The Michael Hill International Ltd (ASX: MHJ) share price is down by 4.5% at the time of writing. The jeweller has disclosed an estimated $80 million reduction in revenue due to the initial Australia-wide lockdown. Accordingly, the company saw a reduction in full year revenue by 13.6% and a reduction in underlying earnings before interest and taxes (EBIT), or operating profit, of 25.8%.
Lastly, the company has cancelled its final dividend and deferred its interim dividend of 1.5 cents. Given the current wave of dividend cancellations during earnings season, I believe this is what most impacted the Michael Hill share price.
Nevertheless, on closer review, there are a lot of signs of healthy shoots for this small-cap, discretionary retail company. Moreover, it appears the challenges of FY20 have forced the organisation to take decisions that will have a largely positive impact.
The opportunity for change
If you dissect the earnings report a little further, you wonder if investors are unfairly selling down the Michael Hill share price. There are a number of interesting statistics worth considering.
First, there is a very large difference between gross profit and operating profit. To explain further, gross profit is the difference between earnings and the price of the product. For example, a diamond ring costs, say, $2,000 to make. If the company sells it for $3,000 it has made a gross profit of $1,000. Operating profit, on the other hand, is the difference between earnings, the price of the product, and the costs required to sell it. For instance, rent, logistics, warehousing costs, and so forth. Operating profit is an interchangeable term with EBIT.
So, having said that, operating profit as a percentage of revenue is 5.2%. That is not a great margin in most businesses. Nonetheless, at the same time, gross profit as a percentage of revenue is 60.6%. That is an outstanding margin! As a result, it becomes clear that the operating costs and activities of the business require attention.
Revenues lost under lock down, while costs remained, helped to cause this poor result. Moreover, it can be seen that the operating profit margin for Australia is 10.3%, a respectable margin. In New Zealand it is 19.7%, which is very profitable. However in Canada it is -2.2%, so the opportunity becomes even clearer.
Digital top line improvement
I believe the future strategy appears positive for the Michael Hill share price, largely due to the digital-first approach. FY20Q4 saw the company's digital sales grow to 5% of total sales, up from 2.8% in FY19. The forced closure of its storefronts made the company move quickly to online sales. Just as consumers have also made a large transition to online shopping.
For example, the company is rolling out a range of digital sales options. These include delivery concepts like click and collect, click and reserve, as well as ship from store capabilities. Moreover, Michael Hill is working on a bespoke product, a digital ring builder technology, something I have seen work very well in other sectors.
A range of sectors have tried and tested most of the initiatives above. Therefore the company should be able to introduce them relatively seamlessly into the Michael Hill sales model. There are two final initiatives which could build additional sales lines. First, to develop key vendor partnerships for a drop shipping model. Second, the company has already launched a pure online brand for affordable jewellery called Medley.
The digital-first approach provides the company with increased sales channels, customer centric delivery options, and the potential to sell jewellery globally. I expect this to stir interest in the Michael Hill share price after the market has time to digest the earnings report.
Cost reduction
The move to increase sales via an omni channel digital environment will undoubtedly reduce operating costs after the initial implementation. Moreover, the company has the potential for productivity improvement in its Canadian operations as a quick win for operating margins. Furthermore, the company has highlighted the need to focus on inventory management via its new ERP platform, as well as enhancing higher margin offerings.
For instance, the company has flagged increased use of laboratory created diamonds. These are absolutely real diamonds – the chemical makeup and optical properties are identical to natural diamonds. They are also far more ethical as they reduce the level of potential exploitation that has dogged the diamond mining industry since the early 20th century.
The final major initiative that caught my eye is the company's new 'Brilliance' loyalty initiative. I joined this recently as part of my research into this company and I think it is a great little scheme. Consequently, the company can start to develop a loyal shopper base. This reduces the costs of customer acquisition, while potentially increasing revenue through repeat sales. While revenue growth is important, I believe the largest impact on the Michael Hill share price will come from higher profit margins, and a reinstated dividend.
Foolish takeaway
I have concluded that investors sold down the Michael Hill share price unfairly. In the heat of earnings season, it is hard to grasp the true potential of companies under such a constant barrage of information. Storefront closures badly impacted the company's results. However it has forced decisions that will transform it into a true omni channel enterprise.
I think Michael Hill is on track to reduce operating costs while expanding sales. It has already seen gross margin improvements in FY21, and its initiatives are already underway. In my view, this company is likely to see a return to higher profitability in the near future, which will help to reinstate a healthy dividend. As such, I feel the current Michael Hill share price of 31.5 cents is a good entry point for growth over a 2 – 3 year period.
