Deflation Ahead For Electronics Retailers?

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

By Greg Peel

While the RBA stood firm this week, the subsequent surprise jobs result is evidence enough the RBA has every right to fear building inflation pressures. Once upon a time 5% was considered “full employment” although economists these days are suggesting 4.5% might be the level. The concept of “full employment” not being zero unemployment may seem illogical, but it is a very important concept.

“Full employment” is deemed to be the line in the sand at which there are enough unemployed ready to fill new positions and enough lay-offs to replace those now employed, such that a level of equilibrium is maintained. Beyond this level it becomes increasingly difficult to fill positions from a limited supply pool and that only leads to one thing – wages on offer have to be increased. When wages are increased, workers have more spending power, and thus prices rise to match that spending power. And bingo, we have inflation.

The ABS does not break down monthly jobs numbers into sectors – it only does so quarterly. Thus we can only assume jobs growth to date has been driven by the mining and energy sectors. But if those sectors suck up available workforce, wages outside those sectors still have to rise to compete. This puts pressure on all other sectors.

And all other sectors are not performing well. In September, the manufacturing PMI fell into contraction for the first time this year, the services PMI fell into deeper contraction, and the construction PMI remained very much in the doldrums. Construction is suffering a hangover period between government stimulus wearing off and major resource sector ramp-ups not scheduled until next year. And the housing market remains moribund.

House prices have begun to slip, housing credit demand has surprised to the downside and retail sales growth, while positive, is currently on a slowing trend.

Why is retail sales growth on a slowing trend?

Well, apart from the fact we have now “cycled” away from government hand-outs – which include not only direct handouts but indirect hand-outs through overpriced insulation installation and school building contracts – we have also seen interest rates rise to a level the RBA deems to be “normal”. These factors are enough to put pressure on retail sales, but then throw in constant talk of further RBA rate rises and/or independent bank rate rises and it's hardly surprising that consumers are worried about mortgage repayments ahead and as such are not splashing out on discretionary items.

There is, nevertheless, the small matter of the Aussie dollar which at present seems hellbent on reaching parity. While the strong Aussie is reducing offshore receipts for exporters, which should help relieve inflation pressure, it does make imported goods “cheaper” once retailers are able to restock shelves based on a stronger currency. This might mean that new HDTV starts to look affordable, assuming households are confident enough to spend the money.

And therein lies the crux of the matter. Australians have a reputation of being spirited “first movers” when it comes to new technology. From VCRs to iPhones, Australians have always been keen to embrace new toys. But the pre-GFC consumption boom can no longer be used as a template. We all of us have one friend who simply must have the newest toy as soon as it hits the shelves, but for every one of those we have several friends who prefer to wait until the price comes down substantially.

It is for this reason that retail groups have noted a lack of price elasticity, according to conversations had with the retail analysts at RBS Australia. Prices are perfectly elastic when a reduction in price leads to a commensurate increase in sales, and vice versa. They are inelastic if “price points” make little difference to demand. If you think you simply must have a new iPhone 4, you'll buy one at whatever the price. If you think your current phone will serve you perfectly well for the time being, and a new one would just be an indulgence, you won't buy an iPhone 4 no matter what the price. Hence price elasticity.

The first half of 2010 saw a rash of new electronic goods released to the world, from HD and 3D TVs to a plethora of “smart” phones, new and more whizz-bang games, and the first of the now highly competitive “tablets”. Producers of these new items were a bit caught out because immediate demand (including that from emerging markets) was stronger than expected. Thus they weren't going make the mistake in the second half, and have since been pumping up the volume.

This has led the National Associated Retail Traders of Australia to suggest there is now an excess of supply, as RBS reports. This could lead to, in the audio-visual category, a drop in “price points” of up to 30%, NARTA suggests.

The temptation here is to say “whoohoo!” because that means cheaper goods and if you throw in the strong Aussie, cheaper still. However, as noted above, electronic goods prices tend to be inelastic. We can perhaps also now assume those geeky “first-movers” have moved, so it just comes down to how many people really think they need an iPad. Notwithstanding much concern is now being raised in the US that if tablets are successful it would only be at the expense of notebooks, if everyone wants the new iPhone 4 then leftover iPhone 3s will simply gather dust, and new 3DTVs will possibly leave shiny new HDTVs sitting there gathering dust as well, or at least lead to discounting.

What Australian retailers also found in the first half of 2010 (or the second half of FY10 if you like) was that increased sales volumes of new products simply means increased “cost of doing business”. Retailers have to set aside floor space and increase staff and also face higher supply chain expenses. So, as RBS suggests, even if higher volumes do result from electronic goods becoming cheaper, the resultant increase in (local) costs simply reduces margins. The whole exercise becomes deflationary.

We are now approaching Christmas. Some retailers make more profits from sales in the Christmas lead-up than they do during the entire remainder of the year. And Christmas is always the time that new products are brought onto the market. RBS notes this year's ready-to-go-in-the-stocking items include major gaming titles (Halo, Gran Tourismo, Call of Duty and WoW, for those of you who could honestly care about such things), a range of new Apple gismos (I already note the new iPod Nano with the rotating screen being heavily advertised during the Comm Games), 3D accessories to keep up with the new 3D revolution, and a range of new tablets of which the iPad is only one.

Typically, new products mean higher price points which mean at least steady if not greater margins on increased Christmas-time costs. But this year, the danger is that the expected net 30% price reduction based on excess supply of such toys will wipe out profits even if there are increased sales, and increased sales are no particular given.

Especially if the RBA chooses to raise rates in November or December, which retailers must be dreading.

With industry feedback under their belts, the RBS retail analysts have responded by downgrading Harvey Norman ((HVN)) from Buy to Hold and JB Hi-Fi ((JBH)) from Hold to Sell. The fact both stocks have joined in with the September stock market rally only aids the decision.

RBS is pre-empting that at next week's Annual General Meeting, JBH will be delivering bearish commentary. Thereafter, across the space, market de-rating will follow, in RBS' view.

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