EUR 850.00 For Business Accounts Only

Morningstar | Myer Shows First Indications of Turnaround in Profits; We Increase Our FVE by 5% to AUD 0.66

No moat-rated Myer surprised the market with a solid first-half result for fiscal 2019, loaded with a raft of clear operational and financial improvements. The market reacted accordingly, with the share price jumping 11%. Nevertheless, shares are still trading at a meaningful discount to our fair value estimate and screen as undervalued. We increase our fair value estimate by 5% to AUD 0.66 due to the time value of money.

The result mitigated two key risks that had been overhanging the Myer share price--they’ve certainly kept us awake at night.

First, Myer’s balance sheet was sailing close to the wind after an AUD 525 million noncash impairment in March 2018. This increased the risk of a covenant breach, dilutive equity raising, and debt restructuring that could have disadvantaged existing shareholders. Even after the refinancing in November 2018, investors remained concerned about the company’s debt and the new restrictions on the payment of dividends to shareholders.

On the back of the strong first-half operational and free cash flow performance, all three main debt covenants improved from six months ago, despite declining sales. Myer’s net debt position is AUD 57 million lower pcp, and equity on its balance sheet increased by AUD 34 million, both improving leverage. Yet, the fixed charges cover ratio of 1.61 was still below the 1.65 threshold before dividends can be reinstated. We expect Myer to be net debt positive by the end of fiscal 2020, putting it in a strong position for the next round of refinancing--the current bank facility matures in February 2021. However, we don’t expect Myer to pay dividends until fiscal 2021.

Second, Myer’s management must navigate a structural headwind facing the Australian department store sector. Our sales growth forecast of Myer is unchanged. We expect sales to remain flat long term, as the chain continues to lose market share to online players and specialty fashion stores.

To remain profitable, we expect department store chains, including Myer, to gradually reduce floor space in line with declining footfall due to the growing online shopping channel. We anticipate Myer will adapt by shrinking its floorspace by 30% over the next decade. During the first half, Myer closed two stores, and two more store closures--one each in Sydney and Canberra--have already been announced. Handing back less profitable floor space to its landlords is a key driver in lifting Myer’s EBIT margins longer term. Management is in advanced negotiations with its landlords, and we expect a detailed update on the company’s store network strategy by September 2019. A broader industry effort of rationalisation of floorspace across the department store sector could act as a tailwind to Myer and its competitors. The smaller store footprint could increase average sales per square meter and signs are emerging that the department store sector has reached its peak footprint. In June 2018, Target announced a 25% reduction in floorspace over a five-year period. Woolworths is currently reviewing Big W’s store and distribution networks, and we expect an update on its plans by April 2019.

Offsetting the reduced sales from its physical stores, we anticipate Myer to significantly grow its online channel. In the first half, online sales grew by 19% and now comprise 10% of sales, in line with our unchanged estimate of 10% online penetration for fiscal 2019. Our unchanged forecast of online sales penetration of 20% by fiscal 2024, increasing to 30% by fiscal 2028, corresponds with management’s aspirational target of reaching over 20% in the medium term.

This online growth, together with maintaining the appeal of its physical store network, will not come without a cost to Myer. We estimate capital expenditures to average around AUD 100 million per year, well above company guidance of AUD 60 million-AUD 65 million.

Sales declined by 2.8% in the half, but this is still a solid outcome. Management previously flagged sales growth would be volatile in fiscal 2019, as it consciously moves away from discounting and abandons profitless sales. The 1.4% decline in sales in the second quarter was a meaningful improvement on the first quarter decline of 4.8%, and sales are tracking in line with our unchanged full-year estimate of a 2.6% decline. Near term, we expect investor spending to be dampened by relatively sluggish wage growth, a weakening housing market, and uncertainty around the upcoming Australian federal elections in May 2019.