The great outdoors

Among the many different segments of the very broad retailing industry, Super Cheap Auto is a brand that has thrived and expanded successfully, both organically and by acquisition. This is another company that has had enough financial and operating discipline to steadily grow its business to the point where the underlying systems are really driving the earnings as much as the appeal of the brands. Even so, with a market capitalisation of $747 million, it is by no means a large stock.

Super Cheap Auto recently broke out from an ascending triangle formation. This resulted in a sharp move higher, reaching an all time high of $6.18 on September 6. Due to the rapid increase in price over a relatively short period of time, we would expect a period of consolidation in the near term.

Support is located between $5.80 and the psychological $6.00 level. Once this corrective move is complete, we would anticipate a continued move higher in line with the broader term uptrend in place.

Most people know Super Cheap Auto for its position in the fairly macho world of automobile accessories. Its advertising is very blokey and the sponsorship of V8 Supercar racing is a highly complementary marketing exercise.

But like any retailer, it still has to put on its pants one leg at a time and do the basics right. In that sense, Super Cheap has developed its corporate model into a nicely maturing team that is now turning its hand to other retailing businesses and applying the same basics.

In recent years, Super Cheap has acquired the BCF chain of outdoor leisure equipment stores, the Goldcross Cycles chain and this year settled the purchase of the Ray’s Outdoor leisure business. BCF and Ray’s Outdoors are very similar businesses and Super Cheap will clearly get some small ($2 million) synergy benefits once the two are fully integrated.

Ray’s Outdoors was acquired for $54 million on 31 May 2010. Super Cheap raised $76.3 million in equity to pay for the purchase via an institutional placement (15.9 million shares at $4.80) and a Share Purchase Plan for individual investors. Ray’s Outdoors had 38 stores (20 in Victoria) across 5 states at the time of purchase and has the potential to expand towards 75 in future, according to the company.

Both formats (Ray’s and BCF) have approximately 35% of sales in camping as the largest category, followed by a variety of categories from fishing (BCF 30% of sales), boating (BCF 25%), clothing (Ray’s 16%) to footwear, tents, BBQs and other general outdoor equipment.

The wider recreational/sporting retail market is a $4.4 billion market with no individual operator having more than 10% share. The fragmented nature of this market indicates potential further consolidation opportunities but also shows the fairly low barriers to entry. The combined Ray’s Outdoor and BCF business now has 103 stores but the company believes BCF has potential for around 90 stores while Ray’s Outdoors could expand to 75 stores.

The company now reports in two segments. The Auto and Cycle division contains the Super Cheap Auto chain and the Goldcross Cycles chain. In the 2010 year, this segment increased revenue by 10.3% to $687.9 million. Same store sales growth of 5% in Super Cheap was offset by a disappointing 4.2% decline in Goldcross. The cycle business turned in a $7 million EBIT loss partly due to an aggressive stock clearance sale in June. Super Cheap opened 11 new stores and refurbished 30 and delivered a very good gross margin performance of 41.2% and EBIT of $55 million.

The Leisure division contains BCF and Ray’s Outdoors. Reported sales of $253 million included just $8 million from Ray’s although it was only included for one month. FY11 sales contribution from Ray’s is expected to be about $130 million with a forecast EBIT contribution of $7.5 million before synergies.

The integration benefits will be spread across a number of factors. Ray’s has a higher cost of doing business of around 34% which can be significantly reduced towards BCF’s 32.5%. Sourcing and buying is obviously another area that can benefit from scale. The logistics and supply chain can also offer some benefits if the Distribution Centres are co-ordinated properly. We do not have much insight into stock turns and merchandising but this could be another area for investigation.

The outlook for consumer spending in Australia is certainly better than it has been over the last year, even taking into consideration the artificial boost from the government cash handouts. Consumer confidence remains high and mortgage interest rates are at ten year average levels, suggesting that households should not be under undue stress. Disposable income should also be in robust shape considering that unemployment at 5.3% is at relatively low levels as well.

Super Cheap’s store expansion plan is credible, but depends on finding suitable sites and securing appropriate terms. The company has demonstrated competence in this aspect of its business.

The valuation of the company therefore becomes the next decision point. If we can tick the boxes on the business, its track record and future strategy - does the share price fully reflect this or is there some value still to be attained? We think the answer is, not enough.

The PE ratio of the S&P/ASX200 Index for FY11 is 12.1 times consensus earnings forecasts, moving to 10.7 times in FY12. For Super Cheap Auto, the FY11 consensus earnings forecast places it on a PE ratio of 13.8 times going to 12.1 times in FY12.

We think the small premium to the market PE suggests the share price is probably fully valued. Compared to other retail stocks, Super Cheap is also looking fully valued with the sector average PE ratio currently at 12.6 times FY11 forecast earnings.

The weekly chart illustrates the clear breakout from the longer term bullish pennant formation. Coupled with the buy signal on the weekly MACD bodes well for further upside over the longer term.

The company’s profile and performance is quite appealing, but we would prefer to buy the stock at cheaper levels. Preferably super cheap!