Are we hearing the full story when it comes to retail stocks? Or being lulled by financial market patois into visions of a cyclical recovery that may never arrive?
We hear a lot about soft patches, we hear the oft-parroted catchcries "challenging" and "tough retail environment". But one gets the eerie feeling that we are not being availed of the full story. What if this retail predicament were a little more structural than the analysts were forecasting? David Jones shares got hammered 20per cent in a day last week on conceding an earnings downgrade. Country Road confessed to lower guidance on Monday. JB Hi-Fi, Harvey Norman, Myer, Noni B, Billabong - you name it - if it's in retail, its share price has seen better days.
A stress test is in order then. How much pain can a retailer bare?
The plight of David Jones has been well telegraphed. The usual suspects: rising interest rates, rising saving rates, a sluggish east coast consumer economy, poor clearance sales, and floods and cyclones were to blame. The chief, Paul Zahra, even blamed falling earnings on the spectre of the carbon tax.
Let's look at Zahra's arch-rival, Myer, for a case study. Last year, Myer notched up sales of $3.284 billion. Its gross profit for the year came in at $1.301 billion, for a gross profit margin of 39.6per cent. Earnings before interest and tax (EBIT) were $271 million, or 21per cent of gross profit.
As almost everything that lies between gross profit and EBIT is fixed costs we can assume, if sales were to fall by 21per cent, there would be no EBIT left.
Sales are falling. For the first half, they were down 3.6per cent on the previous corresponding period. And, by the third quarter sales update in May, it was evident the soft trend had persisted, with sales on a like-for-like basis tracking 3.1per cent lower.
The point of this is that Bernie Brookes and his team at Myer have already done a sterling job stripping the costs out of this business. They've sold the buildings and leased them back. They've snipped the staff costs to a bare minimum.
Short of actually lugging the entire inventory out of the leased properties and creating an echo chamber - a dance party venue perhaps - there is not a lot more cost to come out. So, the future of Myer relies on rising sales.
The concern over sales holds for every retailer. For its part, David Jones, has just forecast that its fourth quarter sales would fall 11per cent. That's a fair leg down. Is it really just cyclical? Or are we talking the internet here, the great unspoken?
Extrapolating further on Myer, there's $420 million-odd in debt, which they have just started to pay down. Let's say $400 million at 7per cent interest and there is $28 million in interest cost a year.
That means, when Myer gets to EBIT of $28 million, that is the year it goes bust. This is entirely hypothetical of course. On the current trajectory the game might be over in five years. But there is time. There is cash.
Now, this perspective is a rather alarmist way of looking at things - and, it must be said, at odds with mainstream forecasting. Take for instance the venerable numbers of Goldman Sachs. Goldman should know a lot more than others, as it was intimately involved in the float and is therefore close to the business.
Looking then at a Goldman report on Myer from March this year, the broker said total sales growth rates had improved since January but "remain negative".
"Importantly, we do NOT believe that recent weakness in sales or earnings represent a structural change in Myer's operations or industry positioning."
The report was emphatic. Nothing structural. It was all cyclical downturn stuff.
Country Road conceded on Monday sales were down 10.9per cent on a comparable store basis in fiscal 2011. We know people are increasingly shopping online. Australian retailers, as a class, have lagged some of their overseas counterparts.
As the Australian dollar has shot up, lowering dramatically their cost of goods, retailers have held their fewer, fatter-margin customers but not passed on the falling costs.
What happens when the Australian dollar goes down again?
Frequently Asked Questions about this Article…
What is the current state of Myer’s business and are its retail sales declining?
According to the article, Myer reported annual sales of $3.284 billion with gross profit of $1.301 billion (a 39.6% margin) and EBIT of $271 million. Sales were down — first-half sales fell 3.6% year-on-year and like-for-like sales were tracking about 3.1% lower by the third-quarter update, indicating a persistent soft sales trend.
How much debt does Myer have and could interest costs threaten its profitability?
The article notes roughly $420 million of debt that Myer has begun paying down. Using a simple example of $400 million at 7% interest yields about $28 million a year in interest costs — meaning if EBIT fell to that level, interest could consume operating earnings. The piece describes this as a hypothetical risk and notes Myer currently has cash and time to manage the situation.
Have Myer’s management and owners already cut costs, or is there more room to reduce expenses?
Myer’s leadership (Bernie Brookes and his team) have already taken significant cost actions: selling and leasing back buildings and trimming staff costs to a minimum. The article suggests there isn’t much more fixed cost to cut short of extreme measures, so future recovery depends largely on rising sales.
Are the recent problems at Australian retailers considered cyclical or structural?
Views are mixed in the article. Some brokers, like Goldman Sachs, argued the weakness is cyclical and not a structural change to Myer’s position. The author, however, raises the possibility that part of the retail slump could be structural — for example, due to growing online shopping — and cautions investors not to assume a simple cyclical recovery.
How have other Australian retail chains performed recently, and which ones were mentioned?
The article highlights broad weakness across retail: David Jones shares fell about 20% in one day after an earnings downgrade, Country Road cut guidance with sales down about 10.9% on a comparable-store basis, and other retailers named with share-price pressure include JB Hi‑Fi, Harvey Norman, Noni B and Billabong.
What impact is online shopping having on Australian retailers?
The article points out that Australians are increasingly shopping online and that Australian retailers have generally lagged some overseas peers in adapting. This shift to online is raised as a potential structural headwind for traditional bricks-and-mortar retailers if sales permanently migrate away from stores.
How could movements in the Australian dollar affect retail margins and pricing?
The article notes that a stronger Australian dollar had lowered retailers’ cost of goods, but many retailers kept higher-margin customers and did not pass cost falls on to shoppers. The author asks what might happen if the dollar weakens again, implying that currency moves can squeeze margins or force price adjustments that affect profitability.
What should everyday investors watch when evaluating retail stocks like Myer or David Jones?
Investors should monitor sales trends (same-store and like-for-like growth), margin trends and fixed-cost coverage (EBIT versus interest), debt levels and interest burden, management’s ability to adapt to online competition, and broker views on whether weakness is cyclical or structural. The article emphasizes that after aggressive cost-cutting, a sustained sales recovery is often crucial for retail turnarounds.
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