Time To Buy Retail, But Not Supermarkets

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-Tables turn on grocery suppliers
-Major supermarket profit growth to slow
-Discretionary price rises encouraging
-Reasons, now, to buy retailers

By Eva Brocklehurst

UBS has decided to put to rest the supposition that suppliers to supermarkets "over earn". In 2012 the broker's analysis found that Australian supplier margins were 210 basis points below the global average but their returns on investment capital (ROIC) were higher, leading to the conclusion that, while suppliers were under pressure, they had more to offer the retailers.

The broker has revisited its assumptions and now finds that gross margins have fallen more than earnings margins, suggesting suppliers have become more efficient and have cut costs. ROIC has fallen materially, and is now 13% compared to the global average of 21%. The magnitude of the decline in supplier profitability means UBS questions the ability of retailers to extract the same margins from their Australian supplier base. This could be a negative signal for Coles ((WES)), Woolworths ((WOW)) and Metcash ((MTS)) in the broker's view as, along with the emergence of Aldi and increased government scrutiny, driving margins via tighter terms with suppliers will become more difficult. Near-term margin growth for Australian supermarkets looks constrained with Metcash and Woolworths considered most at risk.

Morgan Stanley also observes the profit shift to Coles and Woolworths at the expense of suppliers and smaller food retailers. The broker suspects profit growth for the majors will slow and more regulation will become a headwind. The broker's analysis shows aggregated profits in the grocery industry have been reduced to $10.7bn from $11.9bn in FY10 but supplier profits have fallen to $3.7bn from $6.1bn, while Coles and Woolworths combined have increased annual profits to $4.4bn from $3.1bn.

Should the retail profit pool remain flat at the current run rate, the majors will control 100% of the pool by 2020. However, the broker observes the consumer regulator, ACCC, is now taking a more active stance to increase competition in this industry by removing restrictive lease provisions, taking retailers to court over unconscionable conduct and limiting fuel discounting. This will make it more difficult for the majors to expand margins, in the broker's opinion.

Checking the pulse of apparel retailers, Credit Suisse notes Myer ((MYR)) persisted with a big mid-season sale while apparel prices at David Jones, in contrast, were stable and even showed some inflation. Price increases have occurred for the fourth consecutive week at Dick Smith ((DSH)), with aggregate price points in line with January levels. Prices have rebounded more than 12% from peak discounting levels in mid September. Meanwhile, minor price rises have occurred at JB Hi-Fi ((JBH)) and Harvey Norman ((HVN)), which Credit Suisse finds encouraging for the sales and gross margin outlook at both retailers. One category where there is no sign that competition is abating is in white goods, with price points under pressure throughout 2014.

Sales growth is looking better but retailers are struggling to hold onto margins, given lower FX rates, while cost cutting opportunities are harder to find, in Citi's opinion. The broker likes those retailers that are in control of their margin gains through sourcing and supply chain savings such as Super Retail ((SUL)) and Specialty Fashion ((SFH)). The best performers in FY15 are expected to be in food-related categories or those tied to strong house price growth. While FY14 revealed the weakest margin performance among retailers in several years and a need to shift focus to sourcing opportunities and reduce mark-downs, the broker suggests there are some reasons, finally, to buy retail stocks.

Citi is more positive because petrol prices are lower and budgeted tax increases have not been implemented. This could boost retail spending by 1.7%. The broker now rates OrotonGroup ((ORL)) and Pacific Brands ((PBG)) as Buy and has upgraded Myer and Premier Investments ((PMV)) to Neutral. Household finances are in better shape but the near-term risk for retail spending is in initiatives stemming from the government's mid year fiscal and economic outlook, which is released some time before Christmas.
 

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