Myer/DJs Merger Proposal Fails To Impress

This story features MYER HOLDINGS LIMITED. For more info SHARE ANALYSIS: MYR

-Merger benefits questionable
-DJs price now elevated by speculation
-Concerns remain over market share
 

By Eva Brocklehurst

Attention has been squarely on Australia's two upmarket department stores, David Jones ((DJS)) and Myer ((MYR)), after Myer confirmed an approach had been made to DJs late last year to consider a potential merger. Few brokers were impressed, believing the benefits would be hard to achieve and hard to maintain. The merger proposal also does nothing to address any dwindling of market share.

To Credit Suisse it was a poorly conceived play. There is a risk that a proposal will re-emerge in a form that's more attractive to DJs. This makes the downside risk more acute for Myer and more favourable for DJs shareholders. Credit Suisse has decided to reduce Myer's rating to Neutral from Outperform. Moreover, the broker thinks the supposed synergies are based on a sleight of hand. It requires significant integration to achieve the cost reductions and the promise there'll be no downside from a blurring of brand identity. A big ask, in the broker's opinion.

Citi is also suspicious about the claim of significant synergies, doubting these would be retained over the longer term. So, what was this proposal? Myer approached DJs with a nil premium merger and a fixed change ratio of 1.06 share for each DJs share. The merged entity was to operate separately and stand alone. Key were the financial benefits that would be obtained from a back office and support merger and cost savings at head office, amounting to $30-40m, as well as the consolidation of procurement channels. Working capital synergies were also expected to reduce capital by $30m. Citi believes aligning the two retailers would lead to a smaller sales base, taking away a large part of the synergies. The broker expects there would be at least 10 store closures. This brings up the question of landlords. The average lease term to expiry is close to 10 years and getting out of the leases would cost money. A lot of money.

Macquarie doesn't have such a problem with the potential synergies. The first full year earnings accretion as a merged entity was estimated at 36%, using phased synergies. What Macquarie suspects is that, now the approach has been confirmed, this may bring others that have been eyeing off DJs out of the woodwork. After all, the company has $612m of real estate on its balance sheet, which may be attractive to a wider range of potential bidders.

The approach demonstrates concern about the future of department stores, not opportunity, in Citi's view. It focuses on costs rather than growing sales. The broker believe that pressures from the online canibalising of store sales, competition and wage costs means that department stores need to win back market share to solve their problems, something the proposal is not considering. Citi thinks DJs has the advantage, as Myer advanced the proposal. but there's not much share price upside.

JP Morgan believes the rationale is sound, in terms of the cost savings, but the effort to generate the synergies required is high and the execution risks significant. Also, the potential change of control could provide a reason for DJs to trade at an elevated price/earnings multiple and above valuation. To achieve the scale in online would require significant investment and, while there is potential to rationalise the store network, the broker thinks this potential is modest because of the intention to operate multiple brands and the requirements to maintain scale.

DJs rejected the proposal not long after receipt, forming a view that there was not sufficient merit for shareholders. Myer did some work in making preliminary, confidential contact with the Australian Competition and Consumer Commission. Myer is of the view that the proposal would support competition in the market, in that the merged entity could compete more effectively in what the company considers is a global market. To Macquarie, it all comes down to how the ACCC defines the market. JP Morgan concurs. In the event of a narrow definition of full service department stores there would be some challenges. In the context of a broader department store retail market, JP Morgan thinks the market share of the two on a merged basis remains modest.

The other execution risk is that both companies are engaged in the search for a new CEO. Paul Zahra plans to retire from DJs, making the surprise announcement in October 2013, as soon as a replacement is found. Long-standing Myer CEO, Bernie Brooks, will retire in August this year. To JP Morgan the search for a DJs CEO is now disrupted. Management of an integration is likely to need different skills than those required to operate a brand. Key to this view is that some potential candidates may remove themselves from consideration, given the risk of a merger which could see their role eliminated.

JP Morgan and Citi have Underweight and Sell ratings respectively on David Jones. Macquarie and Credit Suisse are Neutral. On the FNArena database the stock has no Buy rating. There are six Hold and two Sell. The consensus target price is $2.79, suggesting 5.2% downside to the last share price. The price dropped 1c after the merger proposal was confirmed. The dividend yield on FY14 forecasts is 5.0% and on FY15 it's 5.4%.

In comparison, Myer has one Buy (Deutsche Bank), five Hold and two Sell ratings. The consensus target price is $2.76, suggesting 10.9% upside to the last share price. The consensus target dropped 5c (from $2.81) after the news. Myer's FY14 dividend yield is 6.9% for FY14 forecasts and 7.4% for FY15 forecasts.
 

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