Is Retail Dead?

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

By Greg Peel

Australia's consumer discretionary sector stock analysts must be feeling a bit black and blue these days after what one might consider two years of earnings surprises.

It was nearly two years ago now that Lehman Bros went under and the world, and Australia, was potentially facing another Great Depression. In any recession, and particularly the one looking inevitable in 2008, the first stocks to jettison from a portfolio are logically consumer discretionary stocks. Consumers have little choice but to keep buying bread and milk, but faced with an uncertain future the average consumer will shy away from big ticket purchases from frocks to furniture, computers to televisions.

It was therefore a natural assumption that stocks such as high-end department store David Jones ((DJS)), electronics retailers Harvey Norman ((HVN)) and JB Hi-Fi ((JBH)), surfwear specialist Billabong ((BBG)) and smaller stocks such as Specialty Fashion ((SFH)), Fantastic Furniture ((FAN)) and so forth would tank.

But while the market initially responded accordingly, it was soon forced to quickly turn around. The oil price collapsed, the RBA began indirectly slashing mortgage rates, and Kevin Rudd flew around in a helicopter throwing out free cash. Recession? Suddenly everyone was flush. And then China started buying record amounts of iron ore and Australia never even had a recession.

At the individual stock level, analysts also underestimated specific factors. DJ's was applauded for its cost management (not to mention its dividend payout), Hardly Normal for its franchise model, JBH for its management, and Fantastic Furniture for being a wily acquirer of distressed competitors, for example. So stock prices mostly spun around, analysts were forced to upgrade earnings forecasts at every sales result, and the stock market in general recovered in 2009.

There was nothing to worry about after all. At least until after the honeymoon.

Oil prices rose again swiftly in 2009, the RBA began to raise once more, and Kevin pulled out his wallet to show all that was left were moths. Slowly retailers' sales figures began to dip, then slip, then plummet. Stock analysts were forced to trim, then cut, then slash their earnings forecasts once more.

In the midst of all of this, middle-level department store Myer ((MYR)) was listed, as was sportswear (particularly cold weather) specialist NZ's Kathmandu ((KMD)). Myers' debut was disappointing, but then that's what you get for buying from a private equity vulture, while Kathmandu fared relatively well.

At least up until yesterday, when cries of despair were heard echoing around the Himalayas.

The numbers announced at Kathmandu's FY10 trading update fell well short of broker forecasts and the forecasts provided in the IPO prospectus. In short, times are tough, and a lot tougher than even pessimistic analysts had assumed.

Kathmandu relies heavily on Christmas, as most retailers do, but also on Easter as the lead in shopping holiday for cold-weather apparel. Unfortunately this Easter most of us were lying on a beach soaking up unseasonable warmth, so shop assistants were left twiddling their thumbs. By the time the chill arrived, global economic slowdown fears had gripped and the tills remained relatively silent.

Is there any light at the end of the tunnel? The RBA is clearly keeping interest rates on hold for the time being but the massive June trade surplus in Australia is a reminder that position is tenuous. Mining might have kept us out of recession, but there's clearly a recession going on everywhere else. And now for the first time in over a year, house prices have ticked down. That's not going to spur consumers into a spending spree either.

It all looks very bleak for retail as we enter the bulk of the FY10 reporting season. But is that bleak outlook now accounted for in prices?

Only four brokers in the FNArena database cover Kathmandu, but three of them had Buy ratings ahead of the update and have kept them intact. Their average target price is $1.83 which is 30% above today's price.

Indeed, with all the doom and gloom surrounding the retail sector – and the latest retail sales data were also gloomy – one might expect analysts now to be collectively negative on the sector. But not one of the stocks mentioned in this report has a negative Sentiment Indicator in FNArena's Stock Analysis.

[The FNArena sentiment indicator aggregates Buy, Hold and Sell ratings and applies a numerical value. A score of +1.0 means all Buys, zero means all Holds and -1.0 means all Sells, with variations implying scores in between.]

In short, analysts are expecting things will eventually pick up as we move into at least the latter half of FY11, even for Kathmandu. And if not FY11, well maybe FY12. But the point is the stock market is a leading indicator, and consensus suggests the market has already adjusted stock prices in the sector to assume the worst. And typically investors go looking for bargains in oversold consumer discretionary stocks well ahead of an expected turnaround given consumers are fickle – they can brighten up pretty quickly.

In fact, RBS Australia has advised its clients in a report today to “beat the rush”.

RBS notes that economists feel Australia's current fundamentals are supporting improving retail conditions in FY11-12, and that the evidence is “relatively compelling”. It's just that in the near term there's not much in sight to spur stock prices on. There may be surprises in earnings season, but the truth is it's very hard for retail companies to post exciting sales numbers when 2009 was such a bumper year under the circumstances, all achieved with exogenous smoke and mirrors

Having said that, RBS does not expect wholesale disappointment at earnings season either, although its a bit wary about a struggling Billabong. One point to note is that the stronger Aussie dollar has reduced the cost of imports, which should at least have a positive impact on margins. The analysts also note the retail sector is currently the most “shorted” in the market (highest number of short stock positions). This suggests a short-covering rally is a possibility.

RBS is sticking its neck out on Billabong with a Buy, while it also favours DJ's, Harvey Norman and Myer.

Credit Suisse believes that apparel retailing will still struggle for a while, but department stores in general should benefit from their own suppliers being forced to discount stock. In the electronics space, purchases fell into a hole in the September quarter last year once everyone had used their Pennies from Kevin to buy the new HDTV. Hence the HVNs and JBHs will be comparing to much lower sales figures come early FY11.

Credit Suisse sees Billabong and Specialty Fashion as two stocks more likely to miss earnings expectations, while it has today upgraded The Reject Shop ((TRS)) to Buy on expectations of a good result. Three out of five FNArena database brokers rate TRS a Buy given its simple business model and the attraction of discount stores when times are tough.

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