Reflecting on the Group's performance for the 2016 reporting period we believe there are three major factors across the regulatory, trading and economic environments which influenced our financial results:
Our biggest challenge has been managing the impact of the new affordability assessment regulations introduced by the National Credit Regulator in South Africa with effect from September 2015. Truworths supports the principle of these regulations which are aimed at ensuring that consumers are not over-indebted through unaffordable credit agreements.
However, we believe that the requirement to provide documented proof of income for all new credit agreements is unreasonably restricting our ability to open new accounts and to grow credit sales, while also denying access to credit to many otherwise creditworthy customers. This issue is addressed in detail later under Onerous Affordability Regulations.
Secondly, the integration of Office, our recently acquired fashion footwear chain in the UK, will be challenging but also presents the Group with significant opportunities for growth and diversification. Through the acquisition we are generating Pound Sterling earnings, which acquisition provides a hedge against the weakness of the Rand while diversifying our country risk, merchandise mix, customer base, sources of revenue and our credit:cash sales mix.
The integration is progressing well and we are appropriately aligning the business with Truworths' retail philosophies, practices and systems. Our focus since acquiring Office in December 2015 has been on improving stock management, range planning and product selection in the merchandise division by reducing stock levels through more aggressive markdowns and better stock flow to stores, and by improving processes in the product areas of the business. Refer to the Office Operational Report and the Chief Financial Officer's Report.
A third factor influencing our performance has been the difficult trading conditions in all the major areas in which we now operate: specifically in South Africa for Truworths and in the UK and Europe for Office.
Our domestic trading environment was impacted by further pressure on consumer spending, the deteriorating credit market and declining consumer confidence, while we also had to contend with the extreme volatility and depreciation of the Rand.
Trading conditions in the UK were challenging owing to unseasonal weather patterns, a general slowing in the economy and uncertainty ahead of the Brexit vote in June. Refer to our report on Responding to the Challenging Trading Environment.
Onerous affordability regulations
As highlighted earlier, the new affordability assessment regulations have had a widespread impact on credit retailers. Besides the extensive systems development and process changes required to ensure compliance, the regulations have also severely limited credit granting in South Africa.
All credit applicants are now required to provide their three most recent bank statements or salary advices, or other forms of proof of income, to validate their income. As many Truworths customers are self-employed or work in the informal sector, they are unable to provide the necessary documentation. Others have found the administrative burden too cumbersome and have not followed through with opening an account despite having applied to do so.
The regulations have resulted in approximately 30% fewer accounts being opened each month. In the period before the new regulations, cash sales in Truworths grew by 26% and credit sales by 18%. However, since the implementation of the regulations we have seen cash sales grow by 19% while credit sales have slowed to 8%. The regulations have resulted in an estimated loss of at least R200 million in credit sales and a profit after tax impact of around R70 million in the reporting period.
Extensive remedial action is being taken to mitigate the impact of the regulations on credit sales and this is covered in the Truworths: Managing the Risk of Credit report.
The impact of the regulations has not been restricted to low income customers, and others who are now being excluded from the credit market are customers who in our opinion are likely to have been able to meet their future payment obligations and who would have qualified for credit under our existing stringent credit granting criteria.
Furthermore, we believe that many South Africans use retail credit to establish a credit record which is necessary to qualify for the financing of larger assets, a process which ultimately supports economic growth in South Africa. This has long-term implications for the economy in general.
Truworths, together with two other major listed retailers, instituted legal action against the National Credit Regulator and the Minister of Trade and Industry in June 2016 to have the new affordability assessment regulations reviewed.
The Group posted a competitive trading and financial performance against the background of the challenges outlined above.
Group retail sales increased by 46% to R17 billion, with Office contributing sales of R3.8 billion. Truworths increased retail sales by 14% as customers responded positively to the improved fashion ranges. The Office e-commerce business continued to gain momentum and increased online sales by 22%, which off-set the decrease in its store sales of 6%.
Trading space across the Group increased by 8.6% following the opening of a net 23 new stores and the addition of 159 Office stores, including 44 concession stores. At the end of the reporting period the Group had 929 stores and concessions across South Africa (723), UK (147), rest of Africa (47), Germany (7) and the Republic of Ireland (5).
The Group's gross margin decreased to 52.9% (2015: 55.2%) as Office operates at a lower gross margin than Truworths. Excluding Office, the gross margin increased to 55.3%.
While the credit environment deteriorated in the second half of the year, the Truworths debtors book metrics continued to improve. The doubtful debt allowance has improved from 12.5% to 12.3% of the debtors book and net bad debt improved from 12.5% to 12.4% of the debtors book as a result of improved collections.
Group operating profit increased 20.7% to R4.2 billion while the operating margin decreased to 24.9% from 30.5% owing to the reduction in the gross margin and higher trading expenses, mainly due to the acquisition of Office. Excluding Office, the operating margin increased to 30.7%.
Refer to the Chief Financial Officer's Report for an analysis of the financial performance.
Our approach to credit
A perennial question we encounter is whether our credit model is sustainable and our consistent response is that the Group is neutral between credit and cash.
Truworths uses credit as an enabler of sales, as opposed to operating a financial services business. Many customers in our mass mainstream middle-income market do not have access to bank credit and credit cards, and use our store credit offering to buy better quality, aspirational fashion.
Our approach is that credit should be largely self-funded and that the cost of credit is balanced each year by interest revenue. In the reporting period our total cost of credit of R1 277 million matched the total income from credit of R1 273 million.
As a Group we are increasingly targeting more affluent, cash customers, many of whom use credit cards. This is evident in our recent acquisitions of Office, Naartjie, Earthchild and Earthaddict, and in the creation of a Truworths Designer Emporium housing our better-end brands Daniel Hechter, LTD and Earthaddict. Our new customer loyalty programme will be tailored to specifically include cash customers while our e-commerce offering will also be appealing to higher income customers. Office London, due to be launched in South Africa in the 2017 calendar year, will also target more affluent customers, as do our existing Mac and Elements departments.
In the reporting period cash sales made up 47% of retail sales, compared to only 30% in the prior period, mainly influenced by the acquisition of Office which only makes cash (including credit and debit card) sales.
We believe that at this stage of the economic development of South Africa, credit is an essential component of our business model within the domestic market and is likely to remain so for the foreseeable future.
Growth strategies: Truworths
Expand kidswear presence
The first Truworths Kids Emporium store was opened in October 2015, housing our three aspirational upmarket brands LTD Kids, Naartjie and Earthchild. A further 13 were opened by June 2016. The kids emporium concept is unique in South African retail and Truworths plans to open over 100 Truworths Kids Emporiums in the next five years.
Develop e-commerce capability
Truworths is committed to increasing customer engagement through digital channels and growing online sales. Our e-commerce platform will be launched in 2017 to facilitate omni-channel retailing and the first phase of the project will be the re-launch of the Truworths website with enhanced functionality, order fulfilment and payment capabilities, with a significantly increased online shop offering the full range of products available in our flagship stores.
Introduce loyalty programme
The loyalty rewards programme scheduled for launch in 2017 is aimed at increasing both the basket size and frequency of shopping of account and cash customers of Truworths. A customer engagement platform has been developed which will enable multi-channel customer communication and allow for personalised offers and promotions.
Enhance supply chain capability
The current distribution facilities are being enlarged to accommodate organic and acquisitive growth, and new distribution methods. Construction of a third owned distribution centre will commence in the 2017 calendar year and is due for completion in 2020. A new warehouse management system has been implemented to enhance supply chain efficiencies.
Growth strategies: Office
Office plans to open approximately 15 to 20 stores over the next three years across the UK and Germany, while closing less profitable stores and relocating others as opportunities arise. The first Office London store will be opened in South Africa in the 2017 calendar year.
Truworths is led by an executive committee which is involved in all key business decisions. The committee has been expanded with the appointment of two of our senior merchandise executives, Sean Furlong and Sarah Proudfoot. They join myself, CFO David Pfaff and merchandise head Doug Dare who was recently appointed as an executive director to the Truworths International board. Further appointments may be made to the committee in the months ahead.
We expect the South African trading environment to remain challenging, with slow economic growth and rising inflation putting pressure on consumers.
The continued impact of the new affordability assessment regulations remains a concern, particularly in relation to the high revenue base established in the first half of the 2016 reporting period.
The trading environment in the UK is also faced with uncertainty after the decision to withdraw from the European Union.
However, in the second half of the 2017 reporting period product inflation could decline from its expected highs in the low to mid-teen percentages depending on the performance of the Rand. The Group also expects to make more progress in implementing mitigation strategies in relation to the new affordability assessment regulations.
The trading environment in the UK is likely to stabilise as more clarity emerges on Brexit while Office should benefit from the Group's influence on stock management and ranges.
The Group remains committed to investing for longer-term growth and capital expenditure of R547 million (Truworths R516 million and Office R31 million) is planned for the year ahead while trading space is expected to grow by approximately 3% (Truworths 3% and Office 6%).
Thank you to our Chairman, Hilton Saven, for his decisive leadership of the board and to my fellow directors for sharing their extensive business acumen and insight. I extend a special note of appreciation to the non-executives for their skill and wisdom during a challenging and significant year for our business.
My executive committee colleagues and the senior management teams continue to lead by example. Thanks in particular to Office CEO Brian McCluskey and his colleagues for their support and engagement through the acquisition and integration process. To all our employees in Truworths and Office I thank you for your commitment, teamwork and energy.
Thank you to our customers for supporting our brands and for making us their first choice for quality fashion apparel and footwear.
Chief Executive Officer