The body shop: retail and business operations

Body Shop is launching a new, three-pronged strategy to attempt to improve financial performance. One of the initiatives "To reinforce stakeholder culture" has nothing to do with financial performance. The other two, however, will have an impact on financial performance. For example, upgrading the stores will result in an increase to fixed assets. Improving the inventory turnover will result in lower cost of sales as we move old inventory that has already been accounted for.

In order to get a sense of the company's performance for the next couple of years, we have created a model. Underlying this model are several assumptions. The base case scenario assumes that turnover will grow at 11%, as this is the average sales growth over the past two years. The impacts of our investments in store improvements will start to show in 2003 and 2004, so the rate of sales growth will increase to 15% and 17% in these years.

We believe that cost of sales will shrink. We have been making steady improvements to out cost of sales, and by improving our inventory turnover we will lower it further. Improving inventory turn will also allow us to use less warehouse space. The company is growing, so we will not give up any warehouse space, we will simply expand it at a slower rate. Thus, we will reduce the operating expense ratio over time by moving the inventory faster. We will assume no exceptional costs -- we will not know these until they happen, by definition. Restructuring costs will reflect the improvements that we intend to make with our stores. This is a major undertaking, as we have become a major chain with hundreds of outlets. The restructuring process will therefore take three years to complete. We have assumed that the costs will be portioned out equally over this period. Our tax and interest rates will remain the same from last year.

The additional debt required over the forecast period will be: In 2002, £16.3 million; in 2003 £25.7; and in 2004 £29.9.

The primary driver of this debt will be the capital needed to modernize the stores. That will account for about 80% of the new debt required. The payoff for this investment will have begun, but will mainly show in added income and profits in 2005 and beyond. The restructuring cost will amount to around £100 over the next three years, about £70 million of which will translate to long-term assets. The rest will be payments to the contracting firms undertaking the work. Moving our inventory faster will help to defray some of these added costs as well.

Debt needs vary with some of the assumptions. The key assumptions are the level of inventory turnover improvement, the level of sales improvement, the operating expenses improvement, and the increase in fixed assets. These are all at the core of the proposed strategy for restoring Body Shop's performance. They reflect directly on management's plan to move inventory faster, to modernize the stores and to drive down costs through our supply chain. The debt needs vary fairly significantly with these assumptions. For example, if inventory turnover does not improve -- that is it stays at 13.7% of sales -- this will cost us £5 million per year. If we scale back our modernization plan such that it only adds 10% to fixed assets rather than 15%, that will reduce our debt requirements by £23.2 million. It will also impact our profitability improves in future years, however. If consumers do not respond to our initiatives and sales do not increase, it will cost us £2.4 million in profit over this span, and more down the road.

In the coming years, the company will be making an investment in the future. This will result in a short-term deterioration of financial position as we take on more debt. The company's long-term debt ratio is 26.5% today and this will increase to 39% in 2004. However, Body Shop's liquidity will remain strong. Profits will continue to grow over this period. Shareholders will not only continue to receive their dividend but will also see an improvement in shareholder's equity. Essentially, the company has the means to undertake this modernization, and will begin to see reward with an immediate return to profitability.