Oz Retail A Hard Sell

This story features WESFARMERS LIMITED. For more info SHARE ANALYSIS: WES

– Retail spending below trend
– Brokers expect slow recovery
– Merrills sees further deterioration in FY14

By Greg Peel

Last month Wesfarmers ((WES)) downgraded profit expectations for its Target discount stores (Target Downgrade Sparks Discounting Fears). Analysts questioned target’s inventory management, and voiced their opinion that warm autumn weather, which had led to low winter apparel sales, may well force Target into discounting which would impact on all apparel retailers, including the department stores. The evidence suggests analyst fears were justified.

Hallenstein Glasson (HLG.NZ) is a New Zealand-based company but also operates thirty stores across the Australian east coast under the Glassons brand. The group has reported falling sales in the period February-May following a difficult first half FY13, citing impact from “aggressive discounting and price based promotion” from large Australian chains commencing winter clearances earlier than usual. Deutsche Bank suggests Target’s inventory problem and aggressive clearance activity has indeed been the trigger. Fortunately both David Jones ((DJS)) and Myer ((MYR)) reported “clean” inventories at their recent March quarter sales updates, and Deutsche suspects the impact of discounting will have been contained. The analysts have Myer as their top pick in the sector given an 8% dividend yield.

Deutsche Bank notes there has been some deterioration in consumer sentiment since earlier in 2013, with the May Federal Budget adding to despondency. The analysts believe, nevertheless, that weather-related weak apparel sales affected a drag on sentiment measurements. Conditions will remain lumpy, say the analysts, but positive signs in the property market following recent interest rate cuts should encourage a gradual improvement in the retail climate.

Consumer spending growth has dropped below trend and is close to recessionary levels in the discretionary sector, notes Deutsche, which is disconcerting given the lack of growth elsewhere in the Australian economy. Wealth is rising, which is usually supportive of spending, but Australians seem more focused on unemployment fears. The unemployment rate surprisingly dropped in May, but well publicised lay-offs across the country can only encourage consumer nervousness.

RBA rate cuts have had only a muted impact, perhaps because they have been well spread, Deutsche offers. Yet sentiment appears now to at least be stabilising and any further rate cuts should have a more positive effect. A pick-up in FY14 thus looks likely, Deutsche believes. Spending on staples remains at trend growth and the impact of last year’s substantial utility bill hikes should soon cycle through, freeing up cashflow. Food inflation is nevertheless a risk.

Deutsche sees logistics and retail real estate investment trusts (REIT) as a better option for investment in an improving retail landscape, with increasing air travel a reason to hold Sydney Airports ((SYD)). Gaming is also an attractive subsector.

A significant issue for listed retailers these past few years has been the growth of on-line shopping and discovery by Australian retailers that similar goods can be purchased at lower prices when bought from offshore. Major Australian chains are once again uniting to lobby the federal government to scrap the $1000 threshold GST exemption, although many an on-line shopper will tell you price variations reflect a lot more than just GST.

Morgan Stanley notes that depending on product category, Australian retailer prices are still 11-35% more expensive than those of offshore on-line peers, but the analysts also note this gap has narrowed from 26-174% in April 2011. A Morgan Stanley survey also shows Australian consumers are prepared to pay a premium to purchase from domestic retailers. The now weaker Aussie dollar should narrow the price gap even further, as well as encouraging more inbound tourism.

Morgan Stanley thus suggests that retailer headwinds are abating.

The analysts also point to evidence wholesalers and brand owners have not been fully passing on the import price benefits gleaned from the Aussie dollar’s rise and considerable time above US dollar parity to retailers, who cannot thus pass benefits onto to consumers. As the Aussie weakens, it is the wholesalers and brand owners who will suffer reduced margins while the retailers will not be impacted.

In the meantime, traditional bricks & mortar retailers have finally pulled their collective head out of the sand, recognised the internet is not just a passing fad this time around and have jumped on the back of the on-line bandwagon, thus closing the gap on the more savvy first movers.

Morgan Stanley has updated Myer to Overweight and JB Hi-Fi ((JBH)) and Harvey Norman ((HVN)) to Equal-weight. The analysts cite more reasonable valuations post share price falls, upgrades to longer term earnings forecasts, and leverage to a slowly improving retail cycle as justification. For the first time in five years, Morgan Stanley prefers discretionary retail to supermarkets, given supermarkets’ rich valuations, minimal earnings growth and “irrational” store roll-out plans.

It was all going swimmingly until BA-Merrill Lynch stepped up to the lectern.

Merrills believes discretionary retailing could be entering a third phase. The first phase was the spending frenzy in the boom years up to 2008, the second phase was the inevitable post-GFC consumer retreat, and the third phase will be “even tougher”, Merrills suggests. The analysts believe traditional retail spending will be “crowded out” by below average income growth falling short of rises in household costs and increasing unemployment. These factors will weight significantly on discretionary retailers in FY14, Merrills warns.

The analysts have downgraded their sector earnings forecasts to 8% below consensus and believe like-for-like sales growth will be very hard to come by, particularly for retailers not in a growth segment. Operating costs will nevertheless increase, weighing on margins.

Merrills previously rated all discretionary retailers under coverage as Underperform, with the exception of OrotonGroup ((ORL)) on Buy. Having adjusted for recent price falls, and overlaying a generally bearish sector view, Merrills continues to rate Myer, JB Hi-Fi, Harvey Norman and Pacific Brands ((PBG)) as Underperform and has also downgraded Oroton to Underperform. David Jones has been upgraded to Neutral due to the value of its property, and Premier Investments ((PMV)) also now enjoys a Neutral rating. Super Retail ((SUL)) has been upgraded to Buy.

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