We spoke with the management of Padini Holdings Bhd (“Padini”) recently to get an update and came away with mixed feelings over its outlook. While Padini is poised to resume its expansion in FY14 after a year-long hiatus of new store openings, the Group is mired by a string of challenges, including: (i) flattish same store sales growth(“SSSG”), (ii) lower gross margins; and (iii) rising operating expenses due to the need to continually refurbish and refresh its outlets. Even with the planned seven new outlets, namely 4 ‘Brands Outlet’ and 3 ‘Padini Concept’ stores for FY14E, we believe that a challenging business environment and higher operating costs will continue to pressure margins in FY14 and FY15. Also, its 4Q13 results are due to be announced soon, and we are expecting a weak quarter reflecting the slower sales during the general elections period in May. We trim FY13E-14E earnings by 4.7%-14.0%. Consequently, we lower our TP to RM1.70 (from RM2.15) as we are also applying a lower target FY14E PER of 12x. Maintain MARKET PERFORM.

4Q13 results preview. Padini’s 4Q13/ FY13 results are slated for release at mid week (28th Aug). 4Q is a seasonally weaker quarter and typically accounts for 16-24% of full year earnings due to the absence of any major festivities. Although we expect the results to be broadly in line with consensus estimates, it is likely to be particularly weak due to the May elections which curtailed consumer spending during that period. This, in effect, would be a double whammy for Padini, where the tepid sales would be unable to keep up with increasing operating expenses.

Back on an expansion track. Now with SSSG virtually flat amid a challenging market environment, we believe that more attention will be focused on new store openings to drive revenue growth. In fact, Padini is poised to resume its trajectory of new store openings after a year-long hiatus. A ‘Brands Outlet’ (“BO”) store and a ‘Padini Concept’ (“PC”) store opened their doors in Gurney Paragon last month, and we understand that management is looking to open 5 more outlets in November-Dec period (A BO and PC each in Miri and Seremban, and another BO in Langkawi). Collectively, this would increase Padini’s total retail floor space by 13% to 811,000 sq ft, which will put the company on an expansion track not seen since FY12.

However, headwinds persist. Nevertheless, we believe that the larger risks to earnings stem from its contracting margins. Padini and the broader retail sector is facing unprecedented challenges where operating costs (such as rental) are skyrocketing on top of the constant need to refurbish its outlets, give discounts and conduct promotional activities to attract customers. The notable shift in consumer preferences towards lower margin value-for-money products (such as ‘Brands Outlet’ apparels) would also be the new paradigm going forward. Consequently, we are toning down our FY13E-FY14E margin assumptions further by 0.5ppt - 1.4ppt to 10.90%-10.86%, which would trim FY13-FY14 earnings estimates by 4.5%-14.0%.

Risk-rewards less attractive with growing uncertainties. This report would represent our second consecutive earnings downgrade this year. The extent of the competition amongst fashion retailers is a big question mark as to how much it will affect product pricing and therefore margins. The subsidy rationalization and GST implementations are additional issues that will impact consumer spending. Hence, there are risks of more margin compressions beyond our already conservative estimates. However, we note that downside risks at current levels are limited given that the stock had been heavily sold down recently and prospects of new store growth should lend strength to the stock whilst FY14E dividend yield is looking attractive at 5.7%. As such, we maintain MARKET PERFORM on Padini but with a lowered TP of RM1.70 (from RM2.15 previously), based on a lowered FY14E EPS and lowered target Fwd PER of 12x compared to 13x earlier to account for the higher risk premium on factors mentioned above.

Source: Kenanga