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Why this struggling retailer could turn out to be the best dividend payer in the sector

Don’t feel like you missed the boat following the 58% surge in the share price of Specialty Fashion Group Ltd. (ASX: SFH) this week. The stock has more room to run, according to Citigroup which upgraded the stock to a “buy” from “hold”.

The embattled women’s apparel retailer excited the market after it announced the sale of all of its brands except for the City Chic business to Noni B Limited (ASX: NBL) for $31 million in cash.

The news sent Speciality Fashion’s share price soaring to 60 cents yesterday from Friday’s close of 38 cents. The stock is holding on to its gains today and Citigroup thinks there is another 25% upside to the stock before it reaches fair value.

Investors would normally be more excited about the bidder given that’s where the growth typically tends to be, but the transaction is arguably more of a godsend to the target, which has been wondering the wilderness since 2013 when it acquired Rivers.

Management thought it was buying a bargain (as did I), but it turned out to be more than what management could chew and the share price started trending down since.

Selling most of its assets gives Specialty Fashion a chance to hit the reset button and may even help the retailer to return to its dividend paying glory days (the last time it paid a dividend was in 2014)!

Citigroup has turned bullish on Specialty Fashion largely because City Chic is on a better footing than most of the other brands the retailer is offloading to Noni B.

City Chic, which sells plus size women’s fashion, is growing sales at a high single digit rate and margins for that business is expanding with management tipping earnings before interest, tax, depreciation and amortisation (EBITDA) of $19 million to $20 million for the current financial year.

The rest of the brands that Specialty Fashion is selling (including Rivers) would have sucked out $31 million from the group’s EBITDA line. Not only can Specialty Fashion be rid of these underperforming assets, it can pocket a cool $31 million in the process.

“City Chic has 116 stores and sales of $140 million. The brand derives 37% of sales from online and has an expanding international wholesale business, primarily in the US,” said Citigroup.

“We expect modest domestic store growth, but continued expansion in online sales and offshore distribution for the brand.”

Specialty Fashion is expected to be in a net cash positive position once the transaction is finalised and should generate a respectable EBITDA margin of around 14%, based on the broker’s estimates.

“Assuming a similar EBITDA contribution for City Chic going forward, the business would generate free cash flow of $8-10 million per annum, providing the opportunity for a dividend of ~3 cents at a 70% payout ratio,” added Citigroup. “The company has over $45 million, or 23-cents per share in franking credits as well.”

This means the stock could be sitting on a yield of over 7% once franking is included. The only question is when will management feel confident enough to restart its dividend payout.

Women’s apparel is a tough space to be in, but as Premier Investments Limited (ASX: PMV) and Noni B has shown, a good operator can make decent returns despite the structural headwinds.

Specialty Fashion will really need to prove itself in the coming months.

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Motley Fool contributor BrenLau has no position in any of the stocks mentioned. The Motley Fool Australia owns shares of and has recommended Premier Investments Limited. 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 Scott Phillips.

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