"...the group achieved all
medium-term targets in the past year."

chief financial officer's report

Keith Warburton
Chief financial officer

CHIEF FINANCIAL OFFICER’S REPORT

Introduction

In its drive to enhance shareholder value by generating sustained earnings growth and financial returns, New Clicks delivered on its commitment to shareholders by achieving all its medium-term financial targets in the past year.

The business again showed its defensive and counter-cyclical qualities in the current economic environment, with approximately 75% of turnover being derived from healthcare and beauty merchandise within Clicks and UPD.

While trading conditions in South Africa became increasingly challenging during the year, overall group turnover for the first and second six-month periods was constant, with Clicks reporting a stronger second half turnover performance. However, the slowdown in consumer spending was evident in Musica and The Body Shop which offer more discretionary merchandise, with both businesses reporting slower second half sales growth.

Headline earnings increased 12.3% from R357 million to R401 million. Diluted headline earnings per share (HEPS) increased 28.1% to 131.9 cents per share (2007: 103.0 cents), continuing to benefit from the share buy-back programme.

The group has shown consistent improvement in financial performance over the past three years, more than doubling its ROE since 2005 from 14.2% to 32.8% while diluted headline earnings per share have shown a 32.0% three-year compound growth rate.

Three-year growth

Financial performance

The following review of the group’s performance for the year ended 31 August 2008 should be read in conjunction with the annual financial statements here, as well as the business unit segmental analysis which appears here.

Income statement

Turnover

The 12.2% increase in turnover from continuing operations to R11.3 billion (2007: R10.1 billion) was most pleasing in the current climate and reflected a high level of real sales growth as price inflation for the period measured 3.9%.

Clicks continued its strong performance and increased turnover by 12.1%, with real sales growth of 8.2%. Sales on a comparable store basis increased 10.2%. The key drivers of growth were the health and beauty merchandise categories which grew 19.5% and 13.0% respectively.

UPD increased turnover by 13.3%, benefiting from the growth of the Link pharmacy buying group, a new distribution contract and sales to hospital groups.

Musica increased turnover by 7.7% as trading slowed in the second half of the year. DVD sales grew 19.7% and gaming 26.2%, although CD sales declined 3.0%, mainly due to the impact of limited releases of popular local music. Sales of international CDs grew 1.1%.

The 17.5% growth in turnover in The Body Shop was driven primarily by new store openings and the Love Your Body loyalty programme.

Intragroup turnover from UPD to Clicks grew by 11.1%, although this growth is moderated by the relocation of certain front shop products previously supplied to Clicks by UPD to the Clicks distribution centre in the previous financial year.

The business unit trading performance is covered in the operational reviews here.

Total income

Total income, comprising gross profit and other income, from continuing operations grew by 14.8% to R2.7 billion with the total income margin improving from 23.5% in 2007 to 24.0%.

The retail income margin increased from 30.6% to 31.7%, with Clicks improving from 29.7% to 31.0%, mainly due to better buying and improved management of shrinkage and waste. The improvement in Musica’s margin from 32.8% to 33.2% was attributable to well-managed buying margins and additional income recoveries.

UPD’s total income margin was stable at 8.4% despite a growing level of ethical products in the sales mix. UPD has benefited from an increase in single exit pricing granted by the Department of Health to selected manufacturers in both 2007 and 2008.

Operating expenditure

The 13.5% growth in operating expenditure from continuing operations was contained below the growth in total income.

Operating expenditure includes the costs relating to the hedge on the employee incentive schemes, with the value of the hedge moving in line with market movements and the period to maturity reducing. When the mark-to-market value of the hedge is excluded, the increase in operating expenditure was held at 10.6%.

Depreciation and amortisation costs increased by 16.9% and reflect the increased investment in each of the businesses during the year.

Occupancy costs were well managed with an increase of 7.7%.

Employment costs increased 10.6% and includes the impact of the cost of opening 32 new stores, the appointment of pharmacy staff with the opening of a further 32 dispensaries in Clicks and people costs relating to the Clicks Blueprint programme.

The 11.2% increase in other operating costs (excluding the hedge mark-to-market) includes the impact of fuel price increases on UPD’s delivery costs, as well as volume-related costs such as credit card commissions.

The mark-to-market costs for the derivative hedge moved from a credit to the income statement of R26.8 million in 2007 to a charge of R22.8 million in 2008, resulting in a year-on-year impact to total costs of R49.6 million.

Operating profit

The retail operating margin improved from 5.4% to 6.1% while UPD’s margin was 3.2%, resulting in an overall increase in the margin to 5.2% (2007: 4.9% and 2006: 4.0%).

Clicks has shown a pleasing improvement in margin, growing from 4.3% in 2006 to 5.3% in 2007 and to 6.0% this year, driven by better buying and improved management of shrinkage and waste.

Despite pressure on transport costs, improved operating efficiencies in UPD resulted in a steady increase in operating profit in the second half of the year, with growth of 11.0% for the financial year. While UPD maintained its operating margin at 3.2% management believes this level is not sustainable and has set a medium-term target of 2.7% to 3.0%.

Musica experienced a flat first half, but tight cost control and good merchandise buying in the second half contributed to a 16.7% increase in operating profit for the year.

The improved margin and higher turnover growth translated into a 19.9% increase in operating profit from continuing operations to R592 million.

Interest

The net interest charge increased by 31.8% in the year to R51 million (2007: R39 million), primarily due to the impact of increased interest rates.

Balance sheet

Inventory

Inventory levels in continuing operations increased 15.0% and the days cost of sales in inventory was 55 days.

Inventory levels for the retail businesses increased 8.4%, well below the level of turnover growth of 11.4%.

UPD’s inventory levels rose 40.8% off a low base and inventory days cover moved from 22 to 28 days, in line with management’s guidance, and are now at a more normalised level.

Cash utilisation    
   Normalised cash flow    
  2008    2007   
   R’m normalised normalised
   Cash generated by operations 724    622   
   Working capital changes (224)    521   
      2006 impact of systems    
      conversion on accounts    
      payable –    (215)   
      UPD accounts payable    
      (2007: inventory) 251    (61)   
      Discom accounts payable 100   
   Net interest paid (43)    (36)   
   Taxation paid (193)    37    
   Utilisation of tax losses and    
   refund of over-payments 28    (166)  
   Normalised free cash flow 643    702  

Cash generated by operations before working capital changes increased by 16.3% to R724 million. The free cash flow (cash inflow from operating activities before distributions) of R264 million is impacted by one-off working capital funding impacts during the past two years, as well as timing differences attributed to cash tax payments after utilising tax losses. A normalised level of free cash flow for the year would be R643 million.

Shareholder distribution

Shareholders will receive a total distribution of 61.1 cents per share (2007: 48.2 cents), an increase of 26.8% on the previous year. The distribution cover ratio was maintained at 2.2 times headline earnings per share. The distribution will be paid partly as a cash dividend from retained income and the remainder as a capital reduction distribution out of share premium.

The board has taken a decision to reduce the distribution cover from 2.2 to 2.0 times earnings cover for the 2009 financial year.

Acquisitions

During the year the group announced two acquisitions to complement its growing healthcare interests. The group purchased a 90% shareholding in Kalahari Medical Distributors, a pharmaceutical wholesaler in Botswana, at a cost of R4.3 million with effect from 1 January 2008. Shortly before year-end the group announced the proposed acquisition of a 60% stake in courier pharmacy business, Direct Medicines, for a cash payment of R13.2 million. The group has an option to acquire the remaining 40% of the business after three years. Regulatory approvals were awaited at the time of the report.

Financial risk management

Through its business activities the group is exposed to a variety of financial risks, including market risk (currency risk, interest rate risk and price risk), credit risk and liquidity risk. The group’s exposure to these risks and the policies for measuring and managing the risk are included in note 29 of the annual financial statements, with further detail on financial risk contained in the Risk Management Report here.

Capital management

The group has an active capital management programme to enhance returns to shareholders and benefits to other stakeholders, and to maintain an optimal capital structure.

The group has a target to maintain the ratio of shareholders’ funds to total assets in the range of 30% to 35%. This can be achieved by meeting the group’s earnings targets, management of working capital, share buy-backs and distributions to shareholders.

During the year the group repurchased shares totalling R607 million, including R126 million acquired by forward agreement in the 2007 financial year. Since the commencement of the buy-back programme in May 2006 the group has acquired R1 219 million in shares at an average price of R13.91, representing 24.7% of the issued shares at the time of initiating the programme.

The share buy-back programme and related balance sheet restructuring has largely been completed. The group will continue to repurchase shares at a more modest rate as a mechanism to maintain shareholders’ funding to total assets within the targeted range.

Shareholding

New Clicks has a diversified shareholder base which includes most of the country’s leading fund managers. At year-end the top ten shareholders accounted for 70.3% of the shares (78.6% of the free float). Currently less than 10% of the group’s equity is held offshore and management is actively seeking to increase its exposure to international fund managers to diversify the shareholder base. The percentage of shares traded increased from 94.1% in 2007 to 100.7%, while the volume traded declined from 316 million to 300 million.

Medium-term financial targets

After achieving the medium-term financial targets in the 2008 financial year, the group has revised the targets for return on total assets, shareholders’ funding to total assets and ROE based on the expectations for continued improvement in performance (refer to Group Strategy and Targets). The revised targets are as follows:

  Achieved   2009 – 2011  
  in 2008   target  
ROE (%) 32.8   35 – 40  
Shareholders’ funding    
to total assets (%) 31.9   30 – 35  
ROA (%) 10.6   10 – 13  
Inventory days 55   55 – 60  
Operating margin (%) 5.3   5 – 6  
     

Outlook for 2009

While capital expenditure has been approximately R160 million per year over the last three years, the group is expecting this to increase to approximately R200 million per year for each of the next three years owing to the accelerated pace of the dispensary rollout in Clicks, as well as more planned store openings and refurbishments. Capital expenditure in the year ahead includes an investment of R40 million in information technology (IT), with one of the main projects being the implementation of a bespoke dispensary IT system in Clicks pharmacies.

An additional R50 million has been budgeted for the new financial year, with the majority committed to the upgrading of UPD’s distribution facilities in Gauteng and Cape Town, bringing total capital expenditure for 2009 to R246 million.

We anticipate price inflation remaining in the mid-single-digit range, although above the 3.9% level reported for 2008. However, this could be impacted by several inflationary pressures related to the crisis in global financial markets and the recent depreciation of the Rand.

The group plans to open 30 to 35 new stores, with retail trading space expected to increase by approximately 5%.

Keith Warburton
Chief financial officer