Chief Executive Officer's report and review of operations

In the context of sustained economic pressure on disposable income, the Group’s solid performance for the period is largely a reflection of the impact of enhancements made in the business rather than improved sentiment or spend by consumers.

Overview

Operating environment

Despite the improved outlook for South Africa and an initial gain in business and consumer confidence following recent leadership changes in government, the macro-economic environment remained subdued during the review period.

The hope that renewed optimism experienced in the country would translate into an economic upturn failed to materialise and is best illustrated in our sector by the June 2018 FNB/BER Building Confidence Index which declined steeply at the end of Q2 and was at the lowest level since Q2 in 2012, with more than 70% of respondents citing dissatisfaction with prevailing business conditions.

In the context of sustained economic pressure on disposable income, consumers remained restrained in their spend on non-essential items, and discerning in their selection of retailer – with the price/value proposition being a key driver of purchasing decisions.

The Group's solid performance for the period is therefore largely a reflection of the impact of enhancements made in the business during the year which started to gain momentum, particularly in the second six months, as opposed to improved sentiment or spend by consumers.

Over the past 30 years since listing on the JSE and almost 50 years since the Group was founded, Italtile has laid down a strong track record of continued improvement, consistency and resilience. Central to this achievement is our unique business model which has served as a major differentiator in the industry and a strong investment proposition for franchisees and shareholders. The key components are:

• Strategic portfolio of strong retail brands, which appeal to consumers across the income spectrum;
• Integrated supply chain which underpins our policy of 'right product at the right time, place and price';
• Flat, low-cost organisational structure comprising strong teams and unique individuals intimately involved in the operations;
• Recognition that our people are key to our competitive advantage and hence continued investment in them is paramount;
• Strong partnerships with employees, equity partners and entrepreneurial franchisees;
• Reward and empowerment ethos which incentivises personnel to participate in the profitability of the business;
• Extensive property portfolio which comprises high profile, well maintained, aspirational stores, state-of-the-art factories, and productive quarries;
• A customer-centric philosophy which ensures all our activities are centred on keeping them top of mind;
• Long-standing reputation as the industry trend setter and fashion authority, retailing highly fashionable products in all the markets we serve;
• Sustained investment in improving and innovating the shopping experience and ensuring the offering remains attractive to traditional customers and new, emerging homeowners; and
• Concerted focus on developing and employing industry-leading technology in both our retail offering and manufacturing operations.

Scorecard: achievement of key strategic imperatives

In my 2017 report, I outlined management's key priorities for the year ahead. The following account provides an evaluation of the progress we made in achieving those imperatives. Within the business, management's performance is rated according to a scorecard and I have applied the same format to our achievements in the year under review. The scorecard comprises the following categories:

At the end of the prior year, I stated that our goal was to open 15 to 20 new stores during the financial year, including at least one Italtile Retail store and three CTM stores. While we fell short of the higher end of the target range, we did succeed in opening 15 stores, including one Italtile Retail store. We are on track to open another 10 to 15 stores in the new financial year. The Property Investment report provides details of the store footprint and capital investment in this portfolio over the year.

In the first half of the year we reported that stock levels were higher than our targets and intense focus would be applied to reducing stock holding and improving stock turn to increase cash balances.

I am pleased to report that across the retail network and supply chain (importers), inventory management improved. Enhanced product mix assisted in increasing stock turn, and where inventory levels have risen, this was a function of improved in-stock levels of business-critical items. This achievement is noteworthy given the extreme supply disruptions experienced during the period caused by shipping and container constraints and the closure of numerous Chinese suppliers. In the year ahead, the Business Optimisation Programme ("BOP"), which is now entrenched across the operation, will be evolved to afford improved forecasting, which will be particularly beneficial in the supply chain import businesses.

In the current weak economy and constrained margin environment, we took a considered decision not to sacrifice margins through excessive promotional activity, instead favouring the route of robust cost leadership in key areas of the business. Good progress was made in the first half of the year and improved on further in the second half, resulting in below-inflation cost growth, while margins improved across the Group despite the weak sales trend.

Our conviction is that control of the supply chain from factory gate to the customer's home affords the Group a key strategic advantage, and we have identified this component of the business as offering meaningful growth opportunities. In this light, the Group's former Financial Director has been appointed to head up the supply chain and related commercial activities, with a view to substantially enhancing the contribution of this operation.

Key initiatives of this growth programme will be to develop new supply chain businesses offering new merchandise categories, and where feasible, bring in-house formerly outsourced supply. In the forthcoming year we will trial a new electrical lighting retail offering in various formats across the brands, ranging from a new merchandise category in TopT, to a shop-within-a-shop in Italtile Retail, and a standalone offering next to existing CTM stores.

In August 2018, we commissioned a new plant, PiViCal Panels, to manufacture PVC panels for the TopT brand. This import-replacement product will substantially reduce lead times of one of TopT's fastest growing merchandise category and afford the Group strategic advantage through its sector-leading technology. PiViCal Panels is a joint venture partnership with a local previously disadvantaged entrepreneur, which will assist to improve the Group's BBBEE scorecard, particularly with regards to preferential procurement and supplier development criteria.

During the review period, the Cedar Point warehouse management function was outsourced to a third-party specialist. Initial results reveal increased efficiencies; should the trial continue to prove viable, consideration will be given to extending this arrangement to management of the new Durban and Cape Town Distribution Centres, which will further streamline the supply chain.

The Ezee Tile business will be expanding its African operations during the new financial year, with strategic partnerships already identified in certain countries. Its African operations will include the manufacture and distribution of tile adhesive, paint and related products.

As noted in the Operating context report, the resource pool of personnel with specialist retail expertise is very limited in the local market, which dictates material investment of resources to train and develop a core of fit-for-purpose employees. During the period, extensive efforts were made to improve our learnership and recruitment methodologies and we made good inroads in terms of upgrading our store operator complement through more relevant performance management and training initiatives. In the year ahead, we will focus on attracting and developing the appropriate calibre of individuals to expand and complement our sales force. The Human resources and training report outlines our achievements in this area over the past year.

Substantial effort was made during the period to build the depth of leadership in the business. Key management appointments were made across the business, including in the supply chain, Finance, Marketing and Property divisions. Additionally, a dedicated human resources specialist will be appointed to each of the retail brands.

While we are satisfied with achievements made during the year, there is significant room for improvement in this key focus area. In the period ahead, we will further strengthen the capacity of our Finance department and Property portfolio (in the latter, formerly outsourced functions will be brought in-house, which will effect cost savings and efficiencies).

One of the Group's key resources is its network of long-standing, experienced franchisees – many of whom are strong leaders with entrepreneurial ambitions. Given the success of the TopT model, which comprises Master Franchisees who operate discrete territories comprising numerous stores, consideration is being given to replicate this format on a smaller scale in the CTM model, which has traditionally not employed a multistore ownership structure.The benefit of this modification will be to simplify the business model (with the Group reducing its owned-corporate store complement), cater to our franchisees' ambitions, and optimise on the existing expertise and experience in the business, without increasing our manpower costs.

In striving to build a core team of people to deliver on the Group's growth strategy, we are cognisant that retail is a challenging environment and requires a unique skill set. We are also mindful that the Group's high performance culture requires like-minded employees.

The Group's webstores, particularly CTM, have continued to benefit from early-mover advantage, both in South Africa and our rest of Africa region (Tanzania and Kenya). Locally the brand recorded 150 000 unique users monthly on average and very high double-digit growth of online sales and online quotes converted to sales in store. The offering is widely approved by users for its unique customer-friendly, interactive and personalised service.

Our online capability is complemented by innovations in-store, with the introduction of technology which is designed to substantially enhance the shopping experience, as discussed in the Operating context report and the e-Commerce report.

As discussed here, our new supply chain businesses will afford the Group strategic leverage in new markets, and we will continue to pursue other appropriate opportunities as they arise.

The state-of-the-art technology employed in Ceramic's tile factories continues to give us a leading edge as the industry fashion trend setter.

Across the brand network we focused on instilling retail excellence disciplines, which resulted in improvements across key areas of the offering, including range, presentation (merchandising and display) and service. Initiatives introduced in the first half of the year gained momentum in the second half, demonstrated by better execution and improved ratings received from customers via various external customer sentiment verification surveys and Mystery Shopper initiatives.

Following a nationwide roadshow to retrain staff on customer service, CTM's Mystery Shopper customer assessment surveys (both in store and telephonic) confirmed that sentiment had improved and compliments significantly exceeded complaints. TopT conducted its first ever customer appraisal survey and received very good reviews, while Italtile Retail's year-round Mystery Shopper customer sentiment measures confirmed consistently high levels of customer satisfaction.

At the half-year, we advised shareholders that we were awaiting regulatory approval to acquire the formerly franchised CTM Tanzania business. This approval was granted in July 2018. It is anticipated that this operation will contribute to the Group's growth prospects in the region, although expansion in the territory will be cautious and determined by the potential return on investment. The goal over the next four years will be to grow the footprint from four stores (including a webstore) to eight stores.

As noted above, Ezee Tile has advanced its expansion drive into sub-Saharan Africa, and its goal is to commission three new factories in the 2018/19 financial year.

Ceramic has investigated opportunities to build new factories in Rwanda and Kenya, and an investment decision in this regard is expected in the new financial year provided adequate raw materials are identified and a local partnership secured.

Results overview

The Group's results are discussed in the Financial Director's report.

In summary, while we were dissatisfied with turnover growth reported for the period, pleasing progress was made in improving profitability and stabilising margins, achieved through robust cost leadership, as outlined earlier in this report.

System-wide turnover for the period grew 39,8% to R8,7 billion (2017: R6,2 billion), while trading profit rose 43% to R1 518 million (2017: R1 063 million).

System-wide retail store turnover grew 2% for the review period compared to the previous corresponding period. Like-on-like retail store turnover decreased by 1,4% with average selling price inflation estimated at 1% (2017: 4,3%). Retail store turnover is defined as the aggregate of turnover of all stores, either corporate or franchised, in the Group's network.

Manufacturing turnover (sales related to Ceramic Industries and Ezee Tile) for the period since acquisition on 2 October 2017 to 30 June 2018, improved 15,2% against the prior comparable period. Manufacturing sales for the full year compared to the prior corresponding period increased by 10,6%. Average selling price inflation for the period is estimated at 3%.

Given the Group's consistent ability to generate cash, and in the interests of improving returns to loyal shareholders, the Board has resolved to reduce the dividend cover from three times to two and a half times.

Group performance

Retail brands

Improvements made across the business in the first six months gained momentum over the year, and better execution of basic retail excellence principles and increased focus on key targets resulted in an improved second-half performance across all the brands. Italtile Retail and TopT built on their solid first-half results, delivering double-digit growth. While CTM recorded lower year-on-year sales as middle income consumers continued to show stronger symptoms of financial hardship, low single-digit growth was reported in the second six months.

During the review period, we gauge that Italtile Retail and TopT grew market share, while CTM succeeded in gaining back share lost in the first half.

In the period ahead, we will be assessing the health of our brands, and where appropriate, refresh and revamp them to ensure they remain contemporary and appealing to existing customers and attract new customers.

Supply chain: importers

During the year under review, both International Tap Distributors ("ITD") and Cedar Point made good progress in rationalising ranges, although stockholding targets were not achieved. This will remain a key imperative in the year ahead. Severe supply disruptions out of China in the first half of the year impacted on the Group's in-stock position; however, better anticipation and prudent inventory management eased the situation in the second half, which proved less challenging. Due to the supply uncertainty, both ITD and Cedar Point have reviewed and succeeded in finding alternative suppliers, both in China and in new markets.

Supply chain: manufacturers

Ceramic Industries

Over the past nine months since acquisition of this operation, our focus has been on improving business-to-business communication, including enhanced production and logistics planning between the stores and the factories.

Tiles

During the review period, improvements were made to the tile matrix, including developing innovative new products and rationalising the ranges.

The key challenge facing Ceramic Industries is constrained market demand which is prevalent in the sector at present. During the second half of the year, destocking took place across the Group's stores and industry-wide, as operators sought to correct over-stock positions evident in the first six months. While demand has increased, volumes are not yet at notable levels. This weak market is anticipated to result in underutilisation of capacity in the factories, which will impact on profitability.

Ceramic's state-of-the-art Gryphon plant has commenced producing extra-large format tiles in various sizes to improve the business's import replacement advantage. Initial consumer response has been very positive; however, to grow this market to projected scale will require education of consumers and installers, and consistency of quality on new innovative product lines.

It is anticipated that in the year ahead, Ceramic will benefit from the reduction of Chinese government export subsidies and decrease in production of smaller format tiles, which will result in inconsistent supply to our local market. Furthermore, Ceramic will look to actively increase its local customer base to counter the weakened demand from existing customers.

Bathroomware and baths

Disappointingly, Betta Sanitaryware underperformed on management's targets. Operational inefficiencies, exacerbated by warehouse space constraints, hampered the division's performance. A new management team has been appointed and a comprehensive review and restructuring of the operation is underway to enable the business to meet the strong demand for its products.

After a difficult first six months, in which Betta Baths experienced various manufacturing challenges, remedial measures implemented served to address shortcomings, and the division reported an improved performance in the second half. Increasing profitability of the business will be prioritised in the year ahead.

Ezee Tile

During the review period, Ezee Tile made good progress in the local market, with the implementation of improvements at several of its production facilities; expansion of product lines; and increased penetration of the open market.

The business also furthered its goal to expand into Africa, concluding joint venture partnerships with resident partners to build manufacturing plants.