TD's View on ROOT's TodayEvent Roots is expected to report its Q1/F22 results in early-to-mid June.
Impact: NEUTRAL
Q1/F22 Preview: Following the material Q4/F21 financial outperformance, it is our view the Roots brand continues to resonate with consumers during the seasonally weak Q1/F22 period. We believe DTC sales should benefit from the lapping of government mandated store closures/restrictions in Q1/F21, freshness of its product offering, and modest price increases. We anticipate gross margin sustainability as demand enables pricing pass-through of inflationary costs, and a degree of SG&A leverage excluding CEWS/rent abatement benefits realized in Q1/F21. This supports our forecast improvement in "clean" EPS y/y.
Valuation: Regardless of valuation metric, be it EV/EBITDA, P/E, or increasingly important these days, FCF yield, shares of Roots in our opinion are undervalued. Having substantially completed its major long-term investments including a sophisticated omni-channel platform, Roots is positioned to generate attractive FCF over our investment horizon. As illustrated in F2021, this profile resulted in the balance sheet being deleveraging from >4.0x at the commencement of the pandemic to 0.5x currently on a pre-IFRS 16 basis. We expect this ratio to decline further in F2022, inclusive of Roots being active with its NCIB.
Q1/F22 Focal Points: With supply chain headwinds and inflation persisting, we will seek an update on both product availability and the ability for the consumer to absorb price increases. Second, we will be looking for an update on its digital expansion strategy in International markets. Third, as noted by management last call, we will look for a build in sales from stores that cater to tourism as the travel market gradually improves.
Summary: We believe that Roots' strategy of limiting promotions, offering compelling assortments, and driving operational improvement within its cost structure is driving improved profitability and FCF. As this track record is further established, this should benefit its current valuation that we view as punitive. We reiterate our view that investors also have a free option on a potential monetization event. TD Investment Conclusion We maintain our ACTION LIST BUY recommendation and $5.00 target price.
Details We forecast a decline in reported EPS for Roots seasonally weakest quarter Q1/F22. That stated, on a "clean" reporting basis, that excludes the benefits of CEWS and rent abatements in Q1/F21, we anticipate a y/y improvement in financial performance. Our forecast for adjusted EPS of -$0.13 is in line with consensus and compares to -$0.15 y/y on a "clean" basis.
Direct-to-consumer (‘DTC’) Sales: We forecast DTC sales to grow in the low double-digits on a y/y basis. Our channel checks indicate that consumer demand remained engaged during the seasonal slowdown, in addition to Q1/F22 lapping a period that was impacted by government mandated closures. Recall that in early April 2021, that all 62 stores in the key market of Ontario were temporarily closed and limited to curbside pick-up only. As a result, we anticipate a decline in the eCommerce sales penetration rate y/y, offset by a meaningful increase in in-store traffic. We also believe that DTC sales should start to see a small benefit from the early days of improving tourism traffic.
Partners & Other (‘P&O’) Sales: We forecast a nominal y/y increase in P&O sales. This is largely due to an anticipated increase in above average price point third-party license sales/collaborations. Adjusted EBITDA Margin: We are focused upon the "clean" adjusted EBITDA margin for comparative purposes as we do not anticipate the benefits of rent abatements/CEWS to repeat in Q1/F22.
Our DTC gross margin calls for a modest y/y decline due to the impact of inflationary costs, including escalating freight costs. That stated, we anticipate the margin to remain strong by historical standards as consumer demand absorbs modest price increases, and management maintains its strategy of optimizing sales through limited C$000's, except per share Q1/F22E Q1/F21A Y/Y Chg Direct-to-Consumer 35,628 31,418 13.4% Partners & Other 6,062 5,927 2.3% Total Sales 41,690 37,345 11.6%
Cost of Sales 17,829 15,871 12.3%
Gross Profit 23,861 21,474 11.1%
Gross Margin % 57.2% 57.5% -27bps
SG&A (excl. D&A) 1 22,096 18,149 21.7% % of Sales 53.0% 48.6% 440bps
Adjusted EBITDA 1,766 3,325 -46.9%
EBITDA Margin % 4.2% 8.9% -467bps
Adjusted EBITDA Pre-IFRS 16 -3,834 -2,537 -51.1%
EBITDA Margin % -9.2% -6.8% -240bps
Reported EPS (f.d.) 1,3 ($0.13) ($0.10) -24.9%
"Clean" Adjusted EBITDA 2 1,766 372 374.6%
EBITDA Margin % 4.2% 1.0% 324bps
"Clean" Adjusted EPS (f.d.) 1,2,3 ($0.13) ($0.15) 14.7%
1 Q1/F21A excluding ~$0.2mm in one-time charges.
2 Q1/F21A excluding ~$2.9mm in CEWS and Rent Abatement benefits or ~$0.05/share.
3 Q1/F21A excluding ~$0.8mm in net one-time charges or ~$0.02/share.
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We forecast a material y/y increase in SG&A excluding D&A as stores reopen, however, upon eliminating the one-time benefits in Q1/F21, we anticipate a decline as a percentage of sales as Roots should benefit from ongoing targeted cost efficiencies and scale.
Outlook
Investment Thesis: For the first time in over two years, it appears that the Roots omnichannel offering should operate free of any government mandated closures. This should provide an opportunity, in our view, for the company to highlight the strategic improvements to its business model that management has undertaken during the pandemic.
We acknowledge the growing risk that inflation and rising rates may have on the outlook for consumer spending. That stated, we feel that Roots is well positioned to achieve improving financial results over our forecast horizon, that should illustrate an overly punitive valuation.
First, we anticipate the movement to casualization to remain a post-pandemic positive to a degree. Second, we believe that near-term, the Canadian consumer/economy should outperform its global counterparts as a function of a strong oil/commodity environment. Third, we do not anticipate store closures going forward to repeat that weighed upon F2020/F2021 results. Lastly, we anticipate a modest benefit from an improving travel//tourism outlook.
This, along with Roots strong brand loyalty, should in our view lead to an improvement in y/y "clean" adjusted EBITDA/EPS in F2022/F2023. Perhaps even more important, in our view, in the current market volatility, is Roots' outlook for FCF. The company has no material capital expenditures required in the foreseeable future. As such, a combination of solid financial results, and limited capital expenditure should maintain strong annual FCF. We forecast sustainable FCF of >$20mm in both F2022/F2023 implying a FCF yield of >15%.
We highlight Roots was active with its NCIB repurchasing ~373k shares in Q1/F22. Valuation Roots is trading at 7.4x/6.7x our EPS forecasts for F2022/F2023, a discount to its premium lifestyle brand peers, which are currently trading at 23.5x/22.7x consensus EPS for C2022/C2023. Justification of Target Price We maintain our target multiple of 10.0x our F2023E EPS. As both metrics are unchanged, so too is our $5.00 target price.
Key Risks to Target Price Key risks to target price include: consumer spending; competition/fashion risk; success in growing the brand in Canada and expanding into international markets; success in deepening the product assortment; maintaining a relevant brand profile; pandemic viruses/diseases; an evolving global retail environment; unfavourable/unseasonable weather conditions; foreign exchange; control by insiders (Searchlight and Founders together hold 55% of the votes); and potential overhang of secondary offerings