The management of Specialty Fashion Group Ltd. (ASX: SFH) has put their credibility on the line this year as it struggles to bed down its acquisition of the Rivers chain.
The apparel retailer provided a mixed trading update today as it reported better-than-expected performance across the group's other brands but said that the turnaround of Rivers was taking longer than expected.
What this means is that Rivers will struggle to deliver the $180 million in annualised sales that the chain was reported as generating when Specialty Fashion bought the business for a song.
The question is whether Rivers has turned out to be a classical "value trap", with chief executive Gary Perlstein admitting that righting the struggling retailer is taking longer than expected and with Rivers dragging heavily on group margins.
Anyone who bought a mining services stock in the past six months will know the allure of what appears to be a bargain. The question is whether Perlstein has miscalculated the risk of the $3.9 million acquisition – a price that was deemed so below fair value that the group had to recognize a $4.6 million profit on the deal last year.
But based on Specialty Fashion's guidance, earnings before interest, tax, depreciation and amortisation (EBITDA) margin for the six months to end December 2014 is expected to collapse by over 300 basis points (three percentage points) to 5.1%, no thanks to Rivers.
There are two main reasons why Specialty Fashion's price hasn't taken a turn for the worse today. In fact, the shares are up 2.1% at 72.5 cents in afternoon trade.
The first reason is the better-than-expected performance of the group's existing labels, particularly Millers.
If anything, profit margins (excluding Rivers) are actually rising due to good cost control, while same store sales (sales at stores opened a year or longer) are up a respectable 5.7%. That's very encouraging given how tired its key brand Millers was looking before the recent transformation program.
If Perlstein can reverse the fortunes of low-end women's apparel store Millers, surely he can work similar magic on Rivers. Both brands share a lot of similarities and synergies.
The other reason is the decline in margins was expected as management had already flagged an aggressive discounting at Rivers to clear unwanted inventory that was ordered by the previous owners of the business.
If the first half of 2014-15 marks the trough for Rivers before the brand catches up to the rest of the group in the current half, then the stock is a screaming buy.
This is why I wrote that the group's results next month is so important – not for the profit figure itself but for the outlook on Rivers.
Perhaps a better way to interpret the outlook for the group won't be in management's comments but its declared dividend. Given how fragile consumer confidence is, and the big turnaround task at hand for the group, management may be reluctant to say much in the way of an outlook.
But if management keeps dividends steady (it paid 4 cents a share in 2013-14) and isn't cutting back on capital expenditure for store rollouts and refurbishments, it will say that the first half underperformance is only a short-term issue.
Specialty Fashion is forecasting a 27.4% increase in group sales to $413 million but a fall in EBITDA to between $21 million and $23 million for the first half. The group posted an EBITDA of $26.6 million, excluding profit from the Rivers takeover.
Perlstein's credibility is on the line as he's chosen high-stakes poker with the Rivers deal. Let's hope he's holding a good hand given Specialty Fashion's shares have tumbled 18.5% over the past 12-months.
