Fear, Greed, And Doomed Retailers

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– CLSA initiates the retail sector with Underweight
– Earnings forecasts 20-30% below consensus
– Target prices lower still

By Greg Peel

“Australian retailers don't get it…We believe the reason boils down to fear and greed”.

CLSA stands for Credit Lyonnaise Securities Asia, although the company's biggest shareholder is Credit Agricole. Either way, CLSA has quietly been bringing the French connection to Australia in recent years and its most recent move is to establish an Australian Consumer Team to research the listed retail sector downunder.

With a sector initiation recommendation of Underweight, it's tempting to envisage the analysts telling Aussie retailers “your mother was a hamster and your father smelt of elderberries,” except that they are actually local boys. So Underweight will do.

No one is going to be shocked by that opening rating, given the clearly parlous state of retailing in this country at present. We all know the roll call of reasons – record debt levels, rising interest rates and fiscal tightening in the form of new taxes have shattered the confidence of the consumer, along with trepidation over offshore issues. All of these factors have conspired against retailers, particularly discretionary retailers, and then there's that small but highly irritating matter of the internet.

The general media, as well as financial analysts, have been conducting a lot of research on Australia's internet marketplace lately and the conclusions are all the same. On-line shopping currently represents a small proportion of all consumer purchases but the growth rate is substantial and will only accelerate over the next few years. And it's not just about the strong Aussie, it's about prices that are excessively cheaper regardless of GST exemptions, freight costs, and even the currency to a large extent. And it's about convenience, choice and rapid delivery.

Australian retailers need to stop whinging and start adapting – fast. It's a one-way structural shift. Music publishers found that out the hard way many years ago, and now embrace the net. Movie and television publishers have lately been following. Newspaper publishers have tardily woken up to the fact their classifieds are now lost forever. And this year it's retailers — at least the ones that never saw it coming. Why did they not see it coming? CLSA's view opens this article.

Retail executives have not been too worried about the internet up to now, CLSA suggests, and instead have extolled the virtues of not spending money if you don't have to. They have cut costs rather than investing in something that once established, runs at a low cost. In the meantime, “record number of Australians are waking up to the massive savings that they reap by buying on-line”. And the irony of course is that public winging from celebrity retailers does nothing but rouse more Australians to a sunrise of internet benefits.

But enough has been said about on-line retailing, in all quarters. Aside from economic uncertainty, a new era of household austerity and the advantages offered by the net, CLSA also notes that for more than a decade, industry consolidation has been a key driver of increasing returns for retailers. Smaller businesses and labels have been swallowed up and large conglomerates have emerged. But those gains are now over, suggests CLSA.

That just leaves organic growth, which means incremental returns will begin to decline and even the best operators will struggle to maintain revenue and margin expansion. Many operators have ambitious store roll-out plans but CLSA does not see targets being met, impacting further on earnings forecasts and returns.

In the pre-GFC frenzy Australian retailers enjoyed seven years of record margin expansion, spurred by industry consolidation and the substantial growth of the consumer's disposable income, CLSA notes (not to mention lax credit availability). The analysts now expect returns to revert back towards their historical mean. And when applying this assumption to forecasts earnings projections, they find themselves 20-30% below current market consensus for the next two years.

The bulk of retail sector analysts in this country have been very, very slow to wake up and smell the roses. Most assumed the GFC would be a blip and, aided by no “official” recession in this country and a rapid drop to low levels of unemployment, that we would all go back to spending with indiscriminate gusto just like we did in the mid-noughties. For a large part, the problem has been one of age, or lack thereof. Many stock analysts in this country have only known “historical”retail spending growth as that prevailing pre-GFC and not that of earlier decades. They have never saved up for anything in their lives and eschewed debt like their parents did.

The “mean” to which CLSA expects spending growth to revert is one of an earlier era. This week the RBA noted that while the pre-GFC growth of household savings in Australia has been rapid, today's levels are only those once considered “normal”.

So who will be the winners and who the losers in the eyes of CLSA?

In general terms, staples beat discretionary, basically meaning food is the constant defensive. However, on a stock by stock basis, this is not a rule to apply. For example, CLSA likes Coles and Metcash but not Woolies, and dislikes all discretionary retailers but not JB Hi-Fi. We'll take a closer look.

CLSA has a Buy on Wesfarmers ((WES)) and a 12-month target price of $37.10. By comparison, the Buy/Hold/Sell ratio in the FNArena database is 5/3/0 and the consensus target is $33.13. CLSA believes the market is underestimating the turnaround story at Coles, and that coal price and production upside underpin the conglomerate.

For Metcash ((MTS)) the CLSA rating is Outperform* with a target of $4.60. [1/5/2; $4.18]. Independent supermarkets and convenience stores provide reliable and defensive earnings, say the analysts, while Mitre 10 is showing excellent early promise and the likely acquisition of Franklins will provide upside.

For Woolworths ((WOW)) the CLSA rating is Underperform with a target of $26.60. [6/1/1; $29.73]. It's one step forward and two steps back as Woolies fights off food competition, invests significantly in hardware and battles with the struggling Big W and Dick Smith brands, the analysts suggest.

Moving into the discretionaries, CLSA has a Sell on David Jones ((DJS)) with a target of $2.30. [1/5/2; $3.69]. DJs needs a “seismic shift”, says CLSA, to bring customers back. This means investing in on-line, lowering prices and spending ad money appropriately. It will be a long and painful road.

CLSA also has a Sell on Myer ((MYR)) with a target of $1.90. [2/5/1; $3.05]. Stuck in no man's land between the high and low ends and trying to promote Myer Exclusive Brands will mean decaying margins and falling earnings, says CLSA, and store roll-outs will be risky.

And CLSA has a Sell on Harvey Norman ((HVN)) with target of $1.90. [4/3/1; $2.98]. The business is tired and not keeping up with changing consumer expectations, including on-line, suggest the analysts. The once successful franchise model is now a hindrance as head office is unable to control costs at individual stores.

On the bright side, CLSA has Outperform on JB Hi-Fi ((JBH)) with target of $18.10. [6/2/0; $19.71]. While prices will come under pressure from on-line competition and the strong Aussie, CLSA believes JBH has the platform, management, cost structure and culture to win in the domestic market. Store roll-out targets may fall a bit short but strong cash conversion and management focused on shareholder returns makes this CLSA's top pick among the discretionaries.

* CLSA uses a five-step rating system rather than three, so Buy is best followed by Outperform while Sell is worst and next is Underperform. The FNArena database converts to only three steps (Buy, Hold, Sell) such that Buy, Outperform and Overweight all count as “Buy” while Sell, Underperform and Underweight all count as “Sell.

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