Retailing Ain’t Broke, Just Changing

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-Retailing is changing, not broken
-Traditional relationships are weaker
-Online versus foot traffic well entrenched
-How about a merger or two?

By Eva Brocklehurst

Retailing's business model ain't broke, according to several analysts. Hence some suggested "fixes" aren't going to… fix. JP Morgan simply sees the sector suffering because the once extremely strong relationship with disposable income and consumption has weakened. Macquarie says it's a volume thing. Morgan Stanley thinks there's opportunity for some very unexpected outcomes as the year progresses.

JP Morgan finds the outlook for consumer stocks quite mixed but it's not just the bricks and mortar versus online story. There are cyclical and structural factors which are impacting, such as a renewed propensity among consumers to save (cyclical), an increased focus on buying "experiences" such as travel rather than goods (structural) and more international players wanting a slice of pie.

JP Morgan is Underweight in its position on consumer discretionary stocks, with consumer staples preferred on a sector relative basis. The analysts see reduced leverage to income growth for the retail sector, particularly listed discretionary retailers. International entrants also pose a threat, lifting the competitive bar for domestic bricks and mortar retailers. This year, JP Morgan sees themes such as value-focused consumers, a continuing shift online, with retailers needing a compelling and improving online offer, and increasing competition. Therefore, value-focused mass retailers with high traffic levels and/or customer insights are well positioned.

Macquarie points out that clothing, footwear and accessories retailing is a large category within the sector but less visible because of the high percentage of unlisted ownership. Nevertheless, there is a perception that they, as well as the sector as a whole, are in distress. Business models are seen failing due to rising costs, new market entrants (competition) and disruptive new technologies (online, mobile). However, Macquarie says things are happening that contradict this. Australian retailers continue to have the highest earnings margins in the world in five of the six retail categories the analysts examined (discount department stores the exception). Furthermore, gross profit margins are rising or stable in most retail categories. For example, the analysts find that grocer gross profit margins have risen around 300 basis points since 2007. Interestingly, in Macquarie's view, so have speciality apparel retailer average gross profit margins.

So, where is the negative perception coming from. It appears, in Macquarie's analysis, that it's mostly on seeing declining foot traffic in stores. ABS chain store volume data shows volumes declined in the apparel, footwear and accessories category by 3% per annum across FY10-12. However, retail volume growth has accelerated over the last 12 months to approximate growth in the consumer base. Hence, Macquarie does not expect large mass or mid-market apparel retailer failures and, where these occur, it will more likely reflect brand relevance and loyalty issues. Macquarie expects traditional retailing cycles will return but at a lower growth level.

On the subject of major retailers — department stores in particular — Morgan Stanley speculates, as one of the broker's "potential surprises", about David Jones ((DJS)) and Myer ((MYR)) merging. Warming to this thesis Morgan Stanley says, collectively, tate broker consensus is overwhelmingly negative on these two: 75% of ratings are either Sell or Hold. So, both stock prices would react positively to news of a merger and the rationale has now never been greater. However, the broker says it's unlikely anyone is even pondering the thought.

Other interesting "potential surprises" are Wesfarmers ((WES)) continuing to improve even after an impressive 2012 and maybe achieving a record share price as well as JB Hi-Fi ((JBH)) reducing its store count for the first time ever. Harvey Norman ((HVN)), viewed quite negatively by the market at present, could also surprise by reducing its consumer electronics footprint. However, Morgan Stanley suspects that company would rather raise capital and be the "last man standing" in the category as opposed to closing stores. Morgan Stanley sees the large property portfolio as a drag on HVN's balance sheet.

Other quirky ones are Coca-Cola Amatil ((CCL)) delivering a flat beverage volumes in a dry and thirsty summer or discretionary retailers providing more earnings upgrades than supermarkets.

In terms of CCL, Australian beverage volumes have been in decline over much of the last two years and investors generally expect them to pick up with the hot, dry summer. However, Morgan Stanley sees scope for this dry-wet theory to be dumped on. Aggressive pricing strategy from Pepsi, competition and a growing avoidance by the health conscious of carbonated soft drinks underline that "surprise" potential.

As for underperformance in discretionary retail, Morgan Stanley thinks investors have focused on the structural issues facing discretionary retail and not appreciated the cyclical element enough. Discretionary retailers are relatively cheaper, generate better dividend yields and arguably have more scope for earnings upgrades than the supermarkets. Online retail sales growth has exploded over the past few years. Morgan Stanley sees the consensus view that this growth will moderate being put to the surprise test, citing retailers aggressively improving online offerings with shopping online only beginning to hit the mainstream.

Morgan Stanley also thinks wine sales could improve and exceed CPI for the first time in 10 years. Why is this a surprise? Many analysts still doubt the industry, coming out of a long period of oversupply, can obtain better prices from the consumer, given the brand fragmentation and consolidated retail structure in Australia. 
 

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