Honeymoon Over For Oz Retailers

This story features HARVEY NORMAN HOLDINGS LIMITED, and other companies. For more info SHARE ANALYSIS: HVN

By Greg Peel

In the first quarter last year it was raining Pennies from Kevin. “I don't care what you do with them,”said Kevin, “eat them, drink them, stick 'em in the pokies, buy something you can't really afford – whatever. As long as you don't save them or use them to pay off your Amex. I want you to spend, spend, spend!”

And spend we did. As a fallout from the GFC, retail analysts were reasonable expecting discretionary spending to tank, impacting on the likes of David Jones ((DJS)), Harvey Norman ((HVN)) and JB Hi-Fi ((JBH)). Indeed, the stock prices of those companies did take an initial bath. But with emergency rate cuts from the RBA, and generous cash hand-outs from the government, Australians did what they do best – they bought flat screen teles.

And they bought computers and iPods and furniture and anything else they didn't really need and all of a sudden it became apparent that Australia wasn't going to have a recession at all. History will long debate whether it was the RBA, Kevin's pennies or actually China that pulled Australia back from the brink, but with some smart management from said respected retailers, share prices soon bounced and bounced hard.

But the honeymoon may now be over. The pennies have been spent. Kevin was also very generous in handing out deposits to first home buyers so they could snap up a variable mortgage they couldn't afford based on a cash rate never to be seen again. The latest housing finance data show demand has fallen 17% from March to March. House prices might still be going up, but it's not because of the natural attrition of new buyers entering the market.

This morning Macquarie noted that sales of plasma teles are down 15% in the March quarter compared to the last March quarter. Sales were also down in LCD teles, cameras, gaming devices and peripherals, and are only just managing to hold up in IT.

The strongest performer in this sector – JB Hi-Fi – has noted flat comparable sales between the two periods. Given the level of stimulus last year, this is a good result. Indeed, Macquarie is maintaining an Outperform on the stock.

Macquarie notes retailers that “dominate” a space tend to achieve around 30% market share. JBH is still growing, but its 21% market share suggests more upside. The company's simple retailing model, concentration on electronics, and preference for shopping centres puts it in good stead, suggests Macquarie, compared to Harvey Norman's franchise, property development and landlord model, spread of products into whitegoods and furniture etc, and preference for bulky goods centres.

Macquarie rates Harvey Norman Underperform, suggesting JBH compares more favourably on potential return on investment capital. Macquarie also rates David Jones Underperform.

The stockbroker has price targets of $23.43 (JB Hi-Fi), $3.77 (Harvey Norman) and $4.45 (David Jones) respectively. Only the latter target is below the present share price.  Macquarie's targets compare with FNArena's consensus price targets of $22.37, $4.28 and $5.28 respectively. For more info see Stock Analysis and R-Factor on the FNArena website.

In the period after the GFC, when the market had assumed the worst for discretionary retailers, the obvious offset trade was to switch into recession-proof consumer staple retailers. Hence stocks like Woolworths ((WOW)) ultimately held up quite well. But while even food & liquor retailers saw a few Pennies from Kevin hitting tills, the immediate outlook for the supermarkets is not one of comparing last year's stimulus period. Problems run deeper than that.

BA-Merrill Lynch has long held concerns over Australia's consumer staples sector. Of all the brokers in the FNArena database, Merrills has been most critical and most pessimistic about Wesfarmers' ((WES)) acquisition of Coles. To that end Merrills has long maintained an Underperform rating on the Wesfarmers conglomerate, suggesting misplaced euphoria over a Coles rebound is sending the WES price into overbought territory, even when one takes coal price increases into consideration.

On the flipside is the all-conquering Woolworths. But Woolies' biggest problem is just that – it has conquered all. Woolies' only avenue from here is to spend money on sprucing up its stores in an attempt to ward off any Coles revival, and to keep its foot on the neck of the pretender Metcash ((MTS)), and to stymie precocious foreigners such as Aldi and Costco. Actually generating decent returns out of cosmetics is a tough ask.

And the market expects a lot out of Woolies. It also expects Coles to make a comeback, and Metcash is working hard at providing the “independent” alternative. Where Merrills sees the real problem, nevertheless, is that all three expect to grow profits in the food & liquor space over the next five years.

It's as if three teams have all declared they will win the premiership – and we know they all can't. Merrills calculates that for all three to be right about their profit growth forecasts, a total of $3bn in growth will be needed. This is a big increase on the $1bn in profit growth in the food & liquor market over the past five years.

And in the past five years Woolies and Coles moved into liquor, and into petrol. They spent a good deal of effort in buying up their supply chains and squeezing their suppliers. Food prices were also rising sharply. If ever the big supermarkets were going to make extraordinary profits, it was over that period.

But now, food inflation is falling. The supermarkets have exhausted obvious market expansion options such as pharmacy (which was disallowed) and have turned to the more costly business of hardware warehouses. They can otherwise only turn to store upgrades, customer offers and competitive discounting – not a formula for excess profits. In other words, Merrills believes that three profit forecasts cannot be right. One, two or all three will soon have to suffer this realisation.

This is not a new opinion from Merrills, but recent market strength has now forced the analysts' hands. They today downgraded both Woolworths and Metcash to Underperform, thus joining Wesfarmers.

All of the above only goes to highlight the problem as discussed yesterday in Australia's Two-Speed Conundrum. A lack of new building, record immigration and a return of investor confidence is creating a house price bubble, and skyrocketing bulk commodity prices are threatening to send Australia's GDP growth into “above trend” territory. On this basis, the RBA is tightening monetary policy with a view to returning rates to “normal”. And “normal” implies no lingering effects from the GFC.

But the retail sectors are telling a different story. Discretionary is set to struggle, in many a broker's opinion, in a rising interest rate environment and without further stimulus. Competition is going to weigh on staples, which might be good for consumers but not for investors. While the mining and energy sectors drive the Australian economy, other sectors are slipping back.

Australia is experiencing a two-speed economy, both across industries and across the geographical locations (states) where those industries are concentrated. It is a difficult problem for the RBA.

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