Is Reject Shop Ltd set for further decline?

What: Analysts at the Commonwealth Bank have cut Reject Shop Ltd (ASX:TRS) to “underweight” from “neutral” with a price target of $8.70, down from $10. The shares currently trade at $9.08. Concerns about weakening per-store metrics, management uncertainty, problematic inventory and the ability of the balance sheet to withstand any more weak trading periods were the key drivers for the downgrade.

So what?: The Reject Shop’s share price has been punished over the past 12 months, falling from a high of $18.47 as investors questioned the company’s future growth prospects. The continued deterioration in profitability per store has raised questions over the viability of The Reject Shop’s aggressive store rollout plan. With falling profitability per store, it is likely that the newly appointed management team will significantly scale back the company’s aspiration for 500 stores and instead focus on network optimisation. One analyst has suggested that the future store count could be cut to as low as 321, down 36%.

Now what?: Future earnings growth is highly dependent on The Reject Shop’s ability to increase margins to previous high levels. In 2012, the company produced a 5% EBIT margin. However, in recent times margins have fallen to as low as 3% as the business struggles to get the right product mix. If margins return to levels seen in 2012, allowing for the continued aggressive store rollout, then the share price will increase significantly. However, if the business continues to see depressed margins, there is further downside. Until I see significant margin improvement, I will be watching from the sidelines.

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Motley Fool contributor Bradley Murphy does not own shares in any company mentioned in this article.

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