The Warehouse Group Five Year Financial Analysis and Projection 2013 Business Report Executive Summary In the last two years The Warehouse Group (WHS) has looked to halt a decline in profits and revenue. The iconic brand fondly referred to as the Red Sheds by New Zealanders had hit rocky ground with a list of failed ventures (including Warehouse Australia), a plummeting share price $8. 50 in 2000 falling to $2. 0 2012 (partly due to the global financial crisis), falling operating profit and stagnant revenue growth. Some local distributors were reluctant to supply the store for fear of brand damage nd their supply chains lacked the diversity to provide on-going profit margins. In 2008 WHS was the target of potential takeovers from Woolworths and Foodstuffs but the commerce commission prevented previous moves due to competition rules relating to the sale of groceries in The Warehouse Extra stores.
Investors have even received unsolicited offers from private investors. Based on the previous two years results the decline has successfully been halted. Plans to bring WHS stores into the 21st century with a $430 million capital spending plan that refits tired stores and rebuilds brand image are underway. Higher end goods have been sourced through a combination of parallel importing and company acquisitions. Share price has begun its recovery reaching a five year high of $4. 9 in May 2013. Dividend pay-outs have been increased to 90% of adjusted net profit providing good return to investors. WHS is still a potential target for takeover, Woolworths and Foodstuffs both still own 10% each and groceries have now been removed from stores which may open the door again. This potential makes medium term investment in WHS shares quite attractive as any such bid would likely be an improvement on current share price.
In summary, WHS shares provide an attractive medium to long term investment, a solid performing business moving in the right direction providing high dividends and the potential for a takeover windfall still on the cards. Table of Contents Executive Summary 1 Introduction 4 Organisation Purpose 4 Organisation Values 4 Organisation Strategies 8 Organisation Non-standard GAAP measures 8 Conclusion 10 Financial Analysts (2008-2012) 10 Financial commentary (2008 – 2012) 13 Return on Ordinary Shareholders Funds (Profitability Ratio) 13 Cash Flow from Operations (Liquidity Ratio) 14
Dividend Pay-out Ratio (Investment Ratio) 14 Dividends per Share and Earnings per Share (Investment Ratio) 15 Operating Cash Flow per Share (Investment Ratio) 15 Recommendation 17 Balance Sheet valuations (2008 – 2012) 17 Non-current deferred taxation 17 Property, plant and equipment 17 Inventories 18 Computer Software 18 Provisions 18 Financial Derivatives 18 Discussion 19 Financial projection (2013 – 201 5) New CEO 19 Sale and Leaseback 19 Stores refurbishment 19 Sales growth 20 Improved margins 20 Government tax cut 20 APPENDIX 21 References 27 Introduction Organisation Purpose 19
With 145 stores throughout the country WHS is one of New Zealand’s most recognised brands and the largest discount retailer operating in New Zealand. Founded in 1982 by Sir Stephen Tindall it has a focus on keeping costs down and reinvesting profits. It is best known for its discount retail chain The Warehouse (Red Shed). WHS also includes Warehouse Stationary (Blue Shed) and the recently acquired Noel Leeming Group.
In the last 12 months they have looked to improve their parallel importing capabilities with the purchase of specialist importers Insight Traders, they have also increased their online presence and offerings through the urchase of a majority share in the online retail business Torped07 (Claire, 2013b) and with the purchase of the Noel Leeming Group they will extend the quality of products available in their stores. They were listed on the New Zealand Stock Exchange in 1994 and the following year added to the NZSE40 Index.
Six years later Organisation Values WHS is designated as a profit oriented entity for financial reporting purposes. It currently targets a 90% dividends pay-out policy for investors. Recent initiatives aim to attract more upmarket customers through modernising stores, improving the uality of goods on sale and enhancing the customer experience through staff training and incentive schemes. The programme of sale and leaseback of existing stores is a move to release capital and improve liquidity. Any cash generated from the sale of property assets would be applied to debt reduction in the first instance.
It also lists the following core purposes as under pinning the organisation: ??? Making the desirable affordable; Supporting our communities and the environment; Putting you, our customer first; and Teamwork. Top of the values is “providing Kiwis with a bargain”. In order to achieve this they utilise their supply chain expertise to buy in bulk from around the globe and retail through the no-frills warehouse style stores located in the larger NZ communities. Another initiative sees stores in smaller NZ communities with The Warehouse Local a scaled down operation that further increases their presence.
They support triple bottom line reporting and have embraced environmental challenges such as reducing waste and recycling, minimizing energy use and emissions, sourcing sustainable products and maintaining ethical trade commitments. Organisation Business Activities In Diagram 1 below we see over the last 5 years WHS has been a reasonable performer with share price holding steady other than an initial fall in the third and fourth quarters of FY2008 which was largely due to a lack of consumer confidence due to the global financial crisis.
More recently investors have been attracted by the high dividend pay-out policy of 90% that has helped recover the share price in 2012. Diagram 1 Below Diagram 2 provides a 13 year record for WHS and highlights the fall in the 2008 market value. The share price pre-2008, can partly be attributed to global inancial conditions where New Zealand households had very high discretionary spend (Kida, 2009), consumer confidence and spending was high but with very large imbalances of savings and investment.
The period known as the Great Moderation (the mid-1980s to the mid-2000s) ended with a string of extraordinary events, a global crisis and an economic slow-down (Bollard, 2009). Therefore, we will focus attention from mid-2008 where we can see WHS performance in the markets has been reasonably steady. Diagram 2 Warehouse Stationery – Warehouse Stationery is a stationery retailer, with 56 stores located throughout New Zealand. The addition of five new stores in 2012 and relocating back office staff to head office has reduced overheads and allowed them to deliver a newer and more modern in-store experience.
Over the last four years the contributed $206 million dollars in 2012. Parallel Importer – WHS had only a few parallel imports prior to 2012 but has increased that significantly due to some local distributers refusing to supply to WHS. WHS is desperate to improve the image of stores and wants higher quality goods to attract more upmarket customers. Insight Traders – WHS has enhanced its sourcing and multichannel capability by purchasing he import specialist Insight Traders.
They are an established business with bargain sourcing capability that compliments The Warehouse’s existing bargain sourcing activities. It enables WHS to continue to provide a more extensive range of products as it looks to target more upmarket customers. Insight Traders specialise in perfumes, cosmetics and skincare products. Complete Entertainment Services – Specialising in the retail and wholesale of books they provide capability in sourcing, inventory management, distribution and online fulfilment in the books category that can potentially be transferred into other categories.
This acquisition will strengthen an existing product supply chain guaranteeing an operating revenue component but also provides the possibility to expand into new product streams leveraging existing operations. Noel Leeming (Bond and Bond) – With the intense competition, low margins and price deflation in the consumer electronics sector Noel Leeming is predicted to contribute $3. 6m of profit each year for the next three years, based on last year’s results and factoring in the borrowing costs of the debt-funded purchase.
The Bond and Bond stores were merged immediately with 12 being closed down altogether. Based on the above it would appear a high risk investment but an alternate objective is to improve leverage over local distributers unwilling to trade with WHS on the belief it may damage brand reputation. This fits with the strategic goal to improve and upmarket The Warehouse in-line with consumer expectations. Torped07 – In conjunction with the existing “Red Hot Deals” website, WHS has increased its online ecommerce presence with the purchase of a majority shareholding in the Australasian online retailer Torped07.
The online channel is an area that WHS will look to capitalise further with online sales increasing 136 per cent n the first half of 2012, partly thanks to the launch of its daily deals site Red Alert in the first quarter. Financial Services and Travel Insurance – WHS is targeting blanket financial services for the entire group, which could offer credit cards and insurance to its customers. They currently already offer a Red Card low-limit credit card, as well as insurance services. Warehouse Extra – The 17 largest stores were rebranded in 2010.
Prior to that in 2007 the first three Extra stores had included pharmacy, fresh food and groceries but in 2009 this format was removed. That move cost $10. 661 million in decommission and restructuring costs, including asset write-downs of $5 million and the reconfiguration of the three existing Extra stores. $100m Fixed Rate Unsecured Bonds – WHS raised $100 million in a fixed-rate bond offer, with the funds being used to reduce existing bank debt and to finance the planned construction of new and replacement stores (“The Warehouse to raise $100m,” 2010).
With the term set to five years this has the advantage of securing debt until 2015 in line with medium and long term capital investment plan. Organisation Strategies In the face of declining revenue the company embarked on a strategy to turn the tide, including refocusing its brand message, improving product range and quality, being a weak link for WHS, particularly in electronics and white ware. The Noel Leeming deal gives it serious leverage with brands that may have resisted a red sheds presence.
He has also looked to by-pass local distributers by strengthening supply chains and increased investment in parallel imports. Improving staff motivation through a number of incentive based programmes is aimed at increasing sales through engaged staff. Adding financial services is outside of the core retail value but in times of financial uncertainty its ability to influence consumer spending could be a wise move. Organisation Non-standard GAAP measures The FMA announced it intends to assess non-GAAP financial information disclosures against its guidelines from 1 January 2013.
WHS use Adjusted Net Profit (non-GAAP) in their performance measures, adjusted for unusual items and provides a more realistic picture of the underlying operations and more indicative of future performance. Adjusted Net Profit makes allowance for unusual items, which in recent ears includes profits from the disposal of properties, fresh food and liquor decommissioning costs, unrealised gains or losses from changes in the fair value of financial instruments and one-off non-cash tax adjustments.
It is considered more informative for investors as many strategic decisions are influenced by these one-off events such as the sale and leaseback of four properties in 2012 which generated net sales proceeds of $117. 154 million. Other examples include changes to government policy such as reducing income tax from 30% to 28% in 2010 and removal of the ability to depreciate buildings for tax purposes. Mentioned in the annual report commentary and on the Income Sheet is Operating Profit (non-GAAP). This is profit before operating expenses, interest payments and taxes.
Operating profit reflects the core profitability of a company before overhead costs, and it illustrates the financial success of a product or service. WHS uses Operating Profit to calculate operating margin which is useful when comparing performance across similar businesses. WHS has targeted improved margins during recent years by improving supply chains so paying less for direct costs (as reflected in lower costs of goods sold). In 2012 the operating profit margin was reported at 5. 6%. WHS also uses Adjusted Earnings (non-GAAP) in its Earnings per Share calculation.
Adjusted Earnings is net income less unusual or one-off items considered not representative of on-going operations. Adjusted Earnings per Share better reflects the underlying business financial performance as it excludes non-recurring expenses so more closely reflects operating earnings. In 2012 WHS reported Earnings per Share as 29 cents and Adjusted Earnings per Share as 21 cents. The lower figure reflects exclusion of the release of $7 million in warranty provisions and $18 million from the isposal of property in the calculation.
Conclusion Financial Analysts (2008 – 2012) The following graphical analysis has been generated for financial ratios that many consider to be most important for decision making purposes (Atrill, 2011). Due to may differ from those used to generate the ratios published in the annual report. Financial Commentary (2008 – 2012) WHS reports on “underlying performance” which is adjusted for unusual items or one-off gains and losses. Summarising ratio performance over the last five years with those adjustments in mind it can be said there is a general trend of consistency.
However, anomalies in the above analysis require explanation: Return on Ordinary Shareholders Funds (Profitability Ratio) Although not a major variation the dip in 2010 to Just below 20% is a marked contrast to the 2012 high of Just over 30%. One factor for this was the 2010 Government Budget changes relating to Income tax expense which created a one-off, non-cash accounting adjustment to taxation expense for deferred tax on buildings of $22. 814 million (Warehouse Group, 2010). That followed on from the withdrawal of fresh food and liquor in 2009 which cost $10. 661 million to decommission.
The above factors are one-off events however, a more concerning factor was the drop in revenue through 2010/11 from $1,720 million to $1,667 million which was blamed on a failure to grow top line sales and market share over the two years (“Warehouse says it expects 8pc profit fall,”). This is an issue the board have addressed head on improving product ranges through parallel importing and the purchase of Noel Leeming. They have also ear marked about $430 million for modernising and refitting stores over a five year period as they seek to refresh the retail brand and reconnect with customers (Nick, 011).
WHS is also looking to invest in staff and incentivise them to be more engaged in sales with the announcement in 2013 that they are to adopt a career retailers wage giving them on average an extra $50 to $100 per week (Claire, 2013a). Cash Flow from Operations (Liquidity Ratio) The 0. 18 fgure for 2012 is quite alarming and may indicate problems. Over the last three years this has dropped from 0. 93 and suggests the business will not be able to meet its current liabilities from operating cash flows alone. It will be a good measure to review when 2013 results are published.
The contributing factors in 2012 are a $78 million increase in borrowing related to seasonal fluctuations in retail and a need to accommodate the increased funding requirements during the peak funding period. Also a $125 million increase in payments to suppliers and employees of which $25 million for 2013 and 2014(Claire, 2013a). The remaining $100 million can be attributed to suppliers which is in part related to the boards strategic decision to take on companies that refuse to supply it, by parallel-importing the brands anyway (Nick, 2012).
With the purchase of the Noel Leeming Group WHS will be able to everage increased buying power over vendors in the electronics and white ware sectors. Dividend Pay-out Ratio (Investment Ratio) WHS’s dividend policy was changed by the board in September 2010. WHS’s previous dividend policy was to pay a dividend equal to 75% of adjusted net profit. The policy pay-out ratio was increased to 90% of adjusted net profit commencing from the final dividend to be paid in November 2010. This change alone accounts for annual increases to the 71. 85% paid out in 2008 however 2009 and 2010 were much higher than either policy pay-out ratio allowed.
The main reason is a non-GAAP measurement used in calculation. Adjusted Net Profit is deemed a more accurate figure because it also reflects one-off unusual events. The figures graphed above (in contrast to those declared by WHS Group) are based on actual Net Profit without any adjustments. As can be seen from the graph Net Profit was actually down in 2009 and 2010 but $10 million for decommissioning fresh food and liquor and $20 million tax adjustment were provisioned for in each year respectively. It is therefore fair to say that the company could afford to pay-out these dividends despite a drop in nderlying operating profit.
Dividends per Share and Earnings per Share (Investment Ratio) Both these ratios reflect measurements in relation to the number of shares. Dividends measure the return to investors whereas earnings measure return to the company. As a result you would expect each to inversely mirror the other. The reason for highlighting these measurements is because of the fluctuations in 2009 and 2010. The earnings anomaly can be tied back to the non-standard GAAP measurement Adjusted Net Profit as explained in the Dividend Pay-out Ratio above.
The Dividends nomaly resulted from the boards’ decision to pay special one-off dividends during the two years to return excess capital to shareholders. Given the strategic realignments we now know were made in 2011 and 2012 those decisions are somewhat questionable and though unrelated it should be noted that since making those decisions WHS has replaced the CEO, CFO and Chairman. Operating Cash Flow per Share (Investment Ratio) It is not unusual for Operating Cash Flow per Share to be higher than Earnings per Share (Atrill, 2011). However, the graphs highlight two points for further investigation.
The first point, a high return in 2009 was due to high Operating Cash Flow of $194 million which incidentally was more than four times that for 2012. The reasons for this relate to the change in trade working capital which was $50 million for 2009. Good margin management through better buying, currency management and reduction in freight costs coupled with an $8 million cash gain from decommissioning fresh food and liquor and a $19 million provision for an employee performance incentive programme. A change to the New Zealand corporate tax rate from 33% to 30% from 28 July 2008 realised an $11 million gain for operating cash low.
The second point is the unusual figures for 2012. Operating Cash Flow per Share is less than Dividends per Share which is a concern. The company set the new share price and helped it recover in 2012 however, unless operating profit can improve this policy will not be sustainable. Summarising the above exceptions it is clear that financial performance for is well managed with no major cause for concern. For investors, a 90% pay-out ratio is very attractive so long as net profit can be maintained through operating activities.
The boards improvement plans targeting igher end retail experience and quality goods shows intent to do this and targeting online channels via internet trading is another positive step. Recommendation Balance Sheet Valuations (2008 – 2012) The following items included in the Balance Sheet are highlighted as the valuations may have an impact on the analysis above: Non-current deferred taxation Non-current deferred taxation relates to the difference between the carrying value and the IRD allowable deduction of an asset. Tax assets and liabilities must have a reasonable likelihood that the tax difference will be realised in future activities.
Deferred tax assets are only included in the Balance Sheet if this is deemed more likely than not that the asset will be used in the future. Management has an obligation to accurately report the actual possibility and in some cases may not know. For WHS, in relation to plant and property sales this could have a huge impact on the Balance Sheet. In 2012 the sale of property generated net sales proceeds of $117. 154 million. Property, plant and equipment Property, plant and equipment generally held at cost less depreciation. However, particularly in relation to property the actual value is much greater.
The result is unrecognised capital that could be used to improve operating performance. Valuations of plant and equipment are calculated based on management estimates for which there is no obligation on accuracy. WHS uses straight line depreciation for calculating the current value for property on the balance sheet which is recommended for this type of asset. However, in 2012 total freehold land and buildings contributed $184,300 million to the Balance Sheet but independent and government valuations and other known factors, have assessed the fair value of freehold land and buildings to be $284. 2 million. This results in a one-off release of capital that is recorded as an increase in net profit on the Income Statement but it is not a result of normal operations and can distort actual performance particularly in relation to the profitability ratios. This is another reason why WHS uses Adjusted Net Profit. Inventories Inventories are the value of stock held for sale. In 2012 this was $309. 421 million up $47 million on the previous year. This is a concern for the company as it could be past its use by date particularly for rapidly evolving electronics or technology items.
The effect to the business could be to reduce margins hence a resulting in a reduced operating profit should the goods need to be discounted to shift them. An increased risk to the business when large amounts of stock is held is that if a product range is lost i. e. negative change to brand reputation for a product may result in stock that needs to be written off. Computer Software Computer software is listed on the Balance Sheet as holding $13. 379 million. As before the asset should be written off. This is at the end of the day a Judgement call and the current carrying amount seems rather high.
Provisions Provisions are based on management estimations and for 2012 held $32. 502 million for current liabilities and $12. 147 for non-current. The majority of these holdings $28,290 million relate to employee benefits in particular annual leave, it is questionable whether this could be better managed. Reducing these provisions would make more capital available for investment and dividends. Financial Derivatives Financial derivatives are used by to hedge fluctuations in exchange rate. These are particularly appropriate as importing goods is a large component of operations.
In 011 WHS recorded current liabilities of $25. 903 million and in 2012 this dropped to $6. 158 million. Currency fluctuations are difficult to predict and reducing financial derivatives increases exposure to risk from exchange rate movements and impact the ability to manage the inventory costing process. A negative outcome could generate a future loss on the Balance Sheet. Discussion The projections for the next three years relate to recent strategic plans to improve revenue and operating profit. It can be seen that the current CEO is targeting a more upmarket store with higher quality products. New CEO
Since becoming CEO in May 2011 Mark Powell has introduced a number of key strategic initiatives to that will have considerable effect on the company financials. These include the sale and leaseback of land and property, the revamp (fit-out) of existing stores, the introduction of a new staff incentive schemes, the purchase of high quality electronics and white ware retailers Noel Leeming and the investment in online ecommerce experts Torped07. These moves are all targeting revenue through the goal of an increased customer base. Customers will be enticed by a better shopping experience and higher quality products.
Sale and Leaseback During 2012 the board identified four properties to be sold that would release considerable capital for reinvestment and result in an improvement to liquidity. WHS has always traded land and property assets but the 2011 announcement that Non- strategic assets worth between $75 million and $100 million would be sold over a five year period and that the proceeds would be reinvested in the business in line with the priorities identified in the company’s strategic plan (“Warehouse looks to sell, lease back property,”), confirms the strategic direction investing in their retail activities.
Having capital in land and property may provide security in diversification but ties up finances that could be better utilised. Stores refurbishment WHS plan to invest $430 million for modernising and refitting stores over a five year period. In 2013 they plan to increase the speed of this process to refit 25 stores in comparison with 5 in 2012. Customers will experience a modern efficient shopping experience in stores with clear structure. The investment in staff incentives will coincide to drive the in store sales.
Sales growth With predictions that the economic outlook in New Zealand is improving and redicted population growth an opportunity exists to increase revenue. Improving in- incentive schemes, higher quality products and bargain prices from improved margins. Online sales are predicted to continue current growth. The online sales channel in New Zealand is growing rapidly without any dominant players. The opportunity has been realised by WHS who aim to become New Zealand’s leading multichannel retailer with their existing “Red Hot Deals” website and online retailer Torped07.
Improved margins With the purchase of Insight Traders and increased use of parallel importing WHS is targeting its margins. Adding expertise in import, distribution and sourcing will provide the competitive advantage that enables WHS to undercut competitors. Government tax cut The government has discussed dropping the tax rate for business from 28% to 25%. Although this is highly speculative, the approaching election year may increase its likelihood. The result of such a change would increase Net Profit which provides more capital for dividends and makes stock more attractive to investors.
APPENDIX 5 year Income Statements Group GROUP Note 2012 NOtE 2011 Revenue 1,73Z168 of sales Gross profit 622056 Other income 6 6,618 6 NOtE 2010 06,299 GROUP GROUP NOtE 2009 NOtE 2008 1 ,672695 5 cost -1,087??75 608,683 633,380 609,171 6,485 6 6,984 6 6,542 6 10,251 Employee expenses 7 -288,331 7 -267,799 7 -268,665 7 -2808247 -259,157 Lease and occupancy expenses 8 -86,823 8 -81,942 8 -78,330 8 -81,664 8 -78,155 Depreciation and amortisation expenses 9 -41,630 9 -39,772 9 -40,937 9 -41840 9 -39,634 other operating expenses 10-115,428 10-109,135 10-103,686 10-110,642 10-121,336 -525,594 -492163 -484,634 -508,428 -488,031 Operating profit 96,462 114,136 124,049 124,952 121,140 Gatn/(Loss) on disposal of property 25 18,230 25 1,470 25- 25 315 25 1,176 Changes in fair value of financial instruments 4 – 2,126 Fresh food and liquor decommissioning costs Gain on disposal of Joint venture Release of warranty provisions 28 7,355 4 194 4 -282 4 -1,698 12- 12-10,661 12- 28 – 28 7,208 4 Equity earnings of associate 27 3,197 27 3,575 27 2,808 27 3,220 27 3,037 28,782 5,239 2526 -8,824 13,547 Earnings before interest and tax 125,244 1 19,375 126,575 116,128 134,687 Net interest expense 11 -10,308 11 -9,845 11 -7,409 11 -6,837 1 1 -6,394 Profit before tax 1 14,936 109,530 119,166 Income tax expense before Government Budget changes 109,291 128,293 13-32022