Did David Jones Limited make too much money?

David Jones has been in the news for all of the wrong reasons lately. Under Mark McInnes, the company was making impressive profits. But did those profits come at the expense of the long-term health of the business? Were David Jones making too much money?

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David Jones Limited (ASX: DJS) has been in the news for all of the wrong reasons lately.

It's been the poster child for the theory that traditional retail is dying at the hands of the internet, its sales have been declining, and now the current and former CEOs are trading verbal blows about who is responsible for the situation in which the company now finds itself.

The drama started with an interview current David Jones CEO Paul Zahra gave to the Australian Financial Review. Among other things, Zahra highlighted some of the company's past missteps, including not persisting with an online shopping strategy, and under-investing in the company's retail 'point of sale' system.

Immediate-past CEO Mark McInnes took umbrage at what he saw as personal criticisms, specifically accusing his successor of 'rewriting history'.

This vignette brings to mind a key consideration investors should bear in mind before investing in a company (or when considering whether to remain invested in that company).

Profits can be too low…
Paul Zahra's comments go to a situation in which investor diligence and thoughtful consideration is important.

In essence, Zahra is suggesting that David Jones has allowed its business infrastructure to become dated, and that the company should have upgraded some of that infrastructure before now, as well as suggesting the company should have persevered with its online initiatives.

Those types of management decisions are – by necessity – a judgement call.

As a shareholder, you don't want management spending money recklessly on the latest fad or over-investing in unproven technologies. The result, more often than not, is that cash which otherwise would have filled the company's coffers is frittered away, and the company will report lower profits.

…and too high
There is, however, another side to this coin. It is possible for management to – with the best of intentions – delay spending on critical infrastructure beyond a reasonable timeframe. Letting machinery run down through poor maintenance or letting brand equity erode through insufficient advertising are two simple examples. The company looks more profitable in the short term – all of that money saved on maintenance activities can be added to the profit line on the P&L.

However, just as skipping low-cost car maintenance now can mean a bigger bill later, a lack of investment in company 'maintenance' in the short term may just be delaying the inevitable. In that event, investors who are used to seeing a higher profit number may get a rude shock when the day comes for the company to spend up big to fix the problems that have accumulated during those years.

Judgement call
I don't know with any certainty who is right in this current war of words. Paul Zahra understandably wants to put the past behind him and start with a clean slate. Part of that process is outlining the key changes the new CEO is planning to make, and explaining why the costs will be incurred this year. If you've shopped in DJs recently, you'll know that the cash register system doesn't seem to have been upgraded for many years.

Equally, Mark McInnes is rightly proud of the turnaround David Jones achieved under his stewardship, and doesn't want to see his legacy tarnished. He believes the decision to shutter the loss-making internet site was the right thing to do when the company was in difficult financial times and that the current challenges shouldn't be blamed on past management.

Foolish take-away
When a company's profits fall, the numbers tell investors a very black and white story. The declines galvanise both management and shareholders, and hard questions are asked. Human nature being what it is, we tend not to take the same approach when times seem better. We don't ask the hard questions when profits are up, instead often congratulating management for good results and ourselves on our good judgement.

Sometimes, those increased profits can come at the expense of investments that underpin the ability of the organisation to continue to succeed and grow. Next time one of your companies turns in a good profit performance, do yourself a favour and ask yourself 'is my company making too much money'. It's counter-intuitive, but that's precisely why it's the right question to ask.

Are you looking for more quality stock ideas? Motley Fool readers can click here to request a new free report titled The Motley Fool's Top Stock For 2012.

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Scott Phillips is The Motley Fool's feature columnist. Scott owns shares in David Jones. The Motley Fool's purpose is to educate, amuse and enrich investors. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson

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