Boxing Day Sale On Reitmans, Why This Undervalued Retailer Can Soar

| About: Reitmans (Canada) (RTMAF)
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Boxing Day is the equivalent of Black Friday in Canada. While many Canadians went out shopping for the cheapest deals, there are also plenty of inexpensive stocks in Canada for investors to add to their portfolios for 2014. Reitmans (OTCPK:RTMAF), a large women's apparel retailer in Canada, is on sale right now because of several missteps in the past two years. I believe these missteps were near-term problems and the company's stock is a good value pick for 2014.

Short Introduction:

Reitmans is one of the largest women's apparel retailer in Canada with 895 stores as of November,2013. The company also has several partnerships that expand the distribution its merchandise. The company's strategy is to provide quality merchandise and exceptional service to its customers. Although there are many competitors in Canada in this space, I believe Reitmans's strategy of providing stellar service along with quality merchandise allows the company to retain a core group of customers. The breadth of the company's products, especially merchandise for plus size apparels, gives the company a competitive advantage.

Reitmans operate under 6 Banners:

  • Reitmans is the company's main banner, which consists of 355 stores selling various merchandise to satisfy women's needs. According to the company, it is the largest women's apparel chain in Canada.
  • Smart Set consists of 138 stores with a focus on the needs of young women including wear-to-work separates, denims, essentials and accessories.
  • RW & CO consists of 77 stores catered towards urban fashion
  • Thyme Maternity consists of 71 stores catered towards moms-to-be and offer a complete line of nursing fashions and accessories.
  • Penningtons is the company's banner for plus-size apparels for women (sizes 14-32). There are 151 Penningtons stores in Canada.
  • Addition Elle is also catered towards plus-size women with a focus on the latest fashions and "must-have" items. There are 103 Addition Elle stores in Canada.

Reitmans also has several partnerships:

  • The company built numerous in-store boutiques (shop-in-shop) in Baby "R" Us stores. As of November,2013, Reitmans has 21 of these boutiques in Canada and 166 in the US. Despite closing many of its own stores, Reitmans is expanding these boutique shops aggressively in Baby "R" Us's stores because the boutiques offer an efficient method to distribute its merchandise at lower cost.
  • The company has partnered with EziBuy, a New Zealand retailer. EziBuy will offer Reitmans's Addition Elle merchandise in New Zealand.
  • The company signed an agreement with Sears to sell its Penningtons plus size apparel in five Sears stores in Canada as well as online at sears.ca

Below are some historical financial ratios. Readers can see there has been a large decrease in profitability after Q2/13, attributable to a major operational issue in June,2012.

Table 1: Selected Financial Ratios

Source: Reitmans Investor Site. The financial ratios are calculated based on financials in the company's quarterly and annual reports found on the site.

Why The Share Price is Low:

I believe the decline in the share price was caused by two factors: (1) The forced exit of income investors after the company's dividend cut (2) Pessimism regarding the company's turnaround.

After it announced its third quarter results for fiscal 2014 on December 2, management decided to cut the quarterly dividend by 75% from $0.20 per quarter to $0.05 per quarter, reflecting a reduction of the annual dividend from $0.80 per year to $0.20 per year. This move was aimed to conserve cash to further facilitate the company's restructuring efforts. The decision was widely anticipated as its dividend yield was north of 10% before the 75% cut. However, the price decline during the past 3 month was exacerbated by income investors selling their shares in anticipation of a dividend cut. Reitmans attracted many dividend investors given it offered a 5% yield (average for the past 5 years) and has been paying dividends for the last 62 years. One of the biggest investors was ETFs like the iShares Dow Jones Canadian Dividend ETF (OTC:ISDJF) which held over 1.3 million shares at the end of 2012. As of December 24, the ETF's holdings in the company was approximately 800,000 shares. Given the ETF's requirement for a high dividend yield and dividend growth, the ETF will sell its remaining shares in the future because Reitmans no longer has a high dividend yield and its dividend growth rate is negative due to the cut. However, the share price has already discounted this in my view as many other income investors sold in anticipation of a dividend cut and forced exists by large investors. Reitmans's investors wanted to get out before many large holders, like the iShares ETF, are forced to sell its holding because they are mandated to hold companies with positive dividend growth.

Many investors are also getting impatient with the company's restructuring efforts to improve its operations. A new warehouse system upgrade in June,2012 turned sour and caused a major disruption to its inventory flow. The company estimated that $7-15 million of pre-tax earnings (approximately $0.11-$0.23 on a per share basis) was lost due to this outage. After the company fixed the problems, the retail landscape in Canada grew more competitive with new retailers entering the market like Target (NYSE:TGT). More competition has resulted in lower gross margins. Gross margins has declined from 65% of sales four quarters ago to 61% in the latest quarter.

Why The Share Price will Rebound (The Catalysts):

I believed its shares will rebound due to: (1) The completion of selling by the income investors (2) Reversion of its current low valuation and poor operational performance

As explained in the section above, I believe many income investors have already abandoned the stock and value investors, such as Fairfax Financial, are absorbing some of the selling given the stock is now trading near its book value. The stock also bottomed at near book value back in 2009 and has increased over 150% after its low in 2009. Although history may not repeat itself, the current valuation is very low compared to its history. To quote Mark Twain: "History doesn't repeat itself but it does rhyme".

With the shares trading at book value, expectations for the company are extremely low. It is easy to point at the company's operational mishaps in the last two years, but investors should not forget that the company is still a leader in women's apparel in Canada and has a few niche areas such as plus size apparels. The company is also nearing the competition of its technology system upgrade which will increase efficiencies and lower costs. Unlike the flawed warehouse management system upgrade, the technology platform upgrade is on track to be completed in fiscal 2015 (calendar year 2014). Thus, the increased efficiencies will lower costs to partially offset the lower gross margins. The company is also looking at cutting administrative expenses. Administrative expenses was about 4.8% of revenue in the past 4 quarter. A cut towards 4.5% of revenue can save over $3 million in pre-tax income (approximately $0.05 per share). The company has responded quickly to close underperforming stores (from over 950 to 895) and same-store-sales has started to show improvement in the latest quarter (see graph 1 below). Hence, various operational improvements and downsizing will significantly improve the company's financial performance.

Graph 1: Changes in Same-Store-Sales (Year-over-year)

Two Important Announcements that Support the Bullish Thesis:

On December 16, the company announced it intends to purchase up to 4 million non-voting class A or 10% of the class A shares outstanding in the next 12 months. Compared to the past share repurchase programs, this one is 2 times larger, which shows management considers the stock price to be attractive at current levels. The company has a dual class share structure where class A shares have no voting rights while the common class has voting powers. The founding Reitmans family and management owns 57% of the common share class and 7% of the non-voting class A shares. In total, management owns 17% of the shares outstanding.

This announcement provides a very positive signaling effect. Table 2 provides history of the company's share buyback program in the past 5 years. The company spent considerable amount of money repurchasing shares. However, not a single share was repurchased under last year's announced program. Management clearly knew the share price may be much lower in the future and decided to wait. Now the share price is 40% lower than last year, they significantly increased the authorization of the share repurchase program despite its cash levels are below historical levels. This announcements provides two signals regarding its future: (1) the current cash burn is likely to slow and will be cash flow positive very soon (2) the share price is attractive at current levels. Given management has better insights regarding the underlying business, the 60% increase in the share repurchase authorization is bullish for the stock price.

Table 2: Past Share Repurchases

Time Frame Dec2009-2010 Dec2010-2011 Dec2011-2012 Dec2012-2013 Dec2013-2014
Maximum Announced Repurchase Amount (1) 2,728,972 2,638,115 2,557,895 2,557,275 4,000,000
Number of Shares Repurchased (2) 1,583,000 1,445,000 1,000,000 0 ?
(2)/(1) 58.0% 54.8% 39.1% 0.0% ?

Source: Reitmans Investor Site

Another positive announcement was regarding Fairfax Financial (OTCPK:FRFHF) adding to its Reitmans position. According to INK Research, Fairfax bought 2 million non-voting class A shares at an average cost of $6.35 bring its total holdings of the class A shares to 13.8% (approximately 7.06 million shares). Canadian disclosure requirements are different than the US and it allowed Fairfax to hide its stake until it went above the 10% mark, which is much higher than the 5% requirement in the US. Given Fairfax's latest purchases at $6.35 triggered the mandatory disclosure requirement, Fairfax may put additional pressure on management regarding the restructuring process as noted by the Globe & Mail. Fairfax previously restructured a furniture company called "The Brick" and formulated a merger with Leon's Furniture years later.

With management and Fairfax both bullish regarding the company's prospects, the share price is likely to advance from current prices.

Valuation Methods:

Although the discounted cash flow method (NYSE:DCF) is preferred by many investors, it may be difficult to estimate the important drivers given the restructuring process. Also, intrinsic values calculated under DCF are extremely sensitive to the key inputs as noted by Bruce Greenwald. Therefore, I prefer to value Reitmans using the average earnings power approach originally championed by Ben Graham and modernized by Greenwald.

Average Earnings Power Method to Calculate Intrinsic Value:

This method of valuation is favored by Ben Graham, the father of value investing who inspired many investors including Prem Watsa of Fairfax. This method essentially capitalizes an average earnings figure at an appropriate cost of capital to arrive at an estimated intrinsic value. Readers should take note that the earnings figure capitalized is an average earnings figure, representing the profits the company can earn in a typical year, which excludes one-time items and the effects of economic tops and troughs.

Table 3: Financial Forecasts to calculate Earnings Power value

Item Forecast for An Average Year
Sales $1,020,000,000
Cost of Sales (377,400,000)
Gross Profit 642,600,000
Less: Selling and Distribution Expense (540,600,000)
Less: Admin Expenses (40,800,000)
Operating Profit 61,200,000
Add: Net Financing Income 3,600,000
Earnings Before Tax 64,800,000
Less: Income Tax Expense (16,848,000)
Net Income $47,952,000

The forecasted net income for an average year in the future of $47.952 million is close to fiscal 2012's earnings. Fiscal 2012's result was before the warehouse management software fiasco and is representative of the company's normalized earnings power. Taking into account the share repurchases, the forecasted average earnings figure of $47.952 million equates to $0.82 per share. Given a cost of capital of approximately 9% for Reitmans, capitalizing the per share earnings of $0.82 equates to a value of $9.11 per share, which is 32% higher than the current share price of $6.90. Readers should take note that there is no growth assumed in this calculation. Adding a small growth component would result in a share price north of $10. However, given the retail landscape is very competitive in Canada, I am cautious to add a growth component to my earnings power value calculated. However, any addition growth realized will be icing on the cake, adding to the 32% upside.

Balance Sheet Method to Evaluate Downside:

I use the balance sheet's equity value to evaluate my potential downside. Reitmans's balance sheet does not need major adjustments to arrive at a net asset value (NYSE:NAV). Therefore, the NAV is very close to the company's book value of $6.80. Making negative adjustments for possible inventory write-downs, I see a good floor around $6.30, which is very close to the $6.35 purchase price by Fairfax and imply a possible 10% downside.

Therefore with a possible 32% upside an 10% downside, the reward-to-risk ratio of 3.2 is attractive especially when the stock is trading near book. Its average historical price to book ratio was above 2.

Conclusion:

After a 25% gain for the S&P500 in 2013, many stocks are trading north of 2 times book value. Nonetheless, an unloved stock like Reitmans is still trading at book value. As Oaktree's Howard Marks famously noted: "The most important thing is the relationship between price and value". With Reitmans' stock price low in relation to its value, it is an interesting value pick for 2014 and the catalysts mentioned in this article should propel the stock 32%. In addition, investors are paid with a 2.9% dividend while they wait for the stock to rebound.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article is for informational purposes only and does not constitute an offer to buy or sell any securities discussed in the article. The stock mentioned in this article does not represent financial advice. The target price presented in this article is based on current information and are subject to change without further notice. Investors are recommended to conduct further due diligence before committing capital to any investment.