ASB INVESTMENT RESEARCH Prepared by: Marc Hemsin – 3386122 Juthakarn Jessica Suwanasilp – 3344346 Tu Lan – 3282178 Bo Qiu – 3308317 DAVID JONES – BUSINESS ANALYSIS AND VALUATION May 2012 ASB INVESTMENT RESEARCH T A B L E O F CONTENT 1. EXECUTIVE SUMMARY 2. DAVID JONES’ PROSPECT AND THE RETAIL INDUSTRY 2. 1 INDUSTRY ANALYSIS 2. 2 COMPANY ANALYSIS 3. ACCOUNTING AND FINANCIAL ANALYSIS 3. 1 ACCOUNTING ANALYSIS 3. 2 FINANCIAL ANALYSIS 4. FORECAST AND VALUATIONS 4. 1 FORECAST ASSUMPTIONS 4. 2 COST OF CAPITAL – WACC 4. 3 VALUE OF DAVID JONES 5.
CONCLUSION 6. REFERENCES AND APPENDIX ASB INVESTMENT RESEARCH 1. EXECUTIVE SUMMARY DAVID JONES LIMITED – DJS Recommendation Valuation $2. 20 Last Price $2. 25 52 Week Range 4. 35 – 2. 16 Market Cap $1,216 M Industry group Retail Business risk High HOLD David Jones is a leading upmarket retail department store with 37 stores throughout Australia and specialises in high end brands of clothing, cosmetics and homewares. It’s only major competitor, Myer, has strengthened its position in the retail industry and has kept pressure on David Jones.
David Jones’ competitive strategy relies on its product differentiation through exclusive brand names supply arrangement, customer loyalty and reputation. However, the company and the retail industry are currently suffering and will remain in future years from online Strong Buy Buy $1. 85 Hold $2. 75 Sell $3. 10 Strong Sell $1. 70 competition, a decline in consumer sentiment and poor economic conditions. In addition, the expiry of the contract with American Express credit cards in FY14 is forecasted to cause a severe fall to its earnings.
Consequently, David Jones would have to prepare for the difficult conditions ahead by focusing on cost-cutting and investing capital in alternative shopping channel such as the web-store. The financial analysis reveals that David Jones has marginally become less liquid and less working capital efficient since inventory turnover has decreased and would have difficulties paying their debts in future assuming the weak retail condition continues. Although Myer’s sales figures are greater, David Jones has been the better performer with respect to Net Profit Margin, indicating that they are more cost efficient.
The accounting analysis reveals similarities between David Jones and Myer’s accounting policies but no concrete evidence of earning manipulation from management. Our valuation estimates David Jones’ intrinsic value at $2. 20. A negative sales growth is forecasted in the assumptions to reflect the challenging prospects of the retail industry. As of the 30th of May, the current price of David Jones closed at $2. 25. ASB Investment Research recommends a HOLD position for this share price. ASB INVESTMENT RESEARCH 2. DAVID JONES’ PROSPECT AND THE RETAIL INDUSTRY 2. I N D U S T R Y A N A L Y S I S The retail industry has not been a shining light of the Australian economy over the past few years as it faces some of the worst trading conditions in 50 years (Hutton, 2012). As shown from the graph below, department stores, the clothing section and the footwear section have been suffering a decline of 6% since FY09 in contrast to steady growth in volume across the remaining retail industries (Bald, 2012). According to the Australian Bureau of Statistics, February retail trade figures showed department stores experienced a year-on-year decrease of 2. % while the clothing and retail sector took a 2% drop and even household goods declined by 0. 5% (ABS, Retail Figures, 2012). The following Porter’s Five Forces model highlights the current competitive intensity and the attractiveness of the department store retail industry. Existing competitors such as Myer and growth of online retail from overseas Products can be found in other cheaper stores and online Competitive Rivalry Moderate Threat of Entrants Threat of Substitutes Very High Industry Attractiveness First mover advantage and relationship with customer and supplier Low High High
Buyers are sensitive to price and there is a low switching cost Bargaining Power of Buyers Bargaining Power of Suppliers Online retail has been a huge opened channel that is cost saving ASB INVESTMENT RESEARCH 2. 2 C O M P A N Y A N A L Y S I S SWOT ANALYSIS David Jones has built its competitive advantage by targeting the premium end of the market through the exclusive supply of national and international brands. By emphasising on product quality and customer service, it differentiated itself in the Australian market as the leading branded department store with 174 years heritage (DJS Announcement, 21st March 2012).
However, David Jones currently faces significant threat of the structural changes of the modern retail industry. The globalisation effect of the internet has brought in greater global price comparisons, hence more competition from high growing online retailing. This includes not only domestic and international online retail pure-plays but also bricks and clicks retailers, brands selling through aggregator websites, as well as established international retailers opening stores in Australia.
This threat is detrimental to David Jones as its weakness is its failure to keep up with technology and invest in its online store chain. In addition, David Jones is facing high and increasing funding costs. Nevertheless, there is still an opportunity for David Jones to be present in the new technologies distribution markets and appeal to online customers. Strength ? Strong brand affinity ? Consumer loyalty ? Strong customer service ethic and reputation–awarded “Department Store of the Year 2011” ? Well positioned stores portfolio ?
Low level of debt and strong balance sheet ? Failure to keep up with IT and invest in its online store along the lines of US upscale department store chain. ? Undiversified range of customers. ? More expensive than other stores. ? High funding costs. Weakness ? Structural Changes: online competition ? Become present in the new technologies distribution markets ? Appeal to online customers by promptly implementing their strategies and start innovative marketing campaign ? Strong Australian Dollar -> net outbound tourism and spending. (Figure 1) ? Price deflation ?
Significant consumer sentiment deterioration (Figure 2)-> high levels of household savings and weak discretionary retail spending. ? Increasing costs (labor, utilities, rent and financing) Opportunity Opportunity Threat ASB INVESTMENT RESEARCH Figure1: Household savings Figure 2: Consumer sentiment index DAVID JONES CORPORTE STRATEGY 1. Structural Transformation -Omni Channel Retailer -Customer service & engagement -Price management with suppliers and distributors David Jones’ Three Points Strategy 2. Store Network Expansion 3. Strengthening core business & reduce cost of doing business
Structural Transformation: • David Jones is in the process of transforming into an Omni Channel Retailer, which will integrate the shopping experience across various sales channels (i. e. physical stores, webstore, mobile applications) to enable customers to choose how and when to engage with David Jones (DJS Announcement, 21st March 2012). It is shifting capital expenditure away from physical stores to improve technology (Hutton, 2012). ASB INVESTMENT RESEARCH • David Jones will focus on pricing management with its suppliers and distributors to bring global price harmonization (DJS Announcement, 21st March 2012).
Store Network Expansion: • David Jones plans to open several new stores in high value locations as well as smaller format stores. Strengthening Core Business: • David Jones has and will continue to offer exclusive national and international brands. DAVID JONES’ PROSPECT Over the years, due to the prolonged downturn in the discretionary retail and consumer credit markets, the company has not achieved the underlying Financial Services growth it had anticipated in FY08 when it entered into its alliance with American Express.
David Jones expects earnings from its credit cards to be flat in the second half of FY12 and in FY13, before halving in FY14 when the current contract with American Express expires. With continuing challenging trading conditions, costs associated with structural transformation and clearing excess inventory, a decline in net profit is expected. Confirming market fears, David Jones has recently announced an expected 35 to 40% drop in profit in second half of FY12 (DJS Announcement, 21st March 2012).
Myer, which has no financial service, has also announced a 20% drop in the first half profits (Myer Announcement, 15th March 2012). The CEO of David Jones, Paul Zahra, has predicted trading conditions would remain challenging for the rest of this financial year and the first half of FY13, as it implements the transformation strategies. The Company expects that its Growth & Core Business strengthening initiatives will deliver incremental EBIT in FY14 that offsets the impact of rising costs & the decline in its FY14 Financial Services EBIT.
Subsequently, assuming no further deterioration in trading conditions, it is expected that David Jones will experience “moderate growth” in future net profit until consumer sentiment fully recovers and sustains. ASB INVESTMENT RESEARCH 3. ACCOUNTING AND FINANCIAL ANALYSIS 3. 1 A C C O U N T I N G A N A L Y S I S Earning manipulation The preparation of financial statements in conformity with the AASB requires management to make judgments, estimates and assumptions that affect the application of policies and the reported amounts (DJ Annual Report, 2011).
This permits a certain degree of judgments, which provides the management of David Jones the opportunity to manipulate the numbers for reasons such as reputation, management pay-per-performance and pressure to avoid negative news. Suspected account to earning manipulation Inventory Cash and cash equivalent at end of financial year Inventory 2011A a $000 8,760 10,838 2010A a $000 14,649 10,885 David Jones has increased inventory in recent years, such as FY11 is 2. 3% higher than FY10. However, comparing with cash equivalents in FY10 ($14,649), David Jones almost has halved their cash to $8,760 million.
From FY09, David Jones has continued to stock inventory despite cash difficulties since the GFC. The reasons of increased inventory could be due to manipulation to (1) decrease COGs to increase earnings, (2) deliberated overvaluing of inventories, or (3) signalling of expected high sales in the future. However, under the weak retail environment, it is unlikely that sales will increase and hence it is doubtful that management have manipulated inventory. 2011A 2010A a $000 256 534 153 Allowance for Doubfult Debt
Age Analysis of Receivables Less than 30 days overdue and not impaired More than 30 days but less than 90 days overdue and not impaired More than 90 days overdue and not impaired a $000 5,738 1,047 1,068 Compared with FY10, there is a tenfold increase in receivables on overdue periods, thus exposing David Jones to credit to risk. This reflects the current credit condition of customers struggling to pay their debt. Even though, based on the credit history, David Jones expected to receive these amounts, it is likely that the receivables are overstated and the related allowance understated.
ASB INVESTMENT RESEARCH 3. 2 F I N A N C I A L A N A L Y S I S For the complete ratio table, please refer to Appendix G. LIQUIDITY RATIO Current ratio David Jones Myer Quick ratio David Jones Myer Cash ratio David Jones Myer EFFICIENCY RATIO Inv. turnover David Jones Myer Rec. turnover David Jones Myer Pay. turnover David Jones Myer FY11 4. 18 4. 23 FY11 92. 56 102. 06 FY11 5. 15 3. 57 FY10 4. 69 4. 72 FY10 84. 33 99. 22 FY10 4. 91 3. 70 FY09 4. 78 4. 76 FY09 9. 01 85. 33 FY09 4. 67 3. 47 FY08 4. 72 4. 91 FY08 5. 10 111. 87 FY08 4. 78 3. 60 FY07 4. 34 5. 2 FY07 9. 74 133. 82 FY07 4. 76 4. 07 TIME SERIES ANALYSIS Liquidity: In the past five years, David Jones’ current ratio value has been above 1 except for FY09 due to the global financial crisis. Excluding inventories and receivables to assess the quick and cash ratio, David Jones’ quick ratio and cash ratio are extremely low. Given the nature of a department store company, a significant portion of their current assets is comprised of inventories and receivables. Therefore, the ratios used might not be an accurate indication of how liquid the company really is.
With increasing inventory and slightly decreasing inventory turnover ratio since FY09, suggests the company has become less liquid as less inventory is being exchanged for cash. FY11 1. 23 0. 81 FY11 0. 14 0. 12 FY11 0. 04 0. 07 FY10 1. 05 0. 87 FY10 0. 15 0. 23 FY10 0. 06 0. 19 FY09 0. 97 1. 01 FY09 0. 16 0. 41 FY09 0. 04 0. 31 FY08 1. 24 0. 88 FY08 0. 81 0. 29 FY08 0. 11 0. 19 FY07 1. 17 0. 95 FY07 0. 79 0. 34 FY07 0. 22 0. 31 SOLVENCY RATIO Debt to asset David Jones Myer Debt to equity David Jones Myer Leverage ratio David Jones Myer FY11 35. 3% 56. 5% FY11 0. 55 1. 30 FY11 1. 58 2. 9 FY10 37. 7% 56. 1% FY10 0. 61 1. 28 FY10 1. 62 3. 18 FY09 39. 0% 80. 9% FY09 0. 64 4. 23 FY09 2. 03 6. 50 FY08 59. 5% 88. 7% FY08 1. 47 7. 85 FY08 2. 79 6. 55 FY07 68. 6% 80. 8% FY07 2. 18 4. 20 FY07 3. 22 5. 62 PROFITABILITY RATIO Gross profit David Jones Myer ROA David Jones Myer Net profit margi David Jones Myer ROE David Jones Myer FY11 39. 1% 41. 8% FY11 14. 0% 8. 3% FY11 8. 6% 6. 1% FY11 22. 0% 19. 0% FY10 39. 7% 40. 8% FY10 14. 7% 8. 3% FY10 8. 3% 5. 8% FY10 23. 9% 26. 4% FY09 39. 6% 40. 4% FY09 11. 8% 5. 7% FY09 7. 9% 3. 9% FY09 23. 9% 37. 1% FY08 39. 6% 40. 5% FY08 9. 3% 5. % FY08 7. 0% 3. 2% FY08 26. 0% 33. 7% FY07 39. 3% 40. 5% FY07 7. 9% 4. 2% FY07 5. 5% 2. 4% FY07 25. 4% 23. 5% Working Capital Management: David Jones’ working capital management has become less efficient in the past five years as Inventory turnover bottomed at 4. 18 in FY11. This has resulted in a days in inventory ratio of 88 days which indicates that the company requires more time to sell its inventory. This problem could have risen from management’s inability to forecast a drop in sales and adjust for stock accordingly. In addition, the days payable ratio declined to 70. 81 days in FY11.
This has led to payables turnover to increase from 4. 76 to 5. 15 in between FY07 and FY11, meaning that the company is paying suppliers at a faster rate. ASB INVESTMENT RESEARCH Solvency: David Jones has strong solvency ratios and low bankruptcy risks due to its low leverage. Over a 5 year horizon, there is a decrease in debt-to-asset ratio (from 68. 8% to 35. 3%), a decrease in debt-to-equity ratio (from 2. 18 to 0. 55) and a decrease in leverage ratio (from 3. 22 to 1. 58). As the percentage of total assets financed by debt has declined, the company bears less financial risk and has become more solvent.
Profitability: Gross profit margin ratio depicts a stable gross profit over the past 5 years while operating profit margin has increased from 9% to 12. 9%. This shows that the company has tightening up cost operations as its operating expenses have also declined. DuPont Analysis: The ROE and ROA were used to measure the return David Jones generates on its equity. After the global financial crisis, ROE has declined year after year. This was contributed by a low leverage ratio as well as a downward trend in ROA which showed the company’s deteriorating capacity to generate return from its assets, especially in FY11.
CROSS-SECTIONAL ANALYSIS Myer, who is the only other dominant competitor in this sector, is used for comparison and for more precise assessment, we have subtracted the Financial Service Business from David Jones calculations as Myer’s credit cards contribution are insignificant to its earnings. 1. David Jones’ current ratio is overall higher than Myer despite Myer having higher cash and quick ratios, indicating David Jones has a higher portion of inventories and receivables and thus, having less cash readily available to pay debts. . It appears that David Jones is less efficient at managing inventory given that Myer requires less time to sell out its inventory. Nonetheless, David Jones manages to repay its suppliers quicker than Myer. 3. Although the solvency of Myer has improved in the last 5 years, it is still performing behind David Jones as the latter has relatively lower debt-to-asset ratio, debt-to-equity ratio and leverage ratio. ASB INVESTMENT RESEARCH 4. Greater net profit margin on David Jones’ side indicates that it has higher profitability.
Meanwhile, it is also worth mentioning that Myer has a higher gross profit margin which potentially suggests that it is more cost efficient. David Jones has relative strong financial strength of generating money, and thus the company bears less liability and is more solvent. However, high risk from intense competition from online retailing and declining consumer sentiment will force both companies to cut expenses and focus on more efficient inventory management. CASH FLOW ANALYSIS The primary source of cash for David Jones originates from operating activities and has historically stabilised around the $200 million benchmark.
This demonstrates that the company has a solid ability of producing cash from core operations. Moreover, cash from operating activities has exceeded net income in the past five years allowing less room for management to manipulate figures. In terms of investing activities, the company invested extensively on property, plant and equipment in 2007. Thereafter, as the capital on property, plant and equipment decreased, cash flow from investment also decreased considerably and stabilised around $100 million. The financing cash flow was able to benefit significantly in 2011 from proceeds of long-term borrowing worth $350 million.
Additionally, cash flow increased almost twice as of FY08 due to proceeds from assignment of store card and credit reserve receivables worth $374 million. Overall, cash flow of the company is healthy and efficient. ASB INVESTMENT RESEARCH 4. FORECAST AND VALUATIONS 4. 1 F O R E C A S T A S S U M P T I O N S Historically, David Jones has enjoyed prolonged moments of strength and dominance in the Australian market. However, the retail industry has recently suffered a major setback and the next five years from FY11 onwards may see a significantly more cautious consumer for David Jones.
In the last few years, David Jones’ sales have been quite volatile. It has experienced a return of -5. 36%, 3. 40%, and -4. 45% in FY09, FY10 and FY11 respectively. FY11 has been a particular difficult year. The Australian consumer sentiment has experienced its longest sustained decline since the start of the GFC (Westpac, 2011). Sales forecast: • Despite the recent interest rate cut by the RBA to stimulate the economy, ASB Investment Research believes that the short term effect will be insufficient to significantly alleviate the challenging conditions ahead.
Furthermore, David Jones has shocked the market by announcing an expected fall of 40% in NPAT FY12. • Starting from FY12, we have projected three years of considerable successive decline in sales. First of all, the severe decline in the equity markets and the financial uncertainty in the US and Europe will have strong repercussions for consumer sentiment. Secondly, the growth of online shopping and the struggling credit card financial services will contribute to the sales decline. • • • For FY13, we have forecasted only a decline of -0. 25% due to further expected interest rate cuts.
FY14 marks the end of the partnership with American Express which will drag revenue further down as the credit card business is likely to halve by then. From FY15 onwards, we anticipate a brighter future for David Jones as the economy and retail sector recovers. The AUSD is expected to hit parity or even fall below the USD which will encourage less spending on offshore online retail. Meanwhile, we expect that by FY16, the fully matured David Jones’ online site will be a vital driving factor of sales. • A conservative terminal growth of 3. 5% has been estimated to reflect the mean reverting trend of growth.
ASB INVESTMENT RESEARCH David Jones’ projected Sales figures 2,500,000 13. 00% 2,000,000 9. 00% 5. 00% 1,500,000 1. 00% 1,000,000 -3. 00% -7. 00% 500,000 -11. 00% 0 -15. 00% Sales EBIT Sales Growth Growth FY09A FY10A FY11A FY12E FY13E FY14E FY15E FY16E Expenses, Depreciation and Tax forecast: • Our analysis on the COGS, SG&A, Other Income/Expenses and Depreciation/Amortisation has indicated that these items have historically been proportionally constant to Sales. As a result, our average forecasts for COGS, SG&A, and Depreciation/Amortization as a ratio of Sales are 60. 0%, 27. 05% and 2. 23% respectively. Capital expenditures and Net Working Capital forecast: • David Jones is a company that is positioned in the mature phase of the business life cycle. It is a well-established company that has moderate capital requirements. Forecast of capital expenditures will include the planned comprehensive redevelopment of Sydney and Melbourne CBD stores as well as IT solution equipment for the online site. • David Jones has traditionally had a strong working capital management which has allowed for an above average dividend yield.
However, a difficult year in FY11 year has resulted in a large excess of Inventory (DJS Announcement, 21st March 2012). The clearing of this excess is expected to weaken Net Working Capital’s short term forecasts. ASB INVESTMENT RESEARCH 4. 2 C O S T O F C A P I T A L – W A C C C A L C U L A T I O N In order to forecast David Jones’ performance and estimate the value of the company, the Discounted Cash Flow to the Firm valuation has been used as the main method. A budgeting period of 5 years has been estimated which reflects the future assumptions of David Jones and the retail industry as explained in Section 4. . The Weighted Average Cost of Capital (WACC) is used to measure the cost of capital of David Jones. ASB INVESTMENT RESEARCH 4. 3 V A L U E O F D A V I D J O N E S D C F F – (Appendix C) Given the forecasts and assumptions stated above, a DCF model has valued David Jones at a stock price of $2. 24. As of 30th of May, DJS. AX shares are currently trading at $2. 25. It is important to note that the bearish market has suffered a significant drop in the last week. The Sensitivity analysis (Appendix D) shows that the DCFF model is slightly more influenced by changes in the WACC compared to changes in long-term growth.
A more optimistic growth rate could push the valuation price up to $2. 43. MULTIPLES Multiple Analysis – DJS Key measures Value EPS P/E Ratio P/B Ratio P/E growth Ratio P/S Ratio EV/EBITDA Growth rate for David Jones 1Yr Shareholder Return (avg annual) Sales Cash Flow Earnings -43. 4% -4. 4% -10. 8% -1. 8% 5Yr -9. 6% -0. 6% 6. 5% 13. 6% 10Yr 13. 6% -1. 1% 3. 9% 15. 6% David Jones 0. 31 9. 25 1. 46 10. 00 0. 57 5. 89 Myer 0. 27 8. 91 1. 48 10. 00 0. 46 7. 07 Retail Sector N/A 11. 39 1. 98 1. 49 0. 67 N/A D I V I D E N D D I S C O U N T M O D E L – (Appendix F)
David Jones has usually maintained a dividend payout ratio of 85% in the past. For the purpose of this model, we have assumed that dividends will drop to around 25 cents per share for the next few years due to the expected drop in profits and a growth of 5. 5% has been used for the terminal value to signal the recovery period. A value of $1. 85 per share has been estimated. D I S C O U N T E D A B N O R M A L E A R N I N G S – (Appendix E) The Discounted Abnormal Earnings values David Jones at $2. 23 per share. ASB INVESTMENT RESEARCH 5.
C O N C L U S I O N Based on the valuation, ASB Investment Research recommends a HOLD position for David Jones. As of the 30th of May, the current price of David Jones closed at $2. 25. Our valuation estimates David Jones’ intrinsic value at $2. 20. Several methods were used to evaluate the share price of David Jones. After careful consideration, we have allocated 90% weighting to the DCF method ($2. 24) and 10% weighting to the Dividend Discount Model ($1. 85). The Discounted Abnormal Earnings method produced a nearly identical figure to the DCF ($2. 23).
Meanwhile, the Multiples analysis provided a good comparison of key measures against Myer. The similarity between the current share price and our evaluation figure leads ASB Investment Research to recommend a HOLD position. The average 5 year shareholder return for this share is -9. 6% and the future for David Jones is not looking especially bright. The company is forecasted to experience negative profit growth over the next 3 years given online competition, declining consumer sentiment, transformation expenses and deteriorating financial service earnings.
David Jones has further announced that it is likely to suffer a 35% fall in NPAT. The current EPS of 31 cents is expected to fall by 5 to 10 cents in the next two years. Based on our findings, David Jones’ strength is structured from a strong balance sheet and a low leverage level. The financial analysis reveals that David Jones has marginally become less liquid and less working capital efficient since inventory turnover has decreased and would have difficulties paying their debts in future assuming the weak retail condition continues.
Nonetheless, management has planned strategies to respond accordingly to the evolving retail industry structure. It plans to focus on a cost-cutting plan and to integrate the shopping process through various innovative sales channel such as the online website. From FY15 onwards, we anticipate a more optimistic prospect for David Jones as the company will benefit from Omni Channel retailing (website, mobile applications) as well as the recovery of the economy and the retail sector.
ASB INVESTMENT RESEARCH 6. R E F E R E N C E S Australian Bureau of Statistics, Retail Trade 2012, February Figures, Canberra. ASX, www. axs. com. au (Accessed 15th April, 2012) Bald, A 2012, ‘Business and Economic Outlook: Australia 2012’, AFG Venture Group, http://www. afgventuregroup. com/dispatches/afg-venture-group-newsletter/business-and-economicoutlook-australia-2012-andrew-bald-associate-director-agribusiness-afg-venture-group/ (Accessed 20 April, 2012).
David Jones ASX Media Release, ‘David Jones Future Strategic Direction’, 21st March 2012. David Jones ASX Media Release, ‘David Jones Half Year Result’, 21st March 2012. David Jones Annual Report 2011. David Jones Annual Report 2010. David Jones Annual Report 2009. David Jones Annual Report 2007. Hutton, J 2012, ‘Can David Jones recover by 2014? ’, Morningstar, http://www. morningstar. com. au/stocks/article/can-david-jones-recover/4604, (Accessed 20 April, 2012). International Centre of Financial Research,