In this thread I explain why today I have, belatedly, exited my remaining position in $ADH. It is a long-winded thread, but I know that some here are interested in the selling decision process. It is also helpful more for my own purposes to diarise it.

I’ve said before that I am a reluctant seller – particularly of profitable companies – partly because our inclination to sell is often when it is least in our long-term interests to do so. We’ve discussed elsewhere how the selling process is so important, and this is an example of mine at work.

I came very close to exiting after 1H results. In fact I have reduce my exposure to $ADH through the year with my SM trades more or less matching my RL decisions. I summarised the factors weighing in my analysis in my straw after the SM meeting on 21 April, this year, when the SP was hanging around $2.22. (I won’t rehash the arguments, you can read them yourself if interested.) My range of valuations at the time were wide, from $2.00-$4.00, with an expected value around $2.75 (versus a market consensus at the time of ($2.40-$2.72-$3.10)). So, I agreed with the analysts, and my wider range can be reconciled when you understand the analysts range is a range of expected values and NOT a range of scenarios. (Big difference!) I felt my decsion to hold was rational.

Several smarter StrawPeople baled out between that time and when the Trading update came in June. But I stuck to my guns, only to see the SP collapse to $1.35. Having missed the boat, I decided that was definitely now a DUMB time to sell, with my view of value shifting to the lower end of my range as a result of the Trading Update, but still well above the new SP by 70%+.

Roll forward to 1-August for the NDC update. The market took this in its stride, but on digesting it, I don’t feel the thesis was intact. (Finally! You all say). What were the key points?

Background, $ADH had consolidated is warehousing last year to a since DC, managed under an 3PL contract with DHL. Startup of the DC had performance issues, impacting inventory management and customer service, and leading to expediting costs impacting margins and product availabilty.

 However, at 1HFY23 we were told all about it and assured the restructured contract AND reputations all round, would lead to improved performance. At that time, I was prepared to accept the story. I know that reconfiguring the supply chain is a high-risk project and, combined with outsourcing, it is not unusual for the first 6-months or so to have significant problems. DHL are a best-in-class operator, and with their reputation so publicly exposed, everyone was incentivised to get things sorted out.

But on 1-August we were told that things had NOT worked out, and that $ADH have given notice of terminating this contract and taking DC operations back in-house. They laid out the costs of making this change, the longer term margin benefits and the steps to be taken. These were discussed in detail on the recent investor call. Bottom line, DHL are (reportedly) unable to meet $ADH’s expectations for customer service across their product range.

Now, at one level, you might applaud management for taking a tough call with a supplier who they have worked hard with to achieve improved performance over the last 6 months. And that would be fair enough. However, I see things differently, because it raises questions:

• Is all the bad news from the under-performance fully baked into the 2 June Trading Update OR will the ongoing NDC problems be a justification for under-performing the guidance?
• Going forward, we now have a new change project. Transferring management of the NDC back to $ADH operational control. However, this will take time, so we will have a period of 1H FY24 where the unresolved operational issues continue. And we don’t yet know how bad they are.
• As part of this upcoming change in management of the NDC, $ADH will also have to implement a new WMS, intgrate it into their systems, run it alongside DHL system before unplugging the DHL systems. So, a whole new tranche of operational risk. And, as I said earlier, it is not unusual for these projects to go through a rocky transition – particularly if there are new systems involved.

So, for $ADH, I see the following:

• A period of an unknown level of operational under-performance with an exiting supplier.
• A change in management of the NDH to $ADH. But I can't believe this to be a core capability (otherwise, why was it outsourced to $DHL in the first place?)
• A mission-critical systems implementation.

Now, logistics is a big part of retail. There is no argument. You have to be good at it, even if you outsource it. (By comparison, I last week heard Anthony Scali explain how Plush has been folded seamlessly into $NCK's supply chain, leading to increased margins and contributing to $20m synergies. Done. No nonesense. That's what good looks like.

$ADH 's supply chain issues get added to:

• The already-known problems at the Mocka acquisition, where we are either expecting to hear progress that they have been fixed or (potentially) enjoy a write-down of the value, which would certainly be in prospect if the new $ADH-installed management haven't been able to fix things - also supply-chain related.
• Pressure in the homeware and furniture category already captured in the Trading update, and likely getting worse in 1H FY24.

Now while I haven’t fully updated my valuations for $ADH, I can see my expected value range now looking more like ($1.40-$3.00), with an expected value sitting on $1.90-$2.00. But importantly, my conviction in the numbers themselves is shaken.

So, this morning I off-loaded my RL position at $1.765. (Capital has been reallocated to $NCK, mostly, but also $NEU and $BOT, over recent weeks).

So, it is an interesting case, where I have sold a stock for less than my view of its expected value because:

• My conviction has been shaken by clearly identified risks that everyone can now see;
• A macro-environment that is likely to be unforgiving, and therefore I have to limit my total portfolio exposure to the sector (retail – household goods);
• An alternative opportunity in the same sector ($NCK), which needs the same capital, for which I have higher conviction, and which has a more material upside in the valuation.

(Note: at no time have I considered my buying price, even though I know I am crystallising a loss.)

In arriving at the decision, the numbers were only part of it. I expect both companies will survive the current turbulent times and, in a few years, both will be riding high again. Both have clear growth strategies and are well-positioned in their respective markets.

But having heard the management teams of both companies on multiple occasions this year, it is as much about who do I feel most confident will do a good job growing my capital over the next 10 years. The analysis has helped in the decision, but it is confidence in management in delivering things that are under their control that matters even more.

$ADH report their results on Monday, and I will go along because I am genuinely curious to hear how they go. I may well be wrong. That's the thing - we never know for sure, until its too late. But even if they beat expectations, and we see a nice little SP pop (as would follow), it wouldn’t change my conviction on the risks ahead and the relative risk-reward exposures.

So, apologies for the long-winded not, but I know some are interested in the selling decision process.

Disc: Not held in RL and SM

Today’s Strawman meeting with $ADH’s CEO Mark Ronan and CFO Ashley Gardner came at a good time for me. The 1H23 result was ugly, and has been well-discussed here. I’d decided not to sell in the immediate aftermath of the bad news but to wait, expecting some recovery and then to re-evaluate my position (SP has recovered 10% in that time).

(Separately, I have managed down my RL discretionary retail exposure to 10% by exiting $SUL, which has performed strongly, delivering a modest profit on my investment.)

Herewith, my summary of key messages form the meeting.

Re-iterated that the portfolio has strong growth potential over 5+ Years

• Adairs to grow from 172 to 200-220 stores plus upsize 20-25 stores
• Additional potential to grow "Gross Level Area" by 5-10% p.a. as range covers more of the home
• Focus to grow from 23 stores to 50-60 (to be in line with $NCK and Freedom)
• Mocka eventually expects to have 10-20 stores because omni-channel reflects best long term model
• Several references were made to the strength of the omni-channel model. They observe that online sales increase in an area when physical stores open. Having a physical store nearby increases customer confidence to buy online (e.g., ease or returns or swaps if needed, or ability to check stuff out instore and buy at a later time.)

The business is well-positioned for a recession

• They see the environment as more of a down trend than a cliff. Customers have become more active in searchng for a good deal. This is well under way.
• Expect to benefit from “trading down” in mid-market at Adairs and Focus from premium brands
• 85% of Adairs sales are through “Linen Lovers” loyalty club offering potential for tailored offerings to customers
• Product range for the second half of this year will be fine-tuned to meet price-sensitive customers; care will be taken on inventory levels
• Supply chain costs have fallen (e.g., Focus furniture container shipping from 10x back to 1x) but prices are being maintained leading to an ongoing period of magin expansion
• Payout ratio at 65% is below 80% upper limit, allowing for debt from acquisitions to be paid down. Provides some headroom to maintain dividend should revenue/earnings soften

So far, sales are holding up – they expect this to continue, provided unemployment doesn’t increase too much.

Recent Operational Issues are Transient

• All Mocka delivery partners have been changed out with new providers and new SLAs. Performance is now "reliable" albeit with "higher costs". Stock levels have been reduced.
• It has been a challenge to settle down performance at the DHL-operated Adairs national distribution centre. The discussion here didn’t indicate that the issue is completely behind them, but they indicated there was a learning curve for the operator to meet requirements of the kind of business Adairs has. (Refer to more details on this at H1FY23)
• Overall, I was encouraged because both Mark and Ashley appeared at ease in discussing the problems. They clearly see them as transitory and not deflecting them from their overall strategy. (That said, I expect their answers are well-rehearsed as they will have been grilled by their insto shareholders over the last two months.)
• In response to a SM question, they appeared to acknowledge that they could come under pressure for a write down of Mocka, however, they pointed out that the early performance there had exceeded the acquisition case, and that the problems were temporary. Neither appeared unduly concerned.

My Key Take Aways

I went into today’s meeting with my hand poised on the “SELL” button. However, I emerged with the thesis intact:

• Well-managed mid-market, omni-channel retailer
• Strong management team
• Large, in-built growth potential across all three brands
• Integrated model provides access to higher margins and ability to differentiate customer offer
• 1 million+ loyalty club with investments to leverage this
• Undemanding P/E (8.8 trailing; 8.3 forward vs. 5-year average of 11-12) appears to have built in a significant fall in the next 1-2 years' earnings

I’m prepared to give the benefit of doubt for the recent operational problems, seeing these as a stumble along the way, rather than a roadblock or a major diversion. The proof will be how far they can demonstrate progress at the FY.

In addition, positioned in the mid-market for Adairs and Focus, $ADH has the potential to both benefit from trading down from premium brands as well as having the ability to make direct customer offers to its 1million+ loyalty club. Management also seem to be actively preparing for a more challenging retail environment in the second half of the year by fine-tuning the product offering. To be clear, I see these as mitigating/minimising a downside already reflected in the SP ... so it is a potential upside.

Even if unemployment increases and we see $ADH sales and earnings under-pressure in late 2023 / early 2024, I believe that Mark and Ashley will steer the ship through it, and emerge stronger out the other side. I’m happy to batten down the hatches for the ride.

My ongoing support is conditional upon a demonstration at the FY result that the operational problems have been resolved - demonstrated by margin recovery. With little over two months of the FY to run, the result does not at this stage appear to be vulnerble to a major impact from macro-conditions. Of course, the outlook into FY24 is a different matter.

Disc: Held IRL (1.9%) and SM (5.4%)

I attended the $ADH results call this morning. @Strawman has given a comprehensive report, which I will not repeat. Furthermore @Rick has given further analysis on some of the numbers, plus a brilliant summary:

·      Adair’s margins challenged

·      Mocka run amock

·      Focus saved the day

So read those two straws first, as I only intend here to add some further colour and my own conclusion.

As @Strawman has written, management were pretty candid in thir presentation and open in answering the large number of detailed questions from the analysts. Candour by management, particularly where there are issues is a green flag for me.

Let's look at each brand in turn.

Adairs

In FY22 Adairs transitioned to a National Distribution Centre (NDC) operated by DHL. This was expected to deliver $3m in half year operational efficiencies. Wrong, they’ve had issues delivering operational KPIs, and operation costs were reported to be $5m higher. So, that’s $8m off where they planned – this on sales of $220m; so a 4% margin hit.

(I am sure DHL are very motivated to fix this. CEO and CFO were not shy in mentioning them several times, so there is a big reputational incentive for DHL to be mentioned positively in the next report. CEO Mark Ronan did make clear that they are “working collaboratively” to resolve the problems and have a restructured contract in place which is more favourable to $ADH. For now, the relationship sounds constructive.)

The contract with DHL has been restructured, and they are confident of getting the $5m back in H2. But in terms of the originally targeted $3m efficiencies, Mark said they didn’t see themselves getting this “any time soon”.

Both this and other supply chain challenges are expected to unwind in H2 FY23. So even though the EBIT% Margin has fallen to 8.5%, it should be back to >12% in H2. Of course, this depends on how much promotion and discounting they do in response to marco-economic headwinds.

My reflection on this is that it is important to recognise the logistics and supply chain is a big part of retail. Consolidating distribution centres and outsourcing are changes that carry high operational risk, as it is essentially a green-field project and there is always a learning curve. But it is fixable and shouldn't be a long-term detriment to the business. (We’ve also seen this happen to $BAP over the last 1-2 years.)

On the macro-econvironment, Mark said that they were still seeing footfall past the shop front, however, getting people in the door was the issue. He speculated whether people were spending time in the shopping centres more for entertainment rather than spending money? He also said they needed to sharpen "the offer", as customers appear more likely to walk away if they don't thing they are getting a great deal.

 Fantastic Furniture

A great result. This recent acquisition is performing well and, quite frankly, it saved $ADH from a much more embarrassing result. They are still in the early days of moving from a Victoria-centric business to a national brand.

Underlying EBIT% margin was very high at 21.1%, driven by good product availability in the period, which gave them competitive advantage in having shorter delivery times for customers. A second factor was the absence of any new store openings.

One is reportedly close to being agreed in 2H. One drag on the pace of new openings is that there are reportedly few vacancy opportunities available in the Homemaker Centres they are targeting. This says to me that management are being selective on locations, which is a far-sighted strategy. Settling for lower quality locations will erode margins longer term.

I wonder, however, if a second reason for a measured approach that wasn't mentioned, is the expected consumer downturn. It can take a couple of years to establish throughput in a new location. This is probably harder in a downturn.

In terms of long-term expectations, they see EBIT% margins in the “mid-teens”, as new store openings will drag this back. However, they expect to maintain Gross Margins in the “low fifties” (most recent being 51.4%).

So, the good news is that Fantastic Furniture hasn’t missed a beat since the acquisition.

Mocka

Mocka emerged from FY22 with an almost complete failure of its delivery partner, which lead to brand damage and excess inventory that has largely been cleared earlier in 1H. Additionally, with customers moving back to in-store shopping, Mocka is seeing continued decline due to the re-opening headwinds. Its 27%  sales decline puts in good company of other pure play online retailers like $TPW (-12%) and $KGN (-33%). Unlike Focus, this has been a poor acquisition, now making a negligible contribution at the EBIT level, albeit there should be some improvement in H2. Unlike FY22, which was a failure of execution, 1H FY23 is part of getting caught up in a macro-trend.

Overall Conclusion

Management has been transparent about their problems, and what it intends to do and has done about them. They've reiterated the vision of growing the business to $1bn in sales over the coming years.

Acquisitions are always risky. Mocka hasn’t gone well. Focus looks good. A 50% hit rate is not bad. Not all management teams are as transparent, until the writedowns come. (Think $XRO, Disc. held)

I initiated my position in $ADH in late 2021. At the time it seemed like a capable retailer with a good mid-market focus, room to grow, and an undemanding valuation. Had I known what the next 18 months would hold, I probably wouldn’t have acquired, because there are other better retailers (two of which I also own).

However, from this point forward, I am minded to hold. I agree with @Rick’s valuation. $2.75/share is a conservative place to start. If operational performance gets back on track, new openings continue, and the consumer downturn isn’t too deep or too protracted, then I believe patience will be rewarded (and that doesn’t rely on Mocka). In that event I expect a higher valuation would be justified (I haven't done my numbers yet).

Consensus for FY EBIT prior to the results stands at $80m (n=9, www.marketscreener.com), which is the top end of updated guidance, so there may be some further marking down on price targets. Consensus is at $2.88 prior to markdowns.

I do not have a high conviction, and the onus is now on management to deliver on guidance for the FY. I'm not going to sell on bad news, but unless there is a much stronger story at the FY, this capital may well be reallocated in due course.

Disc: Held IRL (2%) and SM (5%)

See @Strawman 's analysis of the FY22 results and examination of implications. I don't have anything to add on the numbers. For me a key question is are they a good retailer? What have we learned from today?

I aim here to complement Andrew's note with some more detailed observations, driving some of the adverse numbers.So its not an uplifting straw. I listened to the results call, and what was interesting is that the presentation was quite short, while the Q&A was rather in-depth. Mark Ronan provided candid and in-depth reponses to on several issues. There was robust questionning by analysts!

The standout disappointment was Mocka, acquired in late 2019. In late Q2/Q3 FY22, there were multiple issues relating to the failures by the Mocka delivery partner, which Mark admitted has damaged brand reputation, and signfiicantly impacted financial performance, due to customer refunds and discounts. These were discussed in H1, but we didn't see the full impact before today. Then, there were product quality issues in Q4 which resulted in some inventory writedowns. Mark believes the problems have been addressed and is hopeful that customers will given them another go. He still believes their is a place in the market for the Mocka product line.

Mark made clear, that several of the Mocka management have been replaced, selling this as a virtue in that it would make the management team more Australian-focused, which is where the major growth will be. Some changeout of staff associated with the founding management team has occurred as part of this (which is very common after the first year following a takeover), together with bringing in expertise in digital retailing. This strengthening of the bench has added costs and will be an ongoing drag on margins. Mark anticipated that FY23 would be a year of rebuilding with FY24 seeing a return to growth. Mark believes that growing Mocka to $150-200m in 3 to 5 years is still the likely plan (but presumably slipped... I haven't checked).

The second issue update was problems in establishing operations in the centralised DC. This is not uncommon. Starting up a brand new DC is like starting any large greenfield operation. It often takes time to get it right. ($BAP reported the same last week.) Mark report that everything is now under one roof, customer service is at the enhanced targeted level and that the operational efficiencies would start to be delivered through FY23, being fully realised in FY24 - later than planned.

So now to return to my question. Are Mark and his team good retailers? Mocka has been in the portfolio for 21 months, so I think it is squarely the responsibility of the current management team. Of course, the business has been through a lot with COVID and then the ongoing supply chain disruptions, so perhaps the usualy standards of judgement require some circumspection.

Coming into today, disappointment on the cost side was expected and, overall, I found the top-line sales number encouraging, including the FY23 outlook.

However, it is clear from the commentary that these bumps in the road are not instantly resolved. For this Mark is to be applauded for his candour. Howver, I suspect it explains the market reaction today. (Down 11-12% at time of writing).

To be honest, I acquired ADH without really having a view of the capability of the management team. (2% IRL; 5% SM) and more on the rationale that others here have also put forward (undemanding multiple, growth outlook, online channel capability, growing loyalty club, expanding to furniture to become a more complete home category).

Based on today's results and the discussion with the analysts, I would not buy ADH today if I didn't hold them. Partly because I am not convinced they are great retailers, partly because of the category headwind they face with a slowing housing market (near certain) and a tougher discretionary retail environment (likely, nothwithstanding positive household balance sheets and strong employment).

Why haven't I sold? Am I anchoring on being down 38% IRL on my purchase price?

As @Strawman points out, the multiple is now quite undemanding. Perhaps what is preventing me from bailing out is that on the call today the CEO provided candid and in-depth responses to a barrage of searching questions being very open about the problems faced, the impact they've had, and what's been done. It sounded like a very honest accounting of where the business is at.

Conclusion:

I am not going to buy any more and will see what progress has occurred in 6-months, keeping an eye on the the retail macro-environment in the meantime. But ADH is a lot lower on my conviction list, so if I need the capital elsewhere, I won't hesitate to cut my losses.

Adairs acquires Focus on Furniture for $80m

https://newswire.iguana2.com/af5f4d73c1a54a33/adh.asx/3A582040/ADH_ADH_Acquisition_of_Focus_on_Furniture

Sounds like a sensible acquisition at an undemanding multiple. (valuation based on historicals, not FY21 COVID turbo-charged).

Now with Adairs + Mocka + Focus you can furnish you house entirely within the group - focused on mid market segment ("We'll be going toe to toe with Freedom").

Prior to this acquisition the furniture part of Adairs and Mocka seemed a bit weak. The acquisitiuon fixes that.

Good opportunity for growth in terms of achieving target national footprint and capturing operational sygeries (corporate, property, supply chain, omni-channel, product portfolio).

Disc: Held IRL

Re: Straw by PortfolioPlus

Google Trends is a great way of generating insights between direct competitors, where you are comparing search frequency for one product compared with another (e.g. Xero vs. MYOB vs. Quickbooks). I urge extra caution if the products are not direct substitutes.

Out of curiosity (and because I am also trying to understand fair value for ADH in an uncertain future retail environment), I compared the frequencies in the data between Mar-Oct 2020 and Mar-Oct 2021. It was interesting as follows:

ADH: March-Sep 2020 = 49.5; Mar-Sep 2021 = 42.0 i.e. down 15%

TPW: March-Sep 2020 = 28.0; Mar-Sep 2021 = 28.4 i.e. up 1%

Not sure what to infer from that if anything, but thought you might find the analysis of interest.