In Myer’s recent interim results, management marked a milestone: ‘We are 18 months into our five-year transformation’. Many of the things we expected when we first upgraded the stock in Is Myer still a pariah? on 11 Nov 15 (Speculative Buy – $0.943) – shortly after management announced the New Myer strategy – have in fact happened.
Earnings declines have abated, while strong cash flow has resumed. Dividends have also recommenced. In fact the 2017 interim dividend was lifted by 1 cent to 3 cents per share, making a total of 6 cents for the past year.
Unfortunately, though, weak sales growth in the result looked like a setback – and it's a big one. One of the key tenets of management’s New Myer strategy from 18 months ago was the introduction of a range of new ‘wanted’ brands. This merchandising overhaul has to a large extent been implemented (although brand management is an ongoing process).
Interim profit supported by cost cutting
Sales growth weakening
Outlook much less favourable
Eighteen months on, the introduction of new brands should have boosted sales growth. But it simply hasn’t happened to the extent expected – in fact second-quarter same-store sales growth fell 0.5% (see Chart 1). After a decent-enough Christmas, sales fell in a hole in January during Myer’s Stocktake Sale. While concession sales rose 25% in the half, private label and wholesale brand sales fell 12% and 4% respectively.
This can all be explained away. Apparel sales are going through a tough period, as recent retail collapses have shown; Myer can’t be immune. The company’s ownership of sass & bide was also a drag in the period as consumers walked away from premium brands. And management’s strategic decision to cease heavy discounting – consistent with its move upmarket – cost it ‘affordable fashion’ customers during the Stocktake Sale.
Myer managed to contain any damage with cost-cutting. A 0.8% improvement in its cost of doing business meant that earnings before interest, tax, depreciation and amortisation (EBITDA) rose 3% to $142m in the half. Lower interest costs boosted net profit by 5% to $63m (see Table 1).
|Six months to 28 Jan||2017||2016|| /(–)
|* Interim dividend, ex date 24 Mar|
|Note: Figures are underlying results|
But the sales numbers the company is now delivering simply aren’t good enough. When we originally upgraded the stock in November 2015, we’d expected that sales growth would be significantly better at this stage in the turnaround (similar to the boost David Jones experienced after its change of ownership, even if it seems to have lost its way more recently). This partly formed the basis for our statement that ‘from 2017, earnings should stage a recovery’.
Myer’s earnings should rise this financial year. But it won’t be by much, and earnings are being driven by cost-cutting rather than sales growth. From our original expectations of 10–11 cents in 2017, the company is unlikely to produce much more than 9 cents this year. Our longer-term aspirational target for earnings per share of 20 cents looks too optimistic given this lack of sales growth. Management’s own sales growth target of an average of 3% a year between 2016 and 2020 also looks optimistic.
There’s some downside risk to profit guidance in 2017 too. Management confirmed that net profit should increase this year, with the caveat that the dire conditions experienced in January and February do not return. As headwinds are par for the course in the department store industry, this is perhaps a risky assumption.
Also weighing on our minds is that Myer, unlike furniture and appliance retailers, does not seem to have benefited much from the house price boom in the eastern states. With the company’s sales growth actually deteriorating in recent months, we hate to think what might happen as housing prices ease or interest rates increase.
If sales aren’t likely to grow, neither are earnings. And if earnings per share are unlikely to approach 20 cents by the end of the current decade, then there’s insufficient margin of safety at this price given the risks. Our recommendation of the stock was based on New Myer delivering good sales and earnings growth, which now looks less likely. Of course, this is the nature of a speculative recommendation.
The fact we purchased the stock cheaply in the first place has protected us to some extent, but our various Myer recommendations (including at up to $1.25) look like mistakes. The earnings upside we envisaged in any turnaround looks unlikely, which means our investment case is broken. There's insufficient reason to maintain a holding without this potential upside.
We’re therefore downgrading the prices in our price guide significantly. This also implies a downgrade of the recommendation to SELL.