Reject Shop share price.

Reject Shop share price.

The Reject Shop’s share price tumbled last week after a profit warning, blamed on warm weather. It's a familiar story. Pacific Brands is the latest retailer to downgrade its profit forecast and the Australian Bureau of Statistics cited below average retail spending over the past few months.

Such dramatic swings are part and parcel of investing in this sector, but The Reject Shop faces more challenges than a bit of warm weather.

Same-store sales growth has stalled, competition has intensified, a falling Aussie dollar has crunched margins and in the latest result an accelerated store roll-out program caused net profit to fall by 15 per cent. Then the CEO quit and the stock price halved in the space of a few months.

The Reject Shop is feeling the pressure.

The Reject Shop is feeling the pressure. Photo: Gabriele Charotte

So why did we recently add this stock to our Buy list, at a time when everyone else is downgrading it?

With discretionary spending weak, retailers are heavily discounting and The Reject Shop is being forced to follow suit. Many investors view this as a permanent, structural shift in the sector but we think that’s unlikely.

This is the first outbreak of aggressive competition and there’s every chance more rational pricing will return. Should sensible pricing return, the recent share price fall would look extravagant.

The abrupt end to growth is also worrying investors, but this too looks unfounded.

In late 2012, creditors pulled the plug on The Reject Shop’s major competitor and management quickly took advantage of the opportunity, swooping on the gap in the market. As a result, the number of store openings in 2013-14 was twice the usual rate. Because it takes stores a few years to become profitable, this expansion led to the profit decline.

There’s a strong case that this is only a temporary, and even desirable, setback because the one-off expenses relating to store openings quickly contribute to earnings in the second year and beyond.

Indeed, store openings aren’t the source of the company’s problems but the reasons for its success. Near-term profits may have fallen due to this investment but underlying long-term profits look as promising as ever.

Two things can happen from here. If the store roll-out continues, The Reject Shop should reach its goal of 400 stores in four or five years. Even if same-store-sales growth remains flat, at least $850 million in revenue would be within reach. With a slight margin improvement the company should be able to achieve a net profit of around $34 million.

On a conservative price-earnings multiple of 15, The Reject Shop would be worth around $17 per share in 2019, making today’s price of $8 or so a steal. With a nice current fully franked dividend yield it looks even better.

On the other hand, the company could abandon its growth strategy . That would reduce opening costs and immediately boost profits in 2015. With underlying earnings of around $21 million in 2014, and a price-earnings ratio of 14, it’s still attractive.

So this is the pitch: if The Reject Shop curtails its store openings, it’s cheap. If it doesn’t, it’s even cheaper.

Of course, lots could go wrong – intensifying competition, supply chain problems, a higher dollar – but the company’s share price goes a very long way to offsetting these risks.

Whether the new CEO sticks to the old strategy or slows down the pace of expansion, The Reject Shop has already taken market share from a failed competitor. It was inevitable that this would lead to lower profits in the short term. What is surprising is the savage market reaction to this predictable event.

With The Reject Shop priced at bargain basement levels, it’s a BUY for up to 4 per cent of a conservatively managed portfolio.

Nathan Bell is a Director of Intelligent Investor Share Advisor (AFSL 282288). To unlock all of Share Advisor’s stock research and buy recommendations, take out a 15-day free membership at shares.intelligentinvestor.com.au