Target Downgrade Sparks Discounting Fears

This story features WESFARMERS LIMITED, and other companies. For more info SHARE ANALYSIS: WES

-Warm autumn affects apparel sales
-Inventory clearance and discounting likely
-Target likely to trigger "Sales" by others
-Shopping Centre operators affected
 

By Eva Brocklehurst

Retailers are still negotiating troubled waters. Wesfarmers' ((WES)) has downgraded earnings expectations for Target stores and sent another shiver through the ranks of retail analysts. It was a warmer-than-usual autumn so people were not buying coats and cardies. Perhaps the fashion trends this year are too subdued. Too much black this winter. Everyone has something in black in the back of the wardrobe.

Of more importance, retailers were not jumping in so fast this time to discount items on a poor start to the season. Maybe shoppers have been spoilt by frequent discounting and are playing a game of bluff with retailers. Who'll win? Probably the shoppers as the first retailer to capitulate will trigger a chain reaction in discounting.

UBS has received trade feedback which suggests April was soft and it affected retailers of apparel. The broker's analysis shows that for every 1% variance in peak temperature there is a relative 4% underperformance in apparel sales. UBS has trimmed earnings estimates for department store and apparel retailers by 1-2% for FY13 but emphasises that earnings are still expected to grow, just more modestly. There's just so much out there to support renewed spending, such as low interest rates, rising confidence and improving housing and equity market prices.

There's a raft of excuses for why the season started poorly, including the upcoming election, but Citi is not buying them all. For Target, it's a case of  too much inventory. The excess could affect earnings by $40-50 million if cleared at cost, so this explains half  Target's $100 million earnings downgrade. The rest is about restructuring costs and "shrinkage" – which leads Citi to question how inventory is managed at Target. UBS suspects Target is carrying $70m in excess stock which will need to be cleared in coming months. This will lead to heightened discounting and put pressure on the industry in the second half.

CIMB is also concerned about the increase in inventory shrinkage, which suggests systems and process issues that may not be easily corrected. The broker believes Target's business model may have to be re-visited. Target's earnings reduction may be to Kmart's gain, perhaps. The other of Wesfarmers' discretionary retailers is expected to grow earnings. Kmart has grown substantially over recent years based on high volume, low margin business, but Citi suspects this has hurt Wesfarmers overall.

Target is between a rock and a hard place. The chain is in the stages of re-positioning up the ladder as a discount department store. For Citi, it is unclear how the chain will build credibility and take market share off Myer ((MYR)) and specialty stores. It either proceeds with this or goes the other way – but then it would bump into Kmart's position on the discount ladder.

UBS estimates marking down prices and the cost of doing business accounts for a substantial amount of decline in second half operating margins for retailers. This is outside the Target-specifics of inventory shrinkage and restructuring. The broker suspects that heightened promotional activity by a large operator sends a message to others in the sector to increase the amount of discounting. David Jones ((DJS)) is expected to have suffered from the unusual April warmth. While not being a competitor to Target, UBS estimates David Jones generates 40% of turnover from seasonal items and the need to discount is likely to adversely impact second half sales and gross margins. Myer competes more with the discount department stores and consequently discounting is likely to impact margins.

A third retailer that might be getting signals from Target is Pacific Brands ((PBG)). While not competing in the store sense, and supplying less seasonally sensitive items, there could be some spill from the discounting and so UBS has also revised down earnings expectations in that quarter. The specialty retailer that could be affected is Premier Investments ((PMV)), with abnormal weather and discounting by Target impacting store margins and volumes.

BA-Merrill Lynch suspects there's been an over-reaction in the market to the news and that Wesfarmers' coal business and Kmart will more than offset the earnings reduction from Target. In the broader market too, UBS believes further earnings downgrades are of a short term nature and should be seen as buying opportunities. 

Regardless of the extent weather, fashion and all else is having on the retailers, they are a powerful link in the consumer chain. If apparel retailers are suffering from poor sales then the re-leasing spreads are pressured for those operators of discretionary retailer-dominated shopping centres. UBS notes Westfield Group's ((WDC)) operating metrics deteriorated in the March quarter and lease deals declined. The broker is therefore inclined to post a Sell rating for discretionary retailer-anchored investments, specifically Westfield Retail ((WRT)),  CFS Retail Property ((CFX)) and GPT ((GPT)). Westfield Group doesn't fit this bill because of the exposure to the US and capital management potential.
 

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