Adairs Limited (ADH) Earnings Call Transcript & Summary

Thank you for standing by, and welcome to the Adairs Limited First Half FY '21 Results Conference Call. [Operator Instructions] I would now like to hand the conference over to Mr. Mark Ronan, Managing Director and CEO. Please go ahead.

Good morning, everyone, and welcome to the Adairs 2021 First Half Results Call. Joining me this morning on the call is Ash Gardner, our CFO; and Jamie Adamson, our Head of Investor Relations. The first half of 2021 has been an exceptional period for the group. The results achieved by Adairs and Mocka through this period highlight the strength of our brands and the hard work of our teams to continue to adapt to the ongoing COVID-19 challenges whilst delivering fantastic products and great customer experiences. The group achieved total sales growth of plus 34.8% with like-for-like sales of plus 32.4% and an increasing gross margin rate of 545 basis points to 66.1%. Over the half, Adairs achieved sales growth of 20.9%. Adairs stores delivered 4.6% sales growth despite 43 Greater Melbourne stores being closed for 82 trading days over the half. After adjusting for the closure of these stores, Adairs achieved store like-for-like sales growth of plus 14.4%. This was well supported by a terrific online result, which grew at 95% for the half. The sales result was supported by a strong 690 basis points improvement in final gross margin rate for Adairs, taking the gross margin to 67.8% for the half. This culminated in the Adairs business delivering a record underlying EBIT of $53.2 million. Mocka also had a strong half with the business continuing to outperform initial expectations. Mocka sales were up 44.4% on the prior year despite the business trading on reduced inventory levels as a result of ongoing challenges with our supply chain caused by COVID-19. This strong sales result was enhanced by the improved gross margin rate, up 230 basis points on the prior year to 53.4%. This saw Mocka deliver a record underlying EBIT of $7 million for the half. As a group, our omni-channel strategy continues to deliver with online sales now representing 37% of total sales or on an annualized basis more than $180 million in revenue. The exceptional results across Adairs and Mocka delivered strong operating leverage, allowing the group to achieve a record profit result with underlying EBIT of $60.2 million, up 166% on the prior year. This record result, together with the group's strong balance sheet, has allowed us to declare an interim fully franked dividend of $0.13 per share. The results outlined today do not include the net benefit of the JobKeeper wage subsidy received during the half as the Board has determined that based on the performance of the company, it is appropriate to return the JobKeeper benefits to the Australian government. JobKeeper has been an excellent policy, enabling Adairs and many other businesses to confidently support their team members through this period whilst delivering significant stimulus to the economy in these uncertain times. I will now hand over to Ash to walk through the financials in more detail before I provide some more information on the strategies that will continue to drive the ongoing growth of the group.

Thanks, Mark, and good morning, everyone. As Mark said, the results for the half were outstanding, and it is an absolute credit to our teams. The group delivered an underlying EBIT of $60.2 million, up 166% on last year. As we've done in prior years, our results are presented excluding AASB 16 and one-off costs related to the acquisition of Mocka and our DC project as well as the exclusion of the JobKeeper wage subsidy benefit, which, as Mark mentioned, will be repaid to the Australian government. Adairs achieved total sales growth of 20.9% with online sales up 95% and store like-for-like sales up 14.4%. Mocka delivered sales growth of 44% on a comparable 26 weeks basis, noting that we only owned Mocka for 5 weeks in the first half last year. Total group like-for-like sales were up 32.4%. And as Mark mentioned, group online sales now represent 37% of total sales. Both businesses continue the progress that has been made in FY '20 with further margin growth. Adairs' gross margin in FY '21 improved by 690 basis points to 67.8% with great quality ranges that resonated well with our Linen Lovers and 29 fewer broad-based promotion days in the half, which saw our average selling price improve significantly. Mocka improved gross margin by 230 basis points to 53.4% following a review of product pricing and continued focus on understanding which promotions work best to drive strong sales and margin growth. The margin outcomes for both businesses were against a backdrop of lower-than-ideal stock levels. It was pleasing to see both teams approach their promotional activity with a very clear focus on maximizing gross margin on limited stock and making that limited stock go further. Whilst Adairs is now in a better stock position, Mocka continues to build its inventory. Of our total stock balance of $67 million at the end of December, some $20 million of this is on the water. That's $12 million higher than it was in June. Operating leverage was a feature for the half. With strong like-for-like sales growth across all channels in both businesses, cost ratios were all favorable and EBIT margins expanded materially. Our Adairs store contribution margin improved by more than 10% to 36.1% and the Adairs online contribution margin grew to 44.1%. Mocka also improved its contribution margin at 38.5% with improved gross margins and a low fixed cost base driving material operating leverage in this online-only business. Cost control continued to be a focus with significant improvements in pick-and-pack efficiency across our distribution centers, providing better customer experience outcomes and at a lower cost, and we continue to see high labor productivity in our stores. Our rental cost for the period includes the full rental cost for the Victorian stores closed during the lockdown with discussions ongoing with our landlords, whilst rebates from the first wave of the FY '20 COVID lockdown of $2.2 million were booked in the half. Increased investment in digital marketing supported our online sales growth and the growth of our Linen Lovers program. Adairs achieved an underlying EBIT of $53.2 million, up $30.8 million on last year and delivering an EBIT margin of 24.7%, well up on the 12.6% for the prior year. Mocka's profit also doubled in the half to $7 million at a 25.2% EBIT margin. And the results for Mocka continue to track ahead of our initial expectations when the business was acquired in December of 2019, just over 12 months ago. The strong operating result translated into cash flow with operating cash flows up 90%. Inventory is well up on last year as a result of the high stocking trends that I mentioned earlier, but our inventory is clean and we are well placed for the upcoming season. We know that additional stock will support our sales growth in both businesses throughout the second half and will help us to manage the instability that we are currently experiencing in our offshore supply chains. We closed the half with $22.1 million of cash on hand and no bank debt. And as Mark mentioned, the Board has approved a fully franked interim dividend of $0.13 per share that will be payable on the 25th of March. I now hand back to Mark.

Thanks, Ash. As we have outlined for a number of years now, the business continues to perform well due to our focus on delivering on our underlying strategies. In the presentation today, we have highlighted 5 key drivers of our future growth that I'll briefly talk to now. If I start with our proven and resilient business model. The strong brands that we own, our vertical supply chain philosophy and our direct-to-consumer store and digital channels allow us to develop and control the expansion of our product offering and customer base. This enables us to be more agile and responsive to changing customer needs through the delivery of exclusive on-trend products at higher margins. Our strong brands, combined with our large and loyal customer base, delivers a lower cost of customer acquisition and provides significant opportunity to enhance and build upon our relationships with our customers. We see the combination of omni-channel retail with loyalty as a key growth driver. Adairs is focused on continuing to grow its market share, and the best way to do this is to grow our customer base whilst increasing our share of spend from our existing customers. Linen Lovers is the program through which we provide value to our members, allowing us to achieve this. The Linen Lover program today accounts for more than 75% of Adairs' sales. Through the program, we are seeing 50% of new customers acquired during the fourth quarter of FY '20 shop again over the first half of FY '21, providing us with confidence that our growing Linen Lover program will support our ongoing sales growth. We will increase our investment in customer data analytics capability over the coming years to further enhance the value of this program for our customers and deliver ongoing returns for Adairs. Our focus on becoming an omni-channel leader is supported by our digital transformation strategy. We are investing in enhancing our digital platform and team to deliver an improved customer experience, driving customer acquisition and increased customer conversion. We are starting from a strong position and have seen significant growth over the half from customers that shop both online and in-store or what we call omni-channel customers, delivering 60% sales growth. We continue to think about how we deliver customers a superior and more flexible shopping experience and will actively explore and trial new technologies, including in-store devices to showcase range; customer traffic measurement and analytics, both in-store and online; online chat; call and collect and call and same-day delivery services; and augmented reality. We will continue to trial these different technologies to ensure that any significant investment truly delivers an enhanced customer experience. The combination of Adairs and Mocka allows us to capitalize on 2 great brands with well-developed digital platforms. With strong online sales growth achieved by both brands and 37% of total group sales now coming from online, we are well positioned to win share as traditional store customers transition to becoming omni-channel shoppers. The addition of Mocka to the group increases our exposure to the fast-growing online segment of the market with the significant benefits of vertical integration. Based on Mocka achieving the same penetration in Australia as it has in New Zealand, there is the potential for Mocka Australia to exceed $100 million in sales revenue simply based on population size. Mocka provides the group with greater exposure to the furniture segment and provides the opportunity to reach a different customer through design-led, value-for-money, differentiated product. With a significant market to grow into, we continue to invest in product category expansion. Whilst this has been more challenging due to travel restrictions, the team have adapted to these restrictions and continue to work on enhancing our width and depth of offer at Mocka. This will enable us to provide customers with a more compelling offer and, in time, allow customers to fit out their entire home with Mocka product. As a result, we have fast-tracked our investment in the Australian warehouse facilities to support this accelerating product growth. We are also investing in additional talent to supplement the Mocka management team, allowing us to build our brand awareness and deliver ongoing profitable growth. If I think about our digital channels, they are enhanced by our store network. The home category, as I've said before, is better with stores as they provide our customers with the ability to engage with the product and the team in an environment that allows them to be inspired to create a look that is right for them. Whilst online should provide you with the ability to easily find what you want, it is harder to recreate the experience of discovery that exists as you walk through a physical store interacting with the product. Our in-store team further enhance this experience through their product knowledge and ability to help customers achieve their vision, providing the opportunity for improved customer conversion, cross-selling and building loyalty to the brand. All of our stores are profitable and our store formats deliver strong contribution margins. Larger stores are more profitable and there is a strong pipeline of new stores and upsize store opportunities for us to capitalize on in the coming periods. Larger stores provide us with that opportunity to showcase more products and categories and generally deliver a higher contribution margin. We have highlighted here on Slide 9 the improved store contribution margin achieved in stores we have upsized over the past few years. Combined with the sales increase, it has seen us average a 60% increase in store contribution dollars from the stores we have upsized. This highlights both the opportunity and the customer engagement that comes from within our store network. With a highly profitable store portfolio, we remain focused on deliberately creating flexibility with our store leases with over 70% of leases expiring within the next 3 years. This allows us to strategically manage our store portfolio through opening new stores, upsize the existing stores, obtaining more favorable terms on renewals or closing stores that simply do not meet our return hurdles. And if we move to our omni-channel business model and the need for it to be supported by an omni supply chain. Our partnership with DHL provides us access to a global leader in the design, implementation and operation of flexible warehousing and distribution solutions to support our omni-channel approach. Construction of our national distribution center in Melbourne is well underway and remains on track to be operational in Q1 of FY '22. The project has experienced some delays due to Victorian building restrictions in August and September 2020 and delays in receiving key components from overseas, both as a result of COVID-19 restrictions. Whilst these delays may impact the savings realized in FY '22, this important initiative will still deliver annualized savings of $3.5 million once fully operational. Consolidating multiple distribution center operations into a single national facility will improve our stock flow and online fulfillment, increase stock availability and improve service level for both our customers and stores during peak trading groups at a lower cost. The NDC is the foundation for Adairs' integrated omni-supply chain strategy to better enable customers to shop Adairs how, where and when they choose and has the capacity and flexibility to support business growth well into the future across all channels. We look forward to the completion and transition to our new national distribution center in Q1 of FY '22. If I move now to our trading update and outlook. And in the first 7 weeks of the second half of FY '21, it continues to be a very positive story. Adairs online is up 65.9% whilst store sales are up 12.4% on a like-for-like basis after adjusting for the various store closures throughout this period. Mocka has also continued to grow strongly, being up 48.6% over the same period last year. Our gross margins have remained elevated over this period and our focus remains on maximizing gross margin dollars. We expect to open 1 to 2 net new stores, upsize a further 3 to 4 stores and refurbish a further 2 to 3 stores over the balance of FY '21. This will be supported by ongoing investment in our digital capabilities. The second half of FY '21 sees us cycle against a period of nationwide store closures last year and a strong finish to the year. As COVID-19 continues to impact our lifestyles, we see customers continuing to spend more on their homes over the coming half. Whilst this current trading remains strong due to the ongoing uncertainty created by COVID-19, the Board did not consider it appropriate to provide full year guidance at this time. Before I finish, I'd just like to thank the Adairs and Mocka teams. Our teams are passionate about our businesses, and this continues to shine through in the way they go about delivering for our customers despite ongoing challenges and changes as a result of COVID-19. In particular, the way the Melbourne-based team handled the lockdown period of the first half is testament to the culture of our organization. I would like to thank all the team members across Australia and New Zealand again for their hard work and dedication. With this team, I am confident that we are well placed to manage and capitalize on the new and evolving retail environment, delivering shareholders ongoing profitable growth. And with that, I'll now hand over for questions.

[Operator Instructions] Our first question comes from Jo Little of Morgans.

Just the first question, just on that significant gross margin uplift. It sounds like that's continued into the second half for various reasons. I guess the key question from that is how much you think you can maintain when we are in a more normal environment. You do have a differentiated product to protect you there, but just interested in any comments, please.

Yes. Thanks, Jo. I think one of the focuses of the business is how we continue to maintain those strong gross margins. Now whilst we acknowledge that some of the gross margin uplift over the first half and even today is being brought about by the lesser inventory levels than us really managing those promotions tightly, I think you rightly point out one of the things that we want to make sure of is as we continue to design and develop product, we maximize the margin on that product by not, in my words, giving it away too cheap by running promotions that are category-wide or storewide. So our focus continues on how we tighten up those promotions and still offer what our customers want whilst maintaining a strong gross margin within the business, and I think we can do that through the differentiated product. And we've learned a lot over the first half around categories, where the right level of promotion needs to be and how we start to manage that a bit better to make sure that we can maintain the reduction in depth of discount and storewide discount days that we've managed to achieve over the last 12 to 18 months as well as ongoing work within the sourcing of product to make sure that we manage that well at the same time. So we'd like to think that we can hold on to a fair chunk of it. We understand that it's probably a bit of a unique period and we won't truly know until we come out of that, but I think one of the things we've made sure of is that we have worked hard at trying to reconfigure our customers to their expectations on discounts, and we certainly won't rush back to the levels that we were perhaps operating at prior to this period.

Okay. Great. And just looking at the cost base. I guess if you exclude JobKeeper, obviously cost base, I think, went up about 5% in Adairs. It feels like you probably used that period to invest a bit harder. Can you maybe quantify that investment you made? I guess it's in people, talent capability?

Yes. I think if we think about what we've invested, we -- there's a couple of investments in there that are ongoing, and I think you can think about that as sort of $0.5 million to $750,000. And there's probably $0.5 million that we see as more one-off-type costs that we can use in the business over that sort of period to set us up for future as opposed to necessarily talent, more making sure that we set up the strategies that we then execute over the next few years. And we've added a bit of bench strength to firstly develop those strategies. And then that $0.5 million to $750,000 is all about how we execute some of those underlying strategies. So that's been a big part of that increased cost base within there as well as there's probably significant incentives within that cost base, given the performance of the business to both the store team and broader across the management team as well.

Okay. Great. So if you look at the second half of last year and add back JobKeeper, do you expect a similar amount of inflation perhaps in the second half?

Yes, that's probably not a bad assessment at this point in time.

Yes. Great. And Ash, just on the inventory, so it sounds like a lot of that stock is still on the water at balance date. So would it be fair to say that trading update was still impacted by stock shortages, I guess, mostly in Mocka? Would that be fair? And the other thing just on the trading update. What did online represent of those total sales?

So yes, in terms of the stock flow, it's really coming good. Particularly for Adairs, it's come good over the last couple of weeks. So most of that trading update period was affected, particularly the January sales period. Mocka in New Zealand continues to be affected, but Australia is in better shape. And most of that benefit for that in-stock position for Australia was there through the trading period. And I don't have at hand the answer to that second question in relation to the online percentage of sales for the 7 weeks, but we'll get it.

Yes. Okay. Great. And I guess if we're just talking about kind of fixed versus variable costs should demand conditions normalize in future periods, how you're planning to manage that cost base if, indeed, you did get negative comps in FY '22, it's all guesswork I imagine. I'm assuming you can manage store labor costs relatively commensurate with sales, but just to the other cost items, please.

Some of them will be there throughout FY '22 to make sure we capitalize on the strategies that we are looking to execute, but that's where we've used this period, in particular, to think about some of the -- how we build the actual base of those strategies, which won't need to be ongoing costs. So I think we've got an element of that cost base that we can withdraw or not have in FY '22. And equally, we can think about the variable cost will obviously move around with sales. But there's a chunk of that that's sort of one-off spend that we think is in FY '21 that, at this stage, we'd only invest again in FY '22 should the sales and profitability be there.

Yes. Great, guys. And just lastly, sorry, on the balance sheet, I'm assuming that, that net cash balance was before the -- you're paying back JobKeeper post balance date, I assume. And just that CapEx profile is a bit more elevated. Would we assume that continues for at least the next couple of years and then just balancing dividends, Mocka earn-outs, higher CapEx, et cetera?

Yes. Probably I think sort of the 13 to 15 is probably where it will settle. I mean we've got a couple of one-off projects this year around -- particularly around the DC which won't recur, but I think that will only get replaced by our ongoing investment in digital initiatives, the data strategy that Mark talked to earlier, an emphasis on customer analytics. And then obviously, we've got opportunities from store refurbishment perspectives, which -- and an upsize which we know pays back. So yes, 13 to 15 is probably the right level for the next couple of years.

Yes. And JobKeeper is post balance date, that repayment?

Yes, yes. The answer to your question is 35% of our sales in the first 7 weeks that are online across Mocka and Adairs.

Our next question is from Aryan Norozi of UBS.

Just in terms of sort of thinking out in fiscal '22 onwards, I mean has COVID changed the way you're consuming back your cost base structurally? In other words, should we expect a different cost to bring business margin pre- versus post-COVID? And I know have sort of -- to follow on to Jo's question, but I mean have you really thought how you sort of allocate staff hours or rents, et cetera?

So I think in terms of sort of managing our variable costs, COVID has taught us a lot about how to manage and manage it quickly. And those variable costs across our online platforms, so our DCs, the pick back and fulfillment activities. Obviously, our store replenishment activities in the DC would vary and they move very much in line with how we see demand. Our store teams, there is a level of minimum wage that needs to sit in our stores in order for them to operate. And we've learned different ways in which to manage that at different times. Obviously, with stores being substantially closed, we ran Victorian stores and call-and-collect for a period of time, which had lots of different options around how we rostered our teams. And we are continuing to invest in better rostering, labor scheduling, projects, activities so that we can continue to make sure we've got the right levels of service in our stores when customers are there. So I think COVID has made us a bit more agile. And we understand our variable costs, and we're able to quickly respond as things change. As time goes, we'll see what we're required to shift and we know which channels are the ones that we can move quickly, and we'll make the changes that we need to when that's required.

The only other thing I'd add to that, Ary, is that we've got to remember we're a service business. So we're not sitting here -- we don't look at labor in-store as a cost. We look at labor in-store as a customer service piece and how do we make sure we maintain that customer service. And I think it's critical for businesses that are retail businesses, and when -- if you think that's part of your DNA, which we clearly do, that we continue to invest in that because it gives customers a reason to get up off their couch, leave the iPad and come in the store and get the true experience and allows us then to work with that customer and obviously create the look that they want and really enhance the customer experience through both, obviously, digital and that in-store experience. So whilst we've looked at our cost bases and we've learned a lot, I don't want anyone sitting there thinking, well, one of the things we've learnt is we could take labor out of store and these sorts of elements because that's not something that we would rush to do. We would make sure that we maintain it. To Ash's point, it's about optimizing that and making sure we've got the right level of service in-store at the right time as opposed to thinking there's a cost base there that we would take out.

That makes sense. And just on capital management, in terms of the payout ratio, it's obviously dipped below certainly the level that you've historically paid at. I mean do we -- should we read into that as your confidence level in terms of the earnings outlook for the next 6 to 12 months? Or is that just you being conservative and not knowing what the future holds?

I think it's a bit of sort of there is still an uncertain world out there. But historically, we've looked to payout roughly half of what we expect to payout in the year. So our payout ratio, we've got a pretty wide range to work within. So we -- our expectation is we'll end the full year inside the normal payout ratio of 60% to 85%.

Perfect. And just following on -- sorry I'm if going to get it 100 times. On the gross margin, I mean, if I look at the last 12 months, it was up 6 percentage points. Can you just tell us how to think about what portion of that is you discounting whilst taking out 28, 29 [ basis ] discounts versus how those movements, whether it be FX or mix? So just to get an idea about how we sort of factor that moving forward.

A fair portion of that, I would say, is increasing average selling price. It's complemented by the work that we did earlier in 2018-2019 in reducing cost prices of products and working with our suppliers to make sure that we balance the cost price and the sourcing initiatives that we put in place. And then equally, there is an element of mix shift, which, interestingly enough, over the last 12 months, has been a mix shift more towards some of our core categories, which, due to the volume that we operate in, operate at higher margins. So you think about something like bed linen, bed linen, we've done a great job on sourcing, which has helped lift the price -- the margin, sorry, as well as we've done a good job on reducing the depth of primer across our bed linen category, which has seen us maximize the margin on that sort of category. And equally, we've probably seen a bit of a mix shift back towards some of those core categories whilst people have been stuck in homes and thinking about upgrading that sort of product over that period of time. So I think when you think about it, we believe that we should -- we will just work on how we maintain that increase in ASP, which we come back to that concept of making sure our product is differentiated, making sure we reward ourselves for the effort that goes in from our teams around putting that together. And we continue to see strong response from our customers as we deliver that product that is truly differentiated from what else is out there in the market. And more importantly than that, we maintain a high level of quality in our core products that enables customers to feel really confident that the reason they pay a slightly higher price at Adairs is because they're getting a high-quality product. So a lot of it is ASP, but it is complemented, I think, by mix shift and that sourcing work that we've done. And obviously, as we head into FY '22, there will be a slight tailwind in relation to FX. And hedging, as we currently see today, we're at $0.74 versus perhaps $0.70 in the past.

Perfect. And just final one for me. Just in terms of Mocka, you've obviously mentioned in the past, you'll be accelerating reinvestment once inventory gets back to normal and that will impact EBIT margin. I mean how do we think about the sales over the next sort of 2, 3, 4 years? I mean, is the current sales growth -- or sorry, maybe put it another way, is the reinvestment you're doing enough to maintain this current growth rate you're experiencing at Mocka, this 40% to 50% growth rate?

Yes, we think so. We think so. You've got to add these resources in gradually over time, and we think we can continue to add over time rather think we need to do a big chunk now and then gain an EBIT margin uplift over years. Effectively, if we can continue to grow the sales at even 30% to 40%, we almost can't reinvest cost back into the business faster than that will deliver on EBIT margin. So we think that EBIT margin and perhaps with -- as we've learned more over the last 12 months and seen the opportunity that is there which is truly exciting, we think we can continue to grow that business at 30% to 40% per annum. And the investment that we'll need to do that is not as significant as perhaps we once thought. And it's why we've done things like fast-track the Australian warehouse facility to make sure that as we expand that product range, we don't run into difficulties with warehousing it and distributing it and then it's impacting on our customer service experience. So we think that EBIT margin probably remains elevated over the longer period, which is a slightly different story to what we initially thought as we acquired the business just over 12 months ago.

[Operator Instructions] Our next question is from Mark Wade of CLSA.

A question on the customer attitude and the health. I mean what are the things going on in their mindset at the moment, Mark? Are they itching to get out and be out and travel? Or do you think there's still a real potential to bunker down at home?