per cent.

Meanwhile, a new pricing agreement with DHL should result in a 20 per cent reduction (compared to the first half) in the variable cost of units dispatched through the distribution centre. The company has also noted productivity at the distribution centre has “improved” in recent weeks. And thanks to an absence of the discounting seen in Q1, gross margins have improved.

Without a catalyst, and with the jury still out regarding interest rates and inflation’s impact on consumption, one could reasonably expect the shares to underperform. The counterargument is that the shares fell almost 20 per cent going into the result announcement, so a relief rally is also possible, especially considering how illiquid the stock is.