The Chief Executive's Report outlines the favourable economic conditions experienced by the retail sector over the past year. However, fast moving consumer goods (FMCG), which comprise the majority of the product sold by the group, have not shown the same growth rates. Purchase inflation for the group continued at low levels throughout the year which presents an ongoing challenge in the face of continuing pressure on cost inflation in areas such as employee remuneration and occupation costs.

Against this background, the group showed satisfactory turnover growth, but a disappointing operating performance from the Clicks brand negatively impacted the overall performance. Most of the other brands delivered strong earnings growth in 2005.

Year-on-year comparison of the group's performance is complicated by the sale of New Clicks Australia (NCA) and the group's interest in Intercare Managed Healthcare last year as well as the consolidation of Purchase Milton & Associates (PM&A) following its acquisition in March 2004. To assist in a review of the results, the financial statements have been compiled to reflect both discontinued and continuing operations and the group has endeavoured to disclose sufficient other detail to enable shareholders to more fully understand the various income and expenditure components of the group.

• The group increased turnover from continuing operations by 18.2% to R8.7 billion for the year, bolstered by the inclusion of the pharmacy operations for the full financial year compared to only six months in the 2004 results.
• However, a 28.5% decline in the operating profit (gross profit plus other revenue less operating expenditure) of Clicks from R293.5 million to R209.7 million adversely affected the group's results. This decline resulted mainly from a loss of approximately R70 million in the pharmacy business for the year and a high level of shrinkage in the brand.
• Owing to the relative size of the Clicks brand, there has been an 8.6% decline in the group operating profit from continuing operations to R358.6 million.
• Diluted headline earnings per share from continuing operations reduced by 5.3% to 63.2 cents per share. Diluted basic earnings per share at 58.4 cents per share was lower than diluted headline earnings per share owing to an impairment of the Link Investment Trust goodwill as well as various other capital items which together totalled R17.0 million.
• Return on equity (RoE) decreased from 18.4% to 16.7%, principally due to the decline in operating performance.

Working capital management remains an opportunity and therefore a key area of focus in the year ahead.

Capital management

Capital is managed centrally by the finance division, and the brands report results on an economic value-added (EVA) basis. While brands are incentivised to grow profits on an EVA basis, the finance division manages capital to optimise the gearing effect with the objective of enhancing the return on shareholders' interest.

Following the sale of NCA in January 2004, the group reduced its net gearing ratio to well below its then target of between 25% and 30%. It therefore initiated a share repurchase programme, buying back 13 million shares for R99.5 million to August 2004 and a further 13.9 million shares for R126.7 million during the current financial year until 20 December 2004 (shares were bought back at an average price of R8.37).

While this programme was RoE enhancing, the group has decided not to purchase any further shares until the cash flow trend is more positive. The group will then also use this opportunity to establish new gearing targets as well as determining optimal capital structures.

Financial results – income statement

The trading performance of the brands has been set out in more detail in the Chief Executive's Report and in the brand reviews.

Income drivers

R’000	2005	2004				2005						2004
Turnover	8 714 338	8 024 123
Cost of merchandise	7 004 862	6 276 773
Gross profit	1 709 476	1 747 350	Gross profit margin		19.6%						21.8%
					multiply						multiply
Other revenue	542 778	540 318	Other revenue		1.32						1.31
					=						=
Net revenue before operating expenditure	2 252 254	2 287 668	Operating		25.8%						28.5%
			expenditure/turnover		less						less
Operating expenditure	1 893 697	1 853 166			21.7%						23.1%
					=						=
Operating profit	358 557	434 502	Operating margin		4.1%						5.4%
					less						less
Net interest paid	49 086	59 778	Net interest/turnover		0.6%						0.7%
					=						=
Headline profit before taxation	309 471	374 724			3.6%						4.7%
					multiply						multiply
Taxation on headline profit before taxation	87 833	110 064	1– Effective taxation rate		0.72						0.71
					=						=
Headline earnings	221 638	264 660				2.5%						3.3%
						multiply						multiply
Average inventory	1 516 610	1 406 200	Average inventory turn		5.75						5.71
					divide						divide
Average other assets	1 657 195	1 899 432	Other net assets		1.08						1.31
					=						=
Average non-interest-bearing liabilities	1 532 181	1 468 185	Average net asset turn			5.31						4.37
Average total assets less non-interest-
bearing liabilities	1 641 624	1 837 447	Return on total				13.5%						14.4%
			non-cash assets
							divide						divide
Average interest-bearing current liabilities	98 228	95 897
Average interest-bearing non-current			Net debt ratio			19.0%						21.6%
liabilities	213 707	301 502
Average total interest-bearing liabilities	311 935	397 398	1– net debt ratio				81.0%						78.4%
Average capital	1 329 689	1 440 049	Return on equity					16.7%						18.4%

Turnover

While the growth in Clicks turnover benefited particularly from pharmacy being included for a full year in 2005 as opposed to six months in the previous year, this growth was, however, impacted negatively by the introduction of the R26/26% pricing regulations introduced into pharmacy earlier this calendar year.

Clicks' turnover was also impacted by the conversion and closure of a number of PM&A stores and the opening of dispensaries in Clicks stores, and year-on-year comparison needs to be seen in this context. Clicks' turnover (excluding pharmacies) increased by 6.9% on a like-for-like basis.

For the first time in a number of years Discom had a net increase in the number of stores, which assisted turnover growth. The brand also showed strong same store turnover growth of 9.2%.

Entertainment's very pleasing turnover growth reflects the benefits of the new wider product offering. This wider offering also means the brand is now less exposed to the vagaries of the music industry.

The Body Shop turnover increase is mainly from the growth in new stores opened this year. Same store growth was down by 1.5% owing to some extent to the cannibalisation of turnover from other The Body Shop stores in surrounding areas.

UPD continues to show very strong turnover growth. The implementation of single exit pricing (SEP) in August 2004 reduced selling prices by approximately 15%, but has driven volumes towards UPD from single channel operators because of UPD's wider offering. UPD's fine distribution capability also allows pharmacies to minimise their inventory holdings by receiving more frequent deliveries.

Gross profit margin

Gross profit margin has been negatively affected by:

• a higher than expected level of shrinkage in Clicks (addressed in more detail in the Operational Review);
• Clicks adopting the R26/26% medicine pricing model earlier this year;
• Musica's strategy of lower priced CDs and the changing mix, with a larger proportion of turnover coming from DVDs and gaming which are at lower margins than CDs;
• a drop in margins in The Body Shop coming mainly from the Clicks ClubCard offering that was trialled in the brand during the financial year, but subsequently discontinued shortly before year-end; and
• the effects of SEP on UPD's margin.

This was offset to some extent by better margins in Discom from improved shrinkage and refinements to the product mix.

Operating expenses

Comparisons in operating expenditure year-on-year are again affected by the fact that pharmacy is included for only six months in 2004 and NCA which was included for only part of last year. We have therefore also presented pro forma amounts in the accompanying table which has the effect of showing pharmacy expenses for a full year in 2004 as well as reflecting NCA separately, in order to assist the reader with a further basis of comparison.

The depreciation and amortisation charge benefited from a number of assets becoming fully depreciated during the year and the closure and conversion of 29 PM&A stores. We do, however, expect that as a result of the new systems implemented in August 2005 (as detailed below), depreciation will increase to around R120 million for 2006.

The increase in occupancy costs reflects the growth in trading space and the annual rental escalation in terms of lease agreements.

Employment costs were reasonably well controlled and within acceptable levels of increases.

Other operating costs were largely impacted by:

• costs associated with the higher sales volumes such as credit card commissions, advertising, bank charges, communication costs and distribution centre-related transport to the stores; and
• shared services costs, which increased as a result of the implementation costs of the new systems.

Operating profit

Operating profit from continuing operations decreased by 8.6%, impacted mainly by the performance of the Clicks brand.

Generally the other brands in the group showed strong operating profit growth.

Interest

The group continues to have a relatively high interest charge, largely attributed to the fixed-rate debt negotiated at a time when interest rates were significantly higher than current rates. The remaining interest expense is mainly related to the monthly working capital needs of the group. The net expense in 2005 has, however, reduced from that reported in the prior year owing mainly to the inclusion of interest received on the Intercare loan.

Goodwill

The group impaired the Link Investment Trust goodwill by R16 million. However, we expect to dispose of this trademark in the near future and anticipate recovering part of our investment.

Financial results – balance sheet

Apart from capital management, the group's other key focus for the balance sheet is on inventory levels, where an improved inventory turn can be achieved. Inventory turns – based on sales at selling prices and inventory at cost – declined marginally in the current period.

This can be attributed partly to the extra inventory of about R30 million held at year-end to ensure continued inventory availability when the group migrated to new systems. UPD also had a slightly worsening trend as SEP reduced the average value of items sold by some 15%. In reality, inventory turns at UPD remain very efficient.

The group now has improved systems and management will be exploring ways of using the information more effectively to extract synergies in the form of lower inventory levels where possible.

Accounts receivable largely arise from UPD and the pharmacy operations. UPD and the pharmacy operations closed the year with debtor's days at 28.9 days and 23.2 days respectively. Pharmacy debtors comprise mainly accounts receivable from medical aids. The remaining debtors are largely attributed to amounts owed by trade suppliers in respect of co-operative income relating to group purchases.

Cash flow

The group utilised a further R345 million of cash during the year. Any comparison to 2004, however, needs to recognise that the proceeds on the sale of NCA of R317 million were included in that year. During the year cash was absorbed mainly by:

• increased inventory of R211 million, which was not supported to the same extent by supplier funding;
• store refurbishments and pharmacy conversions of R70 million;
• R75 million spent on the information technology systems;
• other capital expenditure of R25 million;
• the movement on loans payable and receivable of R106 million in the current year;
• dividends comprising the final dividend from 2004 of R75 million and the 2005 interim dividend of R37 million which were paid during the financial year; and
• the share repurchases, mentioned above, of R127 million.

We will continue to invest in the development of our stores in the year ahead and plan to further expand the UPD facility in Johannesburg to enhance its offering and capability. In addition, various other capital expenditure requirements of R72 million are anticipated. A total amount of R164 million has been budgeted for the 2005 year.

Information systems and financial reporting

The group began a process of re-engineering its enterprise-wide information systems some 30 months ago and the systems were successfully implemented in August 2005.

The new systems, based on an Enterprise Resource Planning 2 (ERP 2) platform, will introduce a very different way of measuring and managing the business and it will therefore take time for the group to extract the full benefits from the systems. The focus for the next two years will be on adapting the business and adding to the systems and processes to allow us to optimise the benefits of ERP 2.

The group now has a new daily sales and cash management system in place, greatly improving the speed, accuracy, control and detail of transactions in stores down to a till point level.

Supplier invoice matching at store level is also now in place, another significant improvement on the past, which similarly will greatly reduce the amount of time spent on inaccuracies, reconciliations, follow-ups and the discrepancies that largely existed in the old paper-based systems.

Currently, continuous inventory counts are being conducted in a pilot phase, which will prove to be a significant enhancement to inventory counts and related control and is due for full implementation during 2006.

The systems will continue to be developed to allow the group to achieve a more efficient end-to-end processing system within the supply chain process with an ability to more effectively track product profitability thereby creating a further refinement to the demand-driven supply network.

International Financial Reporting Standards

In line with the requirements of the JSE Limited, the group will adopt International Financial Reporting Standard (IFRS) with effect from 1 September 2005. The areas affecting the group's results will be, inter alia:

Share-based payments

IFRS 2 applies to equity-settled and cash-settled share-based payments. It requires that equity-settled share-based payments, which would include the share options granted to employees within the New Clicks group, be accounted for by a value being attributed to the options on the grant date and expensed over the vesting period of the options. The treatment prescribed by IFRS 2 in respect of cash-settled share-based payments is consistent with the policy adopted in the current year (refer to the accounting policy on employee benefits and to note 17.1 in the annual financial statements).

Property, plant and equipment – material component approach

IFRS requires an annual reassessment of useful lives and residual values of all property, plant and equipment. IFRS will also require material components of property, plant and equipment to be separately identified and depreciated over the appropriate periods.

Further detail of the impact of IFRS on the group's results will be disclosed with the group's interim results in April 2006.

Conclusion

Key financial focus areas for the year ahead will be:

• improving working capital management and in particular looking at ways of leveraging the benefits that can be obtained from the ERP 2 systems and thereby enhancing cash flow management;
• expense management as we continue to focus on cost efficiencies and using the ERP 2 systems to allow the extraction of these synergies;
• enhancement of controls for management of inventory;
• looking at ways of improving the speed and effectiveness of management information across the group; and
• finally, optimising capital structures and gearing levels once the group displays an ability to generate, rather than consume, cash.

While the group has considerable challenges, given the favourable impact of the above initiatives, I believe it can achieve more acceptable returns for shareholders in the medium term.

KEITH WARBURTON
Chief Financial Officer