Time To Go Shopping?

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

-Can supermarkets trade off discounting?
-Consumption may be starting to improve
-Retailers to benefit from lower rents
-Landlords under pressure
 

By Eva Brocklehurst

Citi thinks investors should be concerned about petrol discounts. Deep reductions on high profile products and increased petrol offers push Coles ((WES)) and Woolworths ((WOW)) to a point where it may be impossible for them to achieve sales budgets without continued aggressive discounting. These petrol discounts are costly. An extra 4c a year in petrol discounting costs Coles $88m and the supermarket needs a 160 basis point acceleration in like-for-like sales to pay for it. Woolworths' response to Coles' aggressive stance gives it some edge, in Citi's view, offering a 15c petrol discount for $100 expenditure.

The competition is making it tough for Metcash ((MTS)). The IGA supermarket distributor is losing share and Citi forecasts a fall of 4% in like-for-like sales in the first half of 2014. The question for the other two rivals is whether they can trade off sales and margins and still meet expectations. The broker has a Sell rating on Wesfarmers and Woolworths. 

So, will the consumer step up to the plate? Macquarie observes that consumption is still in the doldrums. There's no evidence that consumers are returning to spending up big, although their expenditure may become incrementally stronger over the next six months. Macquarie believes that, after three soft years, spending may be at a turning point and this is critical if the economy is to avoid a downturn. Nevertheless, it's not a foregone conclusion. A more rapid decline in mining investment still has the potential to overwhelm any nascent pick up in consumer spending. Macquarie suggests waiting until mid 2014 in order to see whether the Reserve Bank's efforts to stimulate the economy have been sufficient.

Spending has been weak in recent years because consumers had reached the limit on leverage, reacting to falling wealth and, more recently, weak income growth. Moreover, capital gains are not included in measures of household disposable income but they do affect the ability of households to spend. Rising house prices enable households to withdraw on equity even if the capital gain is not realised. After analysing why spending has been so weak, Macquarie has looked at why this may not have changed, yet. First, monetary policy may have only just started to support spending.

The broker thinks a neutral cash rate could now be as low as 3%. A 5% cash rate that was considered neutral five years ago may not have the same effect as a 5% cash rate today. Since the GFC, banks' cost of funding has diverged from a once close relationship with the cash rate. Macquarie thinks a cash rate in an environment where household credit is growing at a 15% pace is likely to be higher than in an environment where credit is growing by 5%. This implies that a neutral cash rate is likely to around 3% now and would partly explain why the economy has not responded as yet to the lowering of the cash rate over 2012 and 2013.

With an improvement in spending on its way Macquarie thinks retailers may be in line for a larger share of consumer purses. Rapid growth in prices for non-traded goods and services such as education, utilities and healthcare has meat less money to spend on consumer goods. With governments and companies attending to containing costs and improving efficiency, costs should moderate, enabling households to spend more on items of choice. If consumption does improve over the next year and companies experience an improvement in earnings growth, then it is possible that by the end of 2014 employment levels will rise and companies will consider increasing investment spending. This is what is needed to broaden growth through the remainder of the non-mining investment economy. Without an improvement in consumer spending, Macquarie finds it difficult to see how that can happen.

Furthermore, the decline in the Australian dollar means more spending by tourists when they come in increasing numbers. Retail sales growth would have averaged 4% over recent years if the net tourism expenditure had been sustained at its previous robust level. In Macquarie's view, with the currency shifting back to the low US90c region, this drag on retail sales growth has been eliminated. If the Australian dollar fell to US80c then it may actually support sales growth.

The outlook is improving for retailers. Citi expects retail rents to fall over the next three years. Using industry averages, sales are down 6% from 2009 to 2013, but rent costs are 19% higher. The good news is that the lease expiries in 2014 are likely to be renewed at lower rents. Premier Investments ((PMV)) and Specialty Fashion ((SFH)) are cases in point. Their lease term to expiry is only three years and they are likely beneficiaries. Super Retail ((SUL)) and JB Hi-Fi ((JBH)) average lease expiries that are closer to 4-5 years and already enjoy special rent deals as "mini anchors", in Citi's view. There's more. Rental growth is likely to be slow for some time. Onerous leases signed in 2009-2011 roll off in 2014-2016. Citi forecasts rent-per-square-metre growth of less than 1% for OrotonGroup ((ORL)), Premier Investments and Specialty Fashion in FY14-FY16. The upside will likely take time, but over the next three years, rents should fall as a share of sales for these three.

Wait, there's more. It appears, in addition to lower rents, risks associated with weaker sales are increasingly being shared with landlords. Two features are creeping into specialty leases, according to Citi. These are percentage rent caps and break clauses. The implication from this is less operating leverage for retailers, which is good news if sales trends remain as weak. OK. It's not all good news. Even though rents are falling, Australian retailers still face tough conditions. The challenges include new international entrants lowering average price points, rising wage costs and near-term excess industry-wide inventories.

What does this mean for retail landlords? They're on the other side of the fence. Citi thinks rent growth will be lower for longer and leasing spreads will be under pressure. Fixed rentals are on the increase and will outpace market growth. The broker thinks specialty store leasing matters for investors because retail A-REITs are large, with a market cap of over $50 billion, and specialty store leasing is their core business. The majority of rental income comes from specialty stores, especially in the larger shopping centres. Commonly on five-year leases with anchor tenants on 10 years or more, movements in specialty rent can be a significant earnings driver for landlords. Rentals appear to be moving in the tenant's favour and slowing rental growth is the result.

The long term nature of the leases means slowing rental growth takes time to impact. Citi notes that, two years out from a report compiled in 2011 about the earnings implications of retail weakness, landlords are showing increasing signs of being affected, yet their share prices have risen an average of 23%, well ahead of the broader market's 16% gain. Increasingly, landlords are not being priced for what appears to be a growing risk. Supply of retail space is also expected to increase substantially over the next year. Some of the forecast space may not be built but it represents another risk for retail landlords. In terms of online shopping, this is a form of supply as well as demand, shifting spending away from shopping centres. A-REIT portfolios have not distinguished themselves to a significant degree and Citi thinks, with sales consistently weaker, pressure is building. Linking this to stock preferences Citi cites Charter Hall Retail ((CQR)), Stockland ((SGP)) and CFS Retail ((CFX)) as best able to grow rents in the future.
 

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