Stronger DJs holds a store of value

As a launching pad for its merger discussions with Myer, David Jones’ first half performance was respectable rather than impressive.

Given that it had been well-flagged that the contribution from its financial service business would roughly halve as a result of changes to its relationship with American Express, holding the decline in earnings to 4.6 per cent was a pretty solid achievement.

In fact, financial services earnings before interest and tax were down almost 53 per cent, from $24.5 million to $11.6m, so David Jones’ ability to nearly blunt that impact with an improvement in its core department store operations was, at face value, a more than respectable outcome.

The department store's EBIT was 8.3 per cent higher at $91.6m compared to the $84.6m generated in the first half of the 2012-13 year.

While that appears to be a quite impressive achievement in a still-difficult retail environment, it does need to be noted that David Jones was cycling a very soft half a year ago. In the first half of 2011-12 the stores had EBIT of $101 million. Since then, the EBIT margin for the stores has dropped, on a stagnant sales base, from more than 12 per cent to less than nine per cent.

Until we see Myer’s first-half numbers later this week it is difficult to put David Jones’ result, and its implications for the merger discussions with Myer (assuming there are discussions), into context.

Myer is expected to disclose a material decline in earnings in the first half as it absorbs a significant increase in labour costs, steps up its investment in its online offering and absorbs the impact on sales and earnings of refurbishing three of its bigger stores.

David Jones’ new chairman Gordon Cairns has commissioned a review of the merger concept by an external consultant, Port Jackson Partners. Unlike his predecessor Peter Mason, he appears prepared to seriously look at Myer’s proposed share-swap "merger of equals".

Whether he’s simply going through the motions to appease shareholders that want the concept explored seriously or not won’t become clear unless and until there is a real engagement with Myer and its advisory team.

Certainly, David Jones and its newly-recommitted chief executive, Paul Zahra, are in better shape than they were six months ago, with positive ‘’like for like’’ sales growth, significant growth off a very small base in inline sales, solid cost management, a stable gross margin and a strong balance sheet.

The sales growth -- total sales were up 3.8 per cent and like-for like sales were up 1.1 per cent -- was a good outcome given that Zahra had made it clear he was going to reduce promotional activity and discounting to protect margins. David Jones held its gross margin at 39 per cent. The majority of the growth in like-for-like sales came from the group’s online channels, with store sales edging up only 0.2 per cent.

There was also good inventory management, with inventories at the end of the half down 11.5 per cent, or $30 million, on the outcome a year earlier, although that also reflects the transfer of about $20m of inventory to Dick Smith as part of the shift of David Jones’ electronics category to a concession offer managed by Dick Smith.

It is too early (and the numbers are too small) to come to any conclusion about the performance of David Jones’ online channels. However, the growth rates are impressive, with first half online sales up 220 per cent. Online sales in the second quarter, however, were still only about 2.2 per cent of total sales.

Judging by the performance of offshore department store groups, Zahra’s target of generating 10 per cent of group sales online by 2018 isn’t fanciful if David Jones executes well but the omni-channel bricks and clicks strategy is, at this point, very immature.

Myer’s proposal was predicated on the synergies that could be extracted from merging the behind-the-store operations of the two groups and spreading the costs of developing and managing the technology platforms and logistics for an omni-channel offering.

The traditional retail turf of the two department store groups is under assault, not just by online competitors but by an invasion of offshore retailers drawn by the relative strength of the Australian economy and the interest in their brands from Australian consumers that has been demonstrated online.

The Myer proposal reflects the view that it is going to be increasingly difficult for physical department store networks to generate top-line growth. Therefore it is critical to lower their cost bases while establishing a meaningful online presence.

A key point of difference between David Jones and Myer is that David Jones owns its own flagship stores, which are valued at $612m.

It is considering development options for the properties to try to add value and said today that it expects to issue an information memorandum on its Sydney site in the final quarter of this financial year. The value and treatment of those properties will be a major discussion point with Myer.