Myer Holdings (MYR) has become one of the most shorted stocks on the market, and we agree with the hedge funds. The FY14 result revealed a company that has to run harder just to maintain earnings at recent levels as external pressures beyond management’s control bite. The stock has fallen 17% since the result to levels it was trading at three years ago. Meanwhile, the recent strong result (on September 17) from retail group Premier Investments (PMV) pleased the market and drove its shares to a 10-year high. The contrasting results are a case study in retail stagnation versus retail success.
Myer now trades on a price-earnings (P/E) ratio of 12x and is capitalised at $1.2 billion, compared with PMV on a P/E ratio of 20x with a market cap of $1.7 billion. This has triggered speculation Myer could become the next target for PMV chairman Solomon Lew. The former Coles Myer chair engaged department store experts to propose a joint venture bid for David Jones in May, indicating an ongoing interest in the sector. However we question whether Mr Lew would want to take on Myer’s structural problems and do battle with David Jones, now owned by the powerful and successful South Africa’s Woolworths. PMV’s recent success derives from the astute management, positioning and expansion of niche brands, not ownership of large-format, full-service brands like Myer.
Myer’s net profit for the year ended July 2014 fell 23% to $99 million, the fourth successive annual decline and below market expectations of a $106m result. As recently as FY11 Myer made a $163 million profit. Margins were weak, the retailer missed its cost guidance and profit guidance for FY15 was subdued. FY14 return on equity was 15%, well below the 20.5% five-year average (see red box below) as a cost blowout crimped margins for earnings before interest and tax (EBIT) (see green box). Over the last five years the equity base expanded by $613 million but $440 million of this came via equity raisings. Less than $73 million came from retained earnings net of lower reserves.
Figure 1. Myer five-year financial history
Returns for Myer shareholders are not about to improve. Myer faces increasing competition from international retailers, online retail and rejuvenated domestic brands. For example, in Sydney’s CBD the French cosmetics chain Sephora is about to open a large store just 50 metres from Myer’s flagship Sydney building where the cosmetics, one of the highest-margin categories in a department store, are on the ground floor. Sephora is certain to take cosmetics share from Myer. H&M, Forever 21 and Uniqlo are also coming and Target could become competitive after its turnaround. David Jones will be better managed and will probably come down into Myer’s segment: the middle market between discount and high end, through a private label offering.
Myer spent $87 million on capital expenditure in FY14 and plans capex of another $80 million in FY15. The risk is that the returns on this incremental equity reinvested could decline due to the rising cost of doing business, higher depreciation expense deriving from the capex, revenue pressures from intensifying competition and a higher cost of imported goods as the Australian dollar depreciates to our US85 cents target over the year ahead. The cost of doing business as a proportion of sales has risen every year for the last four years from 28.4% in FY10 to 32.9% in FY14. Every percentage point comes off gross profit.
Chief executive Bernie Brookes is confident sales will rebound by around $100 million this year due to new store openings and refurbishments, underpinning the first growth in earnings in five years. We agree revenue can recover this year but forecast earnings will soften by $2 million to $97 million due to the costs of refurbishment and maintaining Myer’s competitive position. Myer needs both strong sales growth and significant gross margin expansion to maintain current profits. But delivery of sales growth guidance has historically been lacking, so maintaining current profits is unlikely. The cost base will continue to expand and we don’t think the group can grow sales sufficiently to avoid operating deleverage.
Meanwhile, consumer sentiment remains weak due to political impasses in Canberra, changes in government policy, geopolitical events, cost of living inflation and concerns about job security. As a retailer of discretionary goods, Myer is vulnerable. “We’re the last in the wallet to get any money,” Brookes admitted.
Myer is caught in a difficult place. If it underspends on capex, its competitive position and appeal to customers will deteriorate and it won’t be able to drive higher sales by opening new stores. If it spends up on capex then it reinvests shareholders’ equity into a business with deteriorating economics.
The pressures on Myer reduce the margin for error from overspending on inventory, as seen in FY14. Fourth quarter like-for-like sales exceeded expectations but second-half gross margins shrank significantly. It looks like Myer aggressively discounted prices to clear inventory and drive revenue growth.
Myer needed a deal with David Jones but could not afford to pay a price compelling to DJs shareholders as Myer equity was not valuable enough, reflecting the risks to profitability. Now, without a merger, Myer faces a rejuvenated DJs backed by South Africa’s Woolworths.
Management is valiantly executing a credible strategy but external, structural pressures threaten to cancel out the benefits. Essentially Myer’s outlook is stagnant at best, with the company having to spend more just to stand still. The 31% cut to the final dividend signals directors’ reservations about the future. We recently downgraded our FY15 valuation to $1.88, which leaves the stock overvalued around $2.05. Our view of sustainable return on equity, 15%, is slightly above consensus at 14.8% in FY15 (red box below). Future value growth is negligible at around 2% pa because Myer’s ability to reinvest earnings at 15% is weak. We think Myer can sustainably reinvest just two percentage points of this 15% ROE at 15% (green box below). The rest leaves the business in the form of dividends. Myer’s above-average dividend yield (purple box) signals the business is ex-growth.
Figure 2. MYR valuation and value metrics
Figure 3. Myer intrinsic value (orange line) versus share price (blue shaded)
By David Walker, Senior Analyst StocksInValue