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Why you should avoid Adairs Ltd shares

The Adairs Ltd (ASX: ADH) share price slumped to all-time lows on Wednesday as investors lose faith in Australia’s leading manchester retailer.

Following two profit downgrades this year, Adairs’ closing price of 0.58 cents on Wednesday represents a staggering 76% decline from its issue price of $2.40 in June last year. Accordingly, with the stock trading at a hefty discount from just over a year ago, I thought it was time to take a closer look.

Here’s what I found.

About Adairs

Adairs began operations in 1981 as a speciality retailer of home furnishings comprising bedroom manchester, bathroom linen and kitchen homewares products. The group operates through five distinct retail formats in Adairs, Adairs Homemaker, Adairs Kids, Urban Home Republic and an online retail platform under its namesake brand.

All told, the group forms Australia’s leading vertically integrated retailer of specialty home products with a footprint of over 130 stores across Australia.

In June 2016, Adairs listed on the ASX at $2.40 per share after private equity firm Catalyst Investment Manager and existing investors sold down their stake in the business. Although Adairs’ share price climbed in the months following its listing, unfortunately for existing investors, it’s all been downhill since November last year.

Company fundamentals

Despite two recent profit downgrades, I’ll be the first to admit that Adairs’ shares look very enticing on a fundamental basis at current prices.

In its second revised profit downgrade reported as part of Adairs’ half-year results in February, management expects Adairs’ full-year sales to be in the range of $255 – $265 million. Whilst this reflects a like-for-like sales decline of up to 3%, management believes that its first-half profit margin of 59.3% can be maintained for the full-year. This is a sign of good cost control given stagnant consumer sentiment.

Although net profit after tax is expected to be materially lower on prior year figures as a result of lower same-store-sales, management’s intention to open new stores and growth in Adairs’ online platform should offset some decline to earnings by organically growing total sales (in absolute terms).

Accordingly, based on Wednesday’s close of 0.58 cents, Adairs’ shares currently trade on a forecast price-earnings of 4.5x to 5.3x (if revised guidance is maintained). This makes them very cheap in my opinion, especially when compared to sector peers Temple & Webster Group Ltd (ASX: TPW) and Myer Holdings Ltd (ASX: MYR).

Growth prospects

Nevertheless, I believe that’s where the good news ends for Adairs.

Although the company currently trades on a trailing fully-franked yield of 12%, I do not believe management will be able to maintain its current dividend payout going forward.

This is because Adairs is likely to be heavily impacted by the arrival of Amazon to Australia, given most of its products can be bought online without the need to visit a store. Accordingly, I’d expect sales growth and profit margins to decline over the medium-term as Amazon (and other retailers) fight it out to win market-share in the low-cost, high-margin sector of homewares retailing.

Furthermore, given Adairs’ current strategy to combat sales decline is to open new stores and re-invest in product expansion, I believe this exercise is likely to have an adverse impact on its debt levels. This could limit free cash flow in future periods, meaning the dividend may be at risk of being scrapped altogether if these initiatives don’t yield immediate returns.

As such, even at the discounted share price, I think investors buying Adairs today are stepping on to a sinking ship.

Foolish takeaway

My analysis of Adairs could turn out to be completely wrong and customers may, in fact, continue to purchase Adairs’ products in-store instead of online. If this happens, Adairs’ shares look screamingly cheap.

However, given the risks involved with its business model and the fact that fellow retail stocks like Automotive Holdings Group Ltd (ASX: AHG) and Retail Food Group Limited (ASX: RFG) offer similar value propositions without as much risk, albeit at slightly more expensive multiples, I’d prefer to buy the latter over Adairs’ shares.

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Motley Fool contributor Rachit Dudhwala has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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