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 bear?
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?