High K Co is one of the three largest supermarket chains in the country of Townia. Its two principal competitors, Dely Co and Leminster Co, are of similar size to High K Co. In common with its competitors (but see below), High K Co operates three main types of store:
– Town centre stores – these sell food and drink and a range of small household items. High K Co’s initial growth was based on its town centre stores, but it has been shutting them over the last decade, although the rate of closure has slowed in the last couple of years.
– Convenience stores – these are smaller and sell food and drink and very few other items. Between 2003 and 2013, High K Co greatly expanded the number of convenience stores it operated. Their performance has varied, however, and since 2013, High K Co has not opened any new stores and closed a number of the worst-performing stores.
– Out-of-town stores – these sell food and drink and a full range of household items, including large electrical goods and furniture. The number of out-of-town stores which High K Co operated increased significantly until 2010, but has only increased slightly since.
The majority of town centre and out-of-town stores premises are owned by High K Co, but 85% of convenience stores premises are currently leased.
High K Co also sells most of its range of products online, either offering customers home delivery or ‘click and collect’ (where the customer orders the goods online and picks them up from a collection point in one of the stores).
High K Co’s year end is 31 December. When its 2016 results were published in April 2017, High K Co’s chief executive emphasised that the group was focusing on:
– Increasing total shareholder return by improvements in operating efficiency and enhancement of responsiveness to customer needs
– Ensuring competitive position by maintaining flexibility to respond to new strategic challenges
– Maintaining financial strength by using diverse sources of funding, including making use in future of revolving credit facilities
Since April 2017, Dely Co and Leminster Co have both announced that they will be making significant investments to boost online sales. Dely Co intends to fund its investments by closing all its town centre and convenience stores, although it also intends to open more out-of-town stores in popular locations.
The government of Townia was re-elected in May 2017. In the 18 months prior to the election, it eased fiscal policy and consumer spending significantly increased. However, it has tightened fiscal policy since the election to avoid the economy overheating. It has also announced an investigation into whether the country’s large retail chains treat their suppliers unfairly.
Extracts from High K Co’s 2016 financial statements and other information about it are given below:
High K Co statement of profit or loss extracts
Year ending 31 December (all amounts in $m)
High K Co statement of financial position extracts
Year ending 31 December (all amounts in $m)
Evaluate High K Co’s financial performance. You should indicate in your discussion areas where further information about High K Co would be helpful. Provide relevant calculations for ratios and trends to support your evaluation.
Note: Up to 10 marks are available for calculations.
Profitability
Revenues from the different types of store and online sales have all increased this year, despite a drop in store numbers. The increase in revenue this year may be largely due, however, to the government-induced pre-election boom in consumer expenditure, which appears unlikely to be sustained. Because the split of profits is not given, it is impossible to tell what has been the biggest contributor to increased profit. Profit as well as revenue details for different types of store would be helpful, also profit details for major product lines.
Improvements in return on capital employed derive from increases in profit margins and asset turnover
The improvements in gross margins may be due to increased pressure being put on suppliers, in which case they may not be sustainable because of government pressure. The increased sales per store employee figures certainly reflects a fall in staff numbers, improving operating profit, although it could also be due to staff being better utilised or increased sales of higher value items in larger stores. If staff numbers continue to be cut, however, this could result in poorer service to customers, leading ultimately to decreased sales, so again it is questionable how much further High K Co can go.
The asset turnover shows an improvement which partly reflects the increase in sales. There have been only limited movements in the portfolio of the larger stores last year. The fall in non-current assets suggests an older, more depreciated, asset base. If there is no significant investment, this will mean a continued fall in capital employed and improved asset turnover. However, in order to maintain their appeal to customers, older stores will need to be refurbished and there is no information about refurbishment plans. Information about recent impairments in asset values would also be helpful, as these may indicate future trading problems and issues with realising values of assets sold.
Liquidity
The current ratio has improved, although the higher cash balances have been partly reflected by higher current liabilities. The increase in current liabilities may be due to a deliberate policy of taking more credit from suppliers, which the government may take measures to prevent. Being forced to pay suppliers sooner will reduce cash available for short-term opportunities.
Gearing
The gearing level in 2016 is below the 2014 level, but it would have fallen further had a fall in debt not been partly matched by a fall in High K Co’s share price. It seems surprising that High K Co’s debt levels fell during 2016 at a time of lower interest rates. Possibly lenders were (rightly) sceptical about whether the cut in central bank lending rate would be sustained and limited their fixed rate lending. Interest cover improved in 2016 and will improve further if High K Co makes use of revolving credit facilities. However, when High K Co’s loans come up for renewal, terms available may not be as favourable as those High K Co has currently.
Investors
The increase in after-tax profits in 2015 and 2016 has not been matched by an increase in share price, which has continued to fall. The price/earnings ratio has been falling from an admittedly artificially high level, and the current level seems low despite earnings and dividends being higher. The stock market does not appear convinced by High K Co’s current strategy. Return to shareholders in 2016 has continued to rise, but this has been caused by a significant % increase in dividend and hence increase in dividend yield. The continued fall in share price after the year end suggests that investors are sceptical about whether this increase can be maintained.
Revenue analysis
Town centre stores
High K Co has continued to close town centre stores, but closures have slowed recently and revenue increased in 2016. This suggests High K Co may have selected wisely in choosing which stores to keep open, although Dely Co believes there is no future for this type of store. Arguably though, town centre stores appeal to some customers who cannot easily get to out-of-town stores. Town centre stores may also be convenient collection points for customers using online click and collect facilities.
Convenience stores
High K Co has invested heavily in these since 2003. The figures in 2014 suggest it may have over-extended itself or possibly suffered from competitive pressures and saturation of the market. The 2016 results show an improvement despite closures of what may have been the worst-performing stores. The figures suggest Dely Co’s decision to close its convenience stores may be premature, possibly offering High K Co the opportunity to take over some of its outlets. Maintaining its convenience store presence would also seem to be in line with High K Co’s commitment to be responsive to customer needs. Profitability figures would be particularly helpful here, to assess the impact of rental commitments under leases.
Out-of-town stores
Although the revenue per store for out-of-town stores has shown limited improvement in 2016, this is less than might have been expected. The recent consumer boom would have been expected to benefit the out-of-town stores particularly, because expenditure on the larger items which they sell is more likely to be discretionary expenditure by consumers which will vary with the business cycle. Where Dely Co sites its new out-of-town stores will also be a major issue for High K Co, as it may find some of its best-performing stores face more competition. High K Co again may need to consider significant refurbishment expenditure to improve the look of these stores and customer experience in them.
Online sales
Online sales have shown steady growth over the last few years, but it is difficult to say how impressive High K Co’s performance is. Comparisons with competitors would be particularly important here, looking at how results have changed over the years compared with the level of investment made. It is also impossible to tell from the figures how much increases in online sales have been at the expense of store sales.
Conclusion
If High K Co’s share price is to improve, investors need it to make some sort of definite decision about strategy the way its competitors have since its last year end. What the chief executive has been saying about flexibility and keeping a varied portfolio has not convinced investors. If High K Co is to maintain its competitive position, it may well have no choice but to make a significant further investment in online operations. Possibly as well it could review where its competitor is closing convenience stores, as it may be able to open, with limited investment, new stores in locations with potential.
However, it also must decide what to do about the large out-of-town stores, as their performance is already stagnating and they are about to face enhanced competition. High K Co will also need to determine its dividend policy, with maybe a level of dividend which is considered the minimum acceptable to shareholders allowed for in planning cash outflows.
Discuss how High K Co may seek to finance an investment programme.
High K Co has not raised any equity finance over the last five years. Its falling share price means that a new share issue may not be successful. It may not only need debt finance to be renewed, but additional funding to be obtained.
High K Co intends to make more use of revolving credit facilities, which it need not draw on fully, rather than loans, which will mean that its finance costs are lower than on ordinary debt. However, these facilities are likely to be at floating rates, so if the government increases the central bank rate significantly, they could come at significant cost if High K Co decides to utilise them fully.
Finance costs on new debt, whatever form it takes, may therefore be significant and lower interest cover. High K Co may have to investigate selling some of the stores it owns either outright or on a sale or leaseback basis.