One Special stock on our radar

Specialty Fashion Group (ASX: SFH) is a retailer focused on the value conscious female market. At 70 cents, Specialty is one falling knife that must be getting close to hitting the ground.

a woman

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Specialty Fashion Group (ASX: SFH) is a retailer focused on the value conscious female market. It has six brand concepts, including Millers and Katies, each focusing on a separate age group. While you or your partner may not shop at one of Specialty's stores, one in three Australian adults are members of their loyalty programs.

At 70 cents, Specialty is one falling knife that must be getting close to hitting the ground. The stock is trading on low multiples of less than 3x EBITDA and 0.2 of sales. A trailing price to earnings of under 8 and an 11% trailing dividend completes the picture of a disliked company in beaten down sector.

Earnings are due on Friday 20th August, at which point we'll get a clearer picture. However, Specialty's pre-announcement shows low growth in revenue and a continuing deterioration in margins. Full year revenue was $574 million, a 0.3% increase year on year, with same store sales flat in the second half after falling in the first half. They expect EBITDA for the full year will be $40 – 41 million, a 33% drop year on year.

That's the bad news. The good news is that looks to be fully priced in. Accounting for the falling EBITDA, Specialty will still trade for under 3x EV/EBITDA, after earnings are announced.

After proclaiming the death of retail, some people may be surprised to see a retailer on my radar. The short answer is I love window shopping, especially during a 50% off sale.

I have a number of retailers on my watchlist, ranging from high return on equity companies, like The Reject Shop (ASX:TRS), OrotonGroup (ASX:ORL) and Nick Scali  (ASX:NCK), through to falling knives like Specialty.

Can Specialty Fashion Group Turnaround?

Specialty is making the right moves to steady the ship and execute a turnaround. It has a pristine balance sheet, is earning better than 30% returns on capital, and in better times, it posted steady operating margins and tight cash conversion cycles.

Despite fighting against the toughest consumer market in memory, Specialty has paid off $34m in debt since 2009 and now sits on $17m in cash and an undrawn credit line for $100m. That is despite weakened sales, opening 65 new stores, and refurbishing 53 more. That's impressive cash management, which points to a strong franchise.

The company boasts 5.8m members of their various loyalty programs, and is still in the process of optimising their management of the data they gather through the plans. Loyalty customers make up 77% of the company's sales, and by refining marketing pitches and special offerings, Specialty should be able to increase sales and profitability.

ASX:SFH long term price and ratio chart Source: Capital IQ – Click Image to Enlarge

3 Value Catalysts

Going forward, there are a few things that could provide a catalyst for the company (apart from the obvious – recovery of Australian consumers). The first is last year's licensing agreement with Limited Brands to sell La Senza lingerie in Australia and New Zealand. The ten year deal should be a growth driver, and if it goes well it is likely Limited will use Specialty as their gateway to Australia for Victoria's Secret.

The second is the company's efforts to both streamline its supply chain and optimise its customer relationship management, a strategy that has propelled Zara to the top of the fashion world. While Specialty isn't fast fashion like Zara, controlling the total logistics chain from design, to direct sourcing and on to the consumer should provide efficiencies and reactivity.

A third catalyst is the opening of the company's City Chic online store in the US. This line is targeted at the fashion-forward plus sized ladies between 18 and 30. This could provide a decent growth avenue for the company, especially given the current consumer issues in Australia (not that I'm expecting much better from US consumers, but it is still a big potential market).

There are, however, a couple hurdles in the near-term. The biggest is shrinking margins due to the inflationary pressures from cotton prices and wages in China. In an industry that has seen price deprecation for the past decade and is facing a customer group that is looking to reduce its debt levels, retailers will have some challenges passing price increases on.

Foolish Bottom Line

Current headwinds have beaten down the stock to 0.2x sales, which is very attractive. With a strong balance sheet Specialty will weather this storm. Growth initiatives and an expansionary approach should bear fruit when shoppers return. Management has a strong plan and are clearly focused on the future. Multiple catalysts exist, including rolling out new exciting brands, logistics optimisation delivering improved margins, and the rollout of online stores.

If management successfully executes a turnaround, investors will be well rewarded. Growing earnings combined with improving sentiment is the secret sauce to share price growth on steroids.

Specialty Fashion Group is on our radar, but we're happy to remain as spectators until after they report results.

This article contains general investment advice only (under AFSL 400691).

Dean Morel is The Motley Fool's Investment Analyst. Dean has no position in Specialty Fashion Group or any other Australian retailer at this time, despite being sorely tempted by a couple bargains last week. The Motley Fool's purpose is to educate, amuse and enrich investors. BusinessDay readers can click here to request a new free Motley Fool report titled Read This Before The Market Crashes.

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