Rugging up for a bleak DJs winter

David Jones appears to have adopted the view that if it has bad news to share with the market it might as well get it all out, unvarnished, at once. That is what it did today when it announced a sharp fall in profit, an even nastier full-year earnings downgrade, a dividend cut and a bleak medium-term outlook.

The first-half decline in earnings of 19.6 per cent was not unexpected, given that it was within the range the company provided with its first-half sales numbers last month, but the full-year guidance of a 35 per cent to 40 per cent slump in after-tax profits appears to have shocked the market.

David Jones also confirmed what the market knew – that under its credit card arrangements with Amex its financial services earnings, with has produced a 7.5 per cent increase in the business's earnings since the alliance was struck in 2008, earnings will now be flat for the remainder of this financial year and next and then halve in 2013-2014 to a "sustainable new base".

It is the combination of the severity of the decline in earnings expected this year and the impact of the structural fall in its financial services income that explains why David Jones put itself into a trading halt on Monday.

The bleak nature of the results and the outlook dictated that Paul Zahra produce a comprehensive response to demonstrate that the group has a plan to haul itself back to its former status as a first-rate department store operator. With the bad news that he delivered today he also produced the outcome of David Jones' strategic review.

There's nothing particularly unique about David Jones' strategy, which is not dissimilar to that of arch rival Myer, albeit not as well progressed.

That's not necessarily a bad thing, with both of the major department store operators pursuing a template developed overseas and which other department store groups are demonstrating with increasing success can work in the new world of an increasingly globalised and online retail environment.

The new slogan for retailers is ‘omni channel' – or a ‘bricks and clicks' strategy that leverages existing physical store networks and supply chains to enable consumers to buy in-store or online and take delivery of the product or return it through either the physical network or the virtual one.

While online retailing is in its infancy in this market, with about 5 per cent of retail sales now online, it is growing quite explosively. David Jones said today that Australian online retail sales grew more than 26 per cent between the first half of calendar 2010 and the first half of 2011. Overseas, Neiman Marcus in the US and John Lewis in the UK, it said, are now generating nearly 17 per cent of their sales online, while there are a group of traditional department store operators in both markets with online sales of between about 7.5 per cent and 9 per cent.

David Jones currently has less than one per cent of its sales base online but expects to eventually generate about 10 per cent of its sales through its website, mobile apps and social networks. It plans to launch a new ‘webstore' and mobile apps before Christmas but the group is lagging Myer in terms of the point-of-sales and IT platforms needed to support an omni channel strategy.

The other point of difference between Myer and David Jones is the additional emphasis David Jones is placing on the opening of new stores, including a smaller store format. It plans to open six new full-line stores and several smaller format stores, as well as to refurbish five existing stores. It says the new full-line stores are expected to generate at least $280 million of incremental sales a year and $30 million of earnings before interest and tax. Myer, of course, has a much bigger store network than David Jones to leverage into an omni channel strategy.

To execute its strategy David Jones plans to spend $70 million to $80 million a year, funded by cash flows and landlord and supplier ‘contributions', with significant investment over the next 18 months and extra costs to be incurred over the next 12 months. David Jones will add around 200 staff to support the new strategy.

With an expectation that the group will face increased funding, labour, occupancy and utilities' costs, David Jones is targeting a $30 million reduction in its cost of doing business over the next three years to offset those cost pressures and restore its gross profit margin to 39.5 per cent to 40 per cent. That margin fell 180 basis points, to 37.9 per cent, in the latest half.

The strategy, and sombre outlook, presented today is predicated on the current hostile environment for retailers continuing for some time, with like-for-like sales growth relatively flat and profit growth, if any, modest.

Zahra believes the changes envisaged by the plan, including an increased investment in customer service (which Myer has already been making) will give his group a leveraged exposure to any recovery in the economic environment.

These are tough and challenging times for traditional retailers, with the worst retail sales environment for more than 20 years, competition from nimble online retailers and, increasingly, from big international retailers with trustworthy brands.

The strength of the Australian dollar and the fact that retailing is rapidly becoming a globalised sector but supply arrangements don't necessarily reflect that adds more layers of complexity and difficulty to Australian retailers' responses.

David Jones and Myer are trying to negotiate globalised prices with their suppliers and increase their proportions of direct sourcing but, while it is almost inevitable that they will get access to product at similar prices to their offshore peers, that is a double-edged sword given that it will import further price deflation and margin pressures.

The subdued economic and bleak retail climates, the structural shift occurring in the sector, its developing globalisation and the costs and complexity of transforming age-old business models and strategies present a daunting near and medium term challenge for department store operators.

They have, however, no alternative but to embrace the emerging new models of retailing if they wish to survive, let alone prosper, and the coincidence of the cyclical and structural shocks they are experiencing has, somewhat belatedly, convinced them of the need for quite radical and costly change.

Whether they can manage their transitions to their new models, of course, will be all in the execution. In the meantime, there's unlikely to be much goods news flowing from the sector and David Jones in particular faces some very tough times in the next year or two unless there is an upturn in consumer spending in its stores.