The recent profit warning for David Jones is just the start of the retail sector’s death spiral, writes Dean Morel of The Motley Fool.

Investors belatedly realised last week that traditional retailing is undergoing a structural change. That dawning realisation created a flood of sellers which sent the shares of David Jones Limited (ASX: DJS) plummeting 18%. Myer Holding Limited (ASX: MYR) is down 8% since then, despite reconfirming profit guidance, and JB HI-FI Limited (ASX: JBH) is down 7%.

If those falls are not enough to get your attention, then consider this. Over the last three months DJs is down 33%, Myers 26% and JB Hi-Fi is down 21%. Ouch! Those drops have to hurt. Smart money has already left the building!

Finance professionals love to make investing seem confusing and difficult, but in my twenty five years of investing, I’ve found it often boils down to one question. For retail that one question is whether the current hard times are cyclical and therefore a buying opportunity, or structural and therefore a value trap. Answer that one question correctly and you’ll be standing tall.

My colleague Scott Phillips argued that the death of DJs is greatly exaggerated. I argue that while the death of DJs and many other retailers is not imminent, it is inevitable. One of the many great things about The Motley Fool is there is no party line, we are all encouraged to speak our minds and share our opinions. I hope you find that refreshing, if a little confronting.

Retail is Dead Long Live Etail

Just as music and printed media are being eaten alive, retail will also be consumed by the Internet. The process will accelerate and most industries will be affected, many radically. While retailers may build dykes to hold back the etail tsunami, or like Harvey Norman (ASX: HVN), try to build their own online presence, the reality is that they are on the wrong side of a structural change and will struggle to survive.

What are DJs and Myer Worth?

First up, forget the current stock price. That’s simply what people are prepared to pay for a share of the company today. In the short-term, which can stretch to several years, share prices are all about perception and any relationship to value is coincidental. You knew that already, right?

Next up, and you might find this idea more challenging, forget cash flow, forget earnings, dividends and the return on equity (ROE).

While during normal business conditions a company is worth their future discounted cash flows, during structural changes those future cash flows and earnings are impossible to reliably estimate. It’s a tough lesson and one which Warren Buffett himself was slow to learn with the original incarnation of Berkshire Hathaway.

At inflections points you need to look at the balance sheet. Here at the Fool we like to think of ourselves as owners of companies, not stocks, and we love to calculate the ballpark value of a company. However, when times get tough it is the balance sheet which underpins the value of a company.

What is Myer and DJs real-estate worth and how does that compare to book value? They own some great brick and mortar sites for residential and commercial developments. What are their current ratios (a financial ratio that measures whether or not a firm has enough resources to pay its debts over the next 12 months) and how quickly could they deteriorate to create a liquidity problem?

Forgetaboutit or Thinkaboutit

  • DJs CEO, Paul Zhara, is a walking advertisement for the vanguard of the new wave of retail that will survive, Zara. Mr Zhara should think about a name change and investors should think about whether outmoded major retailers can compete with the fast turnover business model and efficiency of Zara and its ilk.
  • The strong Australian dollar. Forgetaboutit. Foreign exchange is cyclical, and if that was retails only problem, now would be a great buying opportunity.
  • DJs 2011 full year profit declining 0.5% to 2%. Foregetaboutit. The last half’s 9-12% decline and this half’s forecast 15-20% decline is what you should be thinking about.

This article is aiming to get you thinking about the structural change the Internet is foisting on the world.

I don’t intend to give you all the answers right now. However, I will share a couple thoughts. Myer already has a current ratio in the danger zone of under one, and while DJ’s is just above one, I’ll be surprised if it too doesn’t fall into the danger zone in the coming months.

Based on historical figures and current forecasts both Myer and DJs look cheap, but hey, I already told you to forget about those figures. At best they’ll give you a selling opportunity as value buyers fall into the trap.

Unless the major retailers become so cheap they are a no brainer for a short-term pop, I’m sure both you and I can find better hunting grounds.

Not surprisingly, Dean Morel doesn’t own shares in any of the companies mentioned above. The Motley Fool has a living and breathing disclosure policy.

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