In preparation for this article, I visited one of Melbourne’s prime inner-city shopping precincts, Chapel Street. On a bright Saturday morning, Chapel Street seemed a little flat: plenty of shoppers, but not the usual hustle and bustle that gets cash registers ringing.
I counted six vacant shops in one block and spoke to a handful of retailers. Each said business was slow and they relied on sales to attract customers. A late start to winter had not helped fashion retailers; they were most at risk of closing.
Perhaps it was the long weekend. Or Chapel Street. Or the retailers I visited in my small sample. One should never rely too much on anecdotes when investing, or extrapolate personal observations to an entire industry. But store visits still tell you a lot about retail.
On Chapel Street, the mid-year sales seemed to start earlier than usual and they offered bigger discounts. That suggests that pricing power for retailers is waning amid rising competition and faster growth in the services sectors. Profits margins are under increasing pressure.
The retail mix changed: more foreign retailers taking on the locals and several fashion outlets converted into cafes or restaurants, from what I could tell. We are spending more on eating out and personal services, but expect to pay less for clothes in store, or buy them online.
The economic evidence paints a broadly similar story. The latest interest rate cut and Commonwealth Budget boosted consumer confidence. Unemployment is easing, house prices remain high and another rate cut is likely. Overall, consumer spending is okay.
But retail sales growth has lost momentum since January 2014, in part because of slowing retail inflation, or the ability to lift prices. With wages growth at record lows, inflation is likely to stay low for longer than expected and further reduce pricing power. A lower Australian dollar, which I expect in 2016, is another pressure point for retail importers.
Then there’s current confidence. An extended Federal election campaign is never good for retail and global economic uncertainty abounds. It would not take much to puncture recent gains in consumer confidence, such is the fragility of the domestic and global economies.
On balance, expect tougher conditions for discretionary retailers in 2016-17 and increasing pressure on profit margins. Rising valuations for several retailers in the past 12 months, after better-than-expected Christmas trading and consumer confidence, are another risk.
I outlined two retail strategies for the Super Switzer Report in September 2015: buy domestic retailers exposed to housing; and focus on ‘born-global retailers’ with expanding offshore sales.
JB Hi-Fi and furniture retailer Nick Scali were preferred stocks in strategy one. JB Hi-Fi has delivered a total shareholder return (including dividends) or 21% in 12 months and still looks okay value. Small business tax concessions should support demand for electronic gadgets, JB will benefit from Dick Smith Holding’s demise, and new smartphone launches later this year will get consumers into its stores.
Harvey Norman Holdings, too, will benefit from these trends, but looks fully valued for now.
Nick Scali has returned 36% over one year. Furniture retailers should be struggling, but Nick Scali exemplifies the importance of backing retail management, who understand their consumers, watch every dollar, and can move quickly to maintain margins. Nick Scali remains a core small-cap portfolio holding for long-term investors.
Strategy two, buying offshore retailers, has had mixed success. Premier Investments, owner of the outstanding Smiggle stationery chain, has returned 18% over one year. It has excellent long-term prospects as Smiggle rapidly expands in the United Kingdom and Asia and becomes a global brand. But Premier’s recent share-price gains have captured the near-term potential. It’s one to watch on any price weakness.
Another stock identified, Retail Food Group, has returned 7% over one year. The multi-franchisor looked cheap after heavy share price falls and its sharp rally in the past three months will have buoyed its true believers. Retail Food Group has risen from $4.20 to $5.60.
Jewellery retailer, Lovisa Holdings, disappointed. It has excellent overseas growth prospects, but a nasty profit downgrade hammered its price. Lovisa’s one-year return, negative 28%, detracted from an otherwise collective strong performance from the retailers identified.
Woolworths
I’m adding a third strategy to the retail mix this week: identifying out-of-favour retailers that have recovery potential and make the grade on valuation grounds.
The first is Woolworths, a former market darling that lost favour after falling market share in supermarkets and its disastrous foray into hardware retailing. Woolworths has dropped from a 52-week high of $29.22 to $21.16.
Buying companies undergoing major strategic reviews, at a time of cyclical and structural pressure, is rarely a good idea. But Woolworths’ valuation reflects the competitive pressures, its turnaround risks, and ongoing deterioration in its operating performance.
Recent stumbles at arch-rival Wesfarmers could aid Woolworths’ recovery. Wesfarmers’ underperforming divisions, notably department stores through Target, and its resource operations, are weighing on the group’s return on equity and share-price performance.
The market has a negative view on Woolworths. Eight of 14 broking firms that cover it have a sell recommendation, four have a hold, and two a buy, show consensus analyst forecasts. A median share-price target of $21.21 suggests Woolworths is fully valued at the current price.
Woolworths would look a lot more interesting below $20 and may get there in a hurry in the next few weeks if the global equity market sell off continues. Patient value investors might accumulate Woolworths on price weakness during bouts of market volatility.
At $21.21, Woolworths is on a forward Price/Earnings multiple of 15.7 times – broadly in line with the market average. I’m backing it to regain its premium rating as evidence of the turnaround slowly emerges, with plenty of bumps along the way.
Woolworths suits investors who can wait a few years for the turnaround to unfold and are happy with a 4% fully franked yield along the way.
Chart 1: Woolworths
Source: Yahoo
Metcash
Metcash has had more market love this year, soaring from a 52-week low of 96 cents to $2.09 after signs that its transformation strategy is working. But the turnaround in the wholesaler of groceries, liquor and hardware has further to run in the next few years.
Metcash is a doing a good job to reduce costs and halt sales and profit margin declines at IGA retailers. The divestment of its auto business has improved the balance sheet and given Metcash greater scope to reinvest in its business transformation.
Metcash’s competitive pricing-matching strategy with the big supermarkets is gaining traction with consumers, and helping it contend with intense competition in food and groceries from Woolworths, Coles and increasingly the German supermarket giant, Aldi.
IGA has an interesting market position if Metcash can improve its price competitiveness in groceries and liquor. The big supermarket chains will always win the war on value, but independent, community-based retailers that stock an assortment of product lines will attract those seeking convenience and a different product range.
I can see time-poor consumers favouring nimble suburban retailers, at least for smaller shopping excursions, provided Metcash can demonstrate its value and improve its shopping experience. So far, so good on that front, as it repositions its product offer, pricing and store formats.
Metcash could also benefit from corporate activity in the home improvement sector after Master’s demise, through its Mitre 10 brand, the second largest player in this market and one with increasing strategic value.
More will be known when Metcash reports its full year results on June 20. The market, understandably, is cautious, notwithstanding Metcash’s recent operational gains.
A forecast Price Earnings (P/E) multiple of 11.5 times 2016-17 earnings, based on consensus forecasts, is undemanding. Metcash should trade at a discount given its market position, but investors, even after recent price gains, could be underestimating its turnaround potential.
Macquarie Wealth Management’s 12-month price target of $2.54 for Metcash, and outperform recommendation look reasonable. Metcash is due for a price pullback or consolidation after recent gains, but its medium-term prospects look the best in some time.
Postcript (update June 22, 2016)
Metcash’s share-price pullback, foreshadowed above, was larger than expected. It fell 11% on Monday after delivering a full-year result below analyst expectations, and bounced 4% the next day to $1.86.
The result was mixed: the supermarket strategy is gaining traction but the convenience stores disappointed, partly because of store closures. Deflation remains a growing problem in retail as intense competition drives down prices and margins.
The core view that Metcash’s medium-term prospects are improving remains intact. But share price weakness could weigh on Metcash in the next few weeks as the market digests the results, in turn creating a potential buying opportunity for long-term investors.
Chart 2: Metcash
Source: Yahoo
– Tony Featherstone is a former managing editor of BRW and Shares magazines. The ideas in this column are not stock recommendations or financial advice. Readers should do further research of their own or talk to their adviser before acting on themes in this article. All prices and analysis at June 15, 2016.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
