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Morningstar | Myer Kicks Refinancing Can Down the Road; Strategy Light on Quantitative Goals; FVE Down to AUD 0.63

No-moat Myer’s costs of doing business surprised, materially increasing despite decreasing sales, causing underlying net profit after tax of AUD 32.5 million to miss our estimate of AUD 40.2 million. The refinancing of the company’s debt and associated debt covenants has been addressed, diminishing the likelihood of a dilutive equity raising for now. We were disappointed in the absence of tangible medium targets from John King, Myer’s new CEO. However, the strategic direction matches that of many other retailers. We expect Australian consumers to continuously migrate to the online channel, and department stores to gradually shutter floor space as footfall declines. We expect Myer to reduce its floorspace by 25% over the next decade, either by closing entire stores or handing landlords back only some of the space within stores. We cut our fair value estimate by 5% to AUD 0.63, mainly owing to lower near-term EBIT margin estimates, partially offset by the time value of money impact on our financial model.

John King discussed his strategy in his first results presentation after some 100 days in the new job. He stated that Myer “will be focused on delivery and execution, not promises,” and none were given. We were disappointed by the lack of quantifiable medium-term targets regarding such matters as the physical store footprint, sales growth, and EBIT margins. Nor was guidance provided for fiscal 2019. However, the focal points of the strategy were discussed and are akin to those of other retailers domestically and abroad: a high-quality product range that is hard for others to replicate by offering either private brands or national brands that are exclusive to Myer; enhanced customer service in store, which also includes upgrading stores themselves; and strengthening the online offering. This corresponds with our unchanged investment thesis.

Total sales were better than we expected, down 3.2% versus our estimate of a 3.7% decline in fiscal 2018. Online sales were up strongly, improving the overall like-for-like sales figure to a decline of 2.7%. Without the 34% increase in online sales, we estimate like-for-like sales in the physical stores declined by about 5%. We expect online to continue dominating Myer’s sales growth, and this trend highlights the necessity of consolidating the physical footprint. Comparable sales improved in the fourth quarter of fiscal 2018 to a decline of 1.7%, from a decline of 3.1% in the third quarter. This positive trend has continued into fiscal 2019, and we expect the launch of the new Myer website in late September to further boost online sales, after a weak fourth quarter in e-commerce. Yet the improvement in sales performance falls well short of rival David Jones in the second half, which increased like-for-like sales by 2.7%. We forecast sales to decline by 0.4% per year over the next decade, as on average some 2.6% of floorspace is rationalised per year.

We expect the closure of less productive floorspace to improve operating margins, but the transition of sales to the online channel and the refurbishment of remaining stores come at a cost, and we forecast capital expenditures of around AUD 100 million annually. Cost of doing business represented 33.4% of total sales in fiscal 2018, up some 150 basis points due to operating deleverage and annualisation of cost from the Marcs and David Lawrence acquisition. Together with flat gross margins, this resulted in EBIT margins being crunched to 1.8%, some 30 basis points lower than our estimate of 2.1%. We expect EBIT margins to gradually recover to 3.3% over our 10-year forecast period, less than half of the 6.8% EBIT margin Myer enjoyed only five years ago.

Myer’s dividend remains suspended and no final dividend was declared. The refinancing terms permit dividends to be reinstated once the fixed charge cover ratio is greater than 1.65. We forecast the ratio to stay below this threshold until fiscal 2021 and hence anticipate a dividend from fiscal 2022. Besides extending the maturity of its debt, Myer also generated positive free cash flow after paying dividends of AUD 6 million in fiscal 2018, versus our estimate of AUD 11 million, reducing the company’s net debt to AUD 107 million.