Why I'm backing this beaten-up ASX All Ords share for a big 3-year turnaround

Adairs has suffered a huge drop recently. Here's why I think it's going to rebound in the medium term.

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Key points

  • Sales are starting to decline at Adairs, hurting investor confidence
  • This period looks to me like it’s a cyclical low for the business, but with big rebound potential ahead
  • A recovery for house prices, a growing store network and bigger Adairs stores could boost future profitability

The Adairs Ltd (ASX: ADH) share price suffered a big sell-off last week – it fell around 15% on Friday. It's down 28% from 22 May 2023 and it has dropped 45% from 1 February 2023. The ASX All Ordinaries Index (ASX: XAO) share has been beaten up, but I think this is a great price for a 3-year turnaround.

It's understandable that the business has lost market confidence. The recent trading update showed a significant decline in trading performance in the second half of FY23.

Group sales were down 7% in the FY23 weeks of 27 to 48, and only up by 1.9% for the financial year to date to week 48. These numbers come after the company reported group sales growth of 34.1% in the FY23 first half.

Adairs said that the impact of rising interest rates and higher cost of living has created a "more subdued trading environment since April with lower traffic observed both in-store and online."

There were a couple of positives though. Adairs said that the group gross profit margin in the second half remains "in line with plan" and is expected to be ahead of the FY22 second half, while the group inventory has been "well managed and will finish below December 2022 levels."

Cyclical business

Some ASX All Ords shares are able to generate consistent revenue growth year to year, including names like Coles Group Ltd (ASX: COL), Xero Limited (ASX: XRO) and CSL Limited (ASX: CSL).

However, there are others that might see volatility through the economic cycle such as BHP Group Ltd (ASX: BHP), Woodside Energy Group Ltd (ASX: WDS), Insurance Australia Group Ltd (ASX: IAG) and BlueScope Steel Ltd (ASX: BSL).

Adairs sells homewares and furniture through its Adairs, Mocka and Focus on Furniture brands. Discretionary retailing does seem to go through some lows sometimes, particularly when house prices are falling.

We also saw weakness during 2019, when the Adairs share price dropped around 40% during June 2019 as house prices weakened. By the end of the year, the Adairs share price had risen by more than 80% as the economy and house prices recovered, as we can see on the graph below.

I'm definitely not expecting Adairs to rise 80% over the rest of this year. I think inflation and higher interest rates could stick around for longer than some are expecting.

But, on a 3-year view, I think the operating conditions for the ASX All Ords share (and wider industry) will look a lot better than the uncertainty of today. The Adairs share price could recover much sooner than then as the ASX share market typically moves sooner than the economy's recovery because of its forward-looking nature (like we saw after the COVID-19 crash in 2020).

Cheap valuation

Adairs said that its gross profit margin is expected to be up year over year in the second half. It's expected to make underlying earnings before interest and tax (EBIT) of between $62 million to $65 million in FY23.

I don't know what the FY24 profit numbers are going to look like, but the good inventory position should help maintain its margins.

Assuming conditions are recovering by FY25, I think the current Adairs share price could seem like a really cheap price/earnings (P/E) ratio for what profit it makes in FY25 and FY26.

It has somewhat surprised me how long it has taken for the interest rate rises to start biting into Adairs' sales, yet how rapidly the market has punished the All Ords ASX share.

As a bonus, the future Adairs dividend yield could be very large, assuming the board keep paying a healthy dividend payout ratio.

Long-term business improvement

While short-term sales may seem uncertain, I think the business has a number of improvement plans that can help its future.

That includes a store rollout plan for Focus on Furniture, which is very promising for increasing the company's scale. Even if same-store sales don't grow, total sales can be supported by more stores.

Adairs is also planning to keep upsizing some stores, which are able to make a lot more profit than smaller-sized Adairs stores.

It also has a new distribution centre, which hasn't delivered the expected benefits yet. But, it's working with DHL to lower costs, and this could be helpful for earnings and operational capabilities as teething issues are sorted.

When combining the increased scale of the business and a recovery for the economy, I think the ASX All Ords share is capable of producing total shareholder returns of at least 60% over the next three years when investor (and shopper) confidence returns.

Motley Fool contributor Tristan Harrison has no position in any of the stocks mentioned. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has positions in and has recommended Adairs, CSL, and Xero. The Motley Fool Australia has positions in and has recommended Adairs, Coles Group, and Xero. 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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