Retail’s Downward Paradigm Shift

This story features PREMIER INVESTMENTS LIMITED, and other companies. For more info SHARE ANALYSIS: PMV

By Greg Peel

Last week stock analysts at RBS Australia upgraded their rating on Premier Investments ((PMV)) which owns, among other retail outlets, the Just Group and Portmans. “We believe PMV is well positioned to benefit from the inherent operating leverage in the model as the retail environment improves,” said RBS, as it lifted its rating from Hold to Buy and its price target by 10%.

By “operating leverage” RBS is referring to the fact PMV is an investment vehicle still holding a decent amount of cash, which would allow it to acquire more retail businesses in the coming upswing.

Shortly after Premier had delivered its FY10 result, it was followed by Kiwi cold weather apparel group Kathmandu ((KMD)). Macquarie, as one broker, maintained its Outperform rating on the stock noting, “KMD offers leverage to an improvement in retail conditions”.

The last couple of weeks have brought the retail sector full-year result mini-season, which aside from Premier and Kathmandu has seen results from OrotonGroup ((ORL)), licenced retailer of Polo apparel, and the big department stores Myer ((MYR)) and David Jones ((DJS)). In each case there have been arguments put forward by some analysts that while the current environment remains tough for discretionary retailers, the cycle is troughing and things will start to look a lot better next year.

Why?

Well the most obvious reason is that the Australian economy is now growing above trend – an outcome that seemed unthinkable as we entered 2009. Clearly China's relentless purchase of Australian commodities is the driving force, but the mining sector is dragging along the rest of the economy and with low unemployment and strong house prices, Australia is a stand-out developed nation among developed nations post the greatest economic scare since the Great Depression.

When we entered FY10, analysts had begun to assume the Australian market would soon trough and FY11 would see a real kick-on back to more normal levels of activity. Australia had, by definition, avoided a recession altogether. Once the excess debt in the system had been brought under control, life would return to normal.

But then it all depends on what your understanding of “normal” is.

It was obvious that households overladen with mortgage and credit card debt would run scared as an immediate response to the GFC. But then along came government stimulus, and despite the clear opportunity to reduce debt, HDTVs went flying out the door at Harvey Norman ((HVN)) and poker machines operated by Tabcorp ((TAH)) and Tatts ((TTS)) were lighting up like Christmas trees. Even the supermarkets were doing a roaring trade. The stimulus continued as first insulation layers and then school building contractors were able to rip off the government blind and spend the spoils.

While analysts were not so naïve as to assume anything other than stimulus would provide merely a honeymoon of consumer spending, including the monetary stimulus provided by emergency RBA interest rates, the general assumption was that waning stimulus would be met by economic recovery and as such there wouldn't be too much of a drop-off in earnings in consumer staple and discretionary sector earnings.

But there was. So much so that analysts had to keep revising their earnings forecasts down, and down, and down. Yet because the market had already trashed the consumer discretionary sector in particular as an immediate response to the GFC, and sold down even the supposedly defensive staple sector, there was still room for stock prices to recover. And indeed, David Jones, for example, is currently trading not much below its pre-GFC high.

That seems unthinkable. There we all were before 2007 spending our little hearts out as if there were no tomorrow, buying McMansions that families would get lost in, fitting out home entertainment centres, snapping up every latest computer accessory, gaming console and i-Thing with abandon, and next thing we know we're looking at Great Depression II. Talk about a wake-up call. Judging by the David Jones share price, clearly, at least in Australia's case, it was all just a storm in a tea cup.

But just how has DJs managed to maintain strong earnings levels? By cutting costs, particularly in the area of customer service. Indeed, RBS noted on the release of its full-year result that 80% of DJ's margin expansion over the past four years had come from cost cutting. And DJs was not alone in such a strategy. Aside from reducing risky gearing levels, companies across the globe have responded to the GFC with rapid cost-cutting.

Cost cutting can either be a good or bad thing. Either it means you are taking excess fat out of your expense ledger to leave a leaner, meaner business, ready to enjoy strong margin growth in a recovery, or it means you are jettisoning cargo you might have otherwise kept to simply avoid going down. In the latter case, a subsequent recovery finds you with a much smaller business and thus a much longer road back.

RBS is concerned that David Jones has gone too far with its cost cutting, particularly given its rival Myer has been adding to customer service and brands in order to take its more upmarket competitor on at its own game. This has meant Myer has underperformed David Jones while still not performing too badly anyway since re-listing, but then which chain now stands to benefit more when, as RBS suggests, the “retail environment improves”?

Companies cannot, by obvious definition, simply keep cutting costs forever. Eventually earnings growth has to be driven by a return to revenue growth, and that revenue growth cannot be sustained if retail discounting is sustained. Go into any store at the moment – department or otherwise – and see if you can find one where nothing has been marked down. Many analysts are assuming the mark-downs will soon end because, as noted, we are about to hit a recovery. It will be a good Christmas, and then 2011 will be a much better year.

But again, what is normal? Is normal a return to the spending patterns of the decade preceding the GFC, or is normal that represented by decades of historical spending patterns, including times when Australians did not live in ridiculously big houses, run up huge debts on multiple credit cards, or shove half their weekly earnings down the pokies?

Last week Westpac and the Melbourne Institute released their monthly consumer confidence survey, and the economists were somewhat surprised by a 5% fall. The fall came despite Australia's second quarter GDP surprising to the upside, unemployment falling to a surprising 5.1%, and the RBA once again keeping interest rates on hold. Perhaps, they mused, the strong confidence jump in the preceding month had been just a blip.

Yet confidence is still to the positive side of the historical mean so the economists are not overly concerned. But in their extended report, they did make a couple of interesting observations.

Westpac notes that a key gauge of consumer caution over the past few years has been the “wisest place for savings” question within the survey. In short, when consumers are confident the answer to this question is weighted towards risk assets, which includes the stock market but in particular real estate, and when cautious, answers are weighted towards “pay down debt”. Obviously a lot of caution was shown immediately after the GFC and this was not expected to change in a hurry, but by June this year caution had began to give way to a bit more confidence.

Yet in the September survey, those gains were reversed. And whereas respondents seemed upbeat enough about the prospects for the economy this month, responses to “family finances” and “time to buy a major household item” were not upbeat.

This seems strange. Why would consumers be upbeat about the economy but not translate this into their own spending intentions? Why, if the Australian economy is in such good shape, are consumers more keen to pay down debt than invest in real estate?

Westpac suggests that such an attitude will dominate the consumer sector for the rest of 2010 and into 2011. Aside from the prospect of more financial market volatility, the RBA is expected to raise interest rates anytime soon, and keep raising them into next year. Westpac notes that the biggest drops in its consumer confidence survey always come after interest rate rises.

Retail sector stock analysts are not oblivious to the impact interest rate rises will have on retail earnings. However, they are seen in the context of why interest rates are going up – the economy is strong. So a strong economy should ultimately translate into more confident spending once the initial shock of a rate rise has subsided. But the point is: is a “strong” economy in 2011 the same as was a “strong” economy in, for example, 2006?

In its accompanying guidance to its FY10 result, the management of OrotonGroup suggested, in relaying its expectations that FY11 would actually look a lot like FY10, that customers want “excitement, a reason to buy, a new format, an online story, and value at all price points”. Take away the “value” part, which is really a given under any circumstances, and the “online story”, which is simply the Gen Y progression (incidentally, Macquarie was highly critical in its David Jones report about the company's failure to catch up with the online world), and what really stands out is “a reason to buy”.

This is discretionary retail. By definition, there is always a reason to buy staples but never a reason to make discretionary purchases beyond that which is simply a case of happiness and well-being, or even downright greed. Do most women, for example, really have or need a reason to buy a new frock? Well apparently that's now the case.

Commentary from OrotonGroup and from the various Premier Investments brands has led analysts at JP Morgan to declare, “we believe that FY11 should remain challenging for Australian discretionary retailers”. Aside from the interest rate impact, which could also come from banks raising their mortgage rates independently of the RBA, JPM sees “a more purposeful and frugal consumer, and one less willing to consume conspicuously”.

One might suggest perhaps that the new “frugal consumer” is really not so new after all. Perhaps frugality is merely a relative measure, reflecting the “normal” mindset of the Australian consumer in earlier decades, before the conspicuous consumption frenzy of the early twenty-first century.

I have noted in the past that stock analysts often suffer from being young. This was particularly the case with regard to banks over the past couple of years, given one old-hand analyst suggested that because today's bank analysts were not analysing back in the 1992 recession, and that their charts didn't even go back that far, that they simply had no idea what a recession actually could do to bad debts.

Perhaps, amongst the various analysts around town, this observation holds true in other sectors. Gen Y and even Gen X really have little idea what it was like in earlier times to save for a rainy day and only make discretionary purchases when the bank balance allowed. Credit cards were there only for larger spends such as a holiday which could be paid off quickly, or a new tele because the old one had just blown. Debt was not the equivalent of money that grows on trees.

So will the new, “strong” Australian economy be just like the old one, pre-GFC? Or even like the old one of the recent generation?

The equity strategists at BA-Merrill Lynch argued in a report last week that “credit had played an underestimated role in driving the economy over the past three decades, but would be much less stimulatory going forward”. It is interesting to note that the anti-hero of the eighties – Gordon Gekko – is back on the screens. “Greed is good,” said Gekko, and for thirty years he's been right. Right up until greed was spectacularly found out in 2008.

“A range of data that has become available in recent months supports our thesis that consumers are making more conservative financial decisions,” continues Merrill Lynch. “Growth in housing credit remains low and subdued use of personal credit suggests more households are financing major purchases with cash”.

The Merrills strategists agree with other analysts that a cyclical recovery in Australian consumer spending is due. But they also believe too much is expected. Revenue growth assumptions from analysts are aggressive and they have factored in margin expansion for three quarters of all ASX 300 retailers. In short, Merrills believes sales forecasts are “too optimistic”.

It's still hard to deny the strong Australian economy, RBA rate hikes notwithstanding. But then the strategists at JP Morgan have a differing view.

“Australia's economy is at risk of overheating,” they suggest. Investment in the mining and energy sectors is going to test the economy's limit and will be unfazed by any RBA rate rises. In the current wobbly political environment, fiscal policy is unlikely to help. That leaves adjustment to the impact of a mining-driven economy to be borne mainly by the consumer and housing activity. “Combining rising rates with high levels of personal debt and house prices creates an unstable mix,” says JP Morgan.

JPM believes the downside risk from a house price correction is “much more plausible than many think”. If the market is heavily dependent on investment demand then sensitivity to interest rates is unpredictable. And on that basis:

“Against this background it is hard to see what can go right for stocks linked to discretionary consumer spending.”

A strong, commodity-led recovery implies interest rate rises, and that can only lead to modest sales growth in retail rather than any return to a spending frenzy. This might be okay for stock prices if those prices were already subdued given a subdued FY10, but that no longer seems to be the case (take my above David Jones example).

Interest rates aside, what various strategists are arguing in their more top-down approaches, compared to what stock analysts are arguing in their bottom-up approaches, is that even if the economy is strong it is wrong to assume a return to the glory days. Nor anything even close to those glory days, in fact. Yet stock prices are already looking that way.

The GFC was one big wake up call for the Australian consumer. Even those who managed to bungle through by reducing household debt got such a fright they will not likely make the same mistake twice. It is apparent in credit card balances, it is apparent in low sales growth and massive retailer discounting, it is even apparent in continuously falling pokie revenues. It may take another generation before the sort of care-free spending frenzy we have witnessed in the twenty-first century or even beforehand returns.

Greed may be good, but it will no longer be foolish.

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