Lighten the retail property load

Retail and particularly retail property was one of the great sources of Australian wealth generation in the second half of the 20th century, and this has extended into the first decade of the 21^st century.

Retail property will still make money in the decade ahead, but the game is changing and there is now a higher degree of risk than there was at any time in the last 60 or so years.

Today I want you to look at your share portfolio and check to see just how much retail property exposure you have. If it is a relatively small amount no action is required, but if through a series of different and diversified investments you have a large exposure then I would suggest you lighten the load.

We have seen with John Fairfax what can happen to a company where the management and the directors do not comprehend the magnitude of the change that is to hit them. The current management of Fairfax is very much playing catch-up from mistakes that were made around the year 2000. The retail change will not be as fundamental as occurred with newspapers, but an important change will happen to most centres and centres that misjudge the situation are vulnerable.

Let me first explain the forces of change that are now coming into the retail sector. And here I want to acknowledge the research that our Eureka analyst Simon Dumaresq has contributed to this commentary. I am very grateful that from time to time Simon will assist me in some of my research work.

Adapting to the online shopping era

We have been speculating about online shopping for a long time. But, in Australia, retailers have been slow to adapt, and so shopping centres have not been greatly affected. However the overseas retailers have stolen a march on the locals, who are now responding, so the environment is starting to change rapidly.

The big retailers such as Myer and David Jones, plus in the supermarkets Woolworths and Coles, now understand they must become major players in the online area. Internet shopping currently takes around 5% of the market, but in a relatively short time it is likely to go to 10% and may go a lot higher as we get towards the end of the current decade.

Major retailers have long lease agreements with shopping centres and are looking to reduce the amount of space they occupy. The advent of global competition in non-food goods on the internet means retailers can’t charge the same amounts of margins they could before.

The groups that are going to find it hard to develop a presence online are small shops in the shopping centres. They simply don’t have the scale, and yet a great deal of the products they sell will be the subject of internet competition.

This is going to affect a lot of stores in shopping centres. In some cases the store will shut and the shopping centres will have difficulty finding a new tenant, at the old rental. In other situations shopping centres will keep their tenants by lowering their rentals. The shopping centres in the front line of this development are your second and third-ranking centres. Shopping centres such as Chadstone in Melbourne and Bondi Junction in Sydney will not be affected for a long time, if at all.

At the moment online shopping does not have sufficient scale but that will happen, and when it does online shopping will be a cheaper exercise than in-store shopping. The cost of goods purchased in store includes, of course, the rent, expensive packaging, and the salaries of managers and serving staff.

Changes on the retail front

Unfortunately for retail stores, in July next year a compulsory increase in shift allowances and penalty rates will take place as part of a set of stipulations made four years ago when no one realised how important online shopping would be. These extra shift allowances and penalty rates will make shopping centres less economic and contribute to the gaining of scale for internet shopping. It won’t be long before you will see trucks bearing the Myer, David Jones, Coles and Woolworths brands plying the streets much more regularly than they currently do. In a strange way, the van driver is going to become the equivalent of the person serving behind the counter. In addition, when you’re under attack from both online and higher wage costs it seems that a third blow is never far away.

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And that third retail shopping centre blow will be the introduction of fair contracts legislation. A key plank in the Abbott Government is to make contracts between large corporations and small enterprises “fair”. Right now big companies are using their muscle to put forward very unfair contracts. Coles and Woolworths have woken up to this and are getting ahead of the legislation by establishing a code of practice that will be endorsed by their suppliers and by the government. That way they will control the game. By contrast, the shopping centres first of all opposed the legislation. Now they are not formally opposing it, but are asking the government that centres be immune from it. The chances of that happening is not great. The shopping centres would have been far better to introduce their own code in the same way that Coles and Woolworths are doing . Shopping centres are now claiming they are already regulated by the states. That effort is likely to fail and the likely outcome is that the enormous leverage big shopping centres have had over small tenants will be reduced and that change will not benefit the profitability of the big shopping centres.

It is the small stores, rather than the big department stores or supermarkets, that drive most shopping centre profits.

Theoretically all the above can be managed by shopping centres but not everyone will do it well. Simon has produced a fascinating table which sets out the nine large shopping centre groups that are listed in Australia. You will see that by far the biggest shopping centre group is the Westfield Retail Trust. But not far behind is the CFS Retail Property Trust Group and Federation (formerly Centro). These property trusts have virtually 100% retail exposure. Stockland is 49%, Charter Hall is 97%, and Shopping Centres Australasia 88%. GPT is bidding for Commonwealth Property Office Fund. It has about a quarter of its assets in retail, but if it is successful in its bid for Commonwealth Property that percentage will fall sharply. The table also shows how many small stores are in the centres. It is these small stores that are going to feel the pressure.

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Customer-centric model will be king

Increasingly, knowledge of your customers will dominate marketing and many small retailers will not have the technology to take advantage .

Westfield is developing its own site and its small retailers are basically there like they are at the shopping centre, but with a twist.  Westfield will in time get to know the full customer base, so it is a development most of the major retailers will not participate in because the most valuable assets any retailer has these days is the knowledge of who its customers are. Increasingly that is how the marketing will be done, and that marketing via internet and phone will spill over to be online shopping.

You will note that neither Lend Lease or Dexus are on the list. These groups, for the most part, don’t own shopping centres. But they manage them and will be exposed to these retail shopping centre changes, so they will need be very alert in their management. But their exposure is not as great as those that own the centres. So have a look at your own portfolio and see whether in your drive to income you have over-exposed yourself to retail. And just to underline this, there is an old rule in stockmarket investing that when you are watching a major family at work, ‘follow the money’.

The Lowy family are absolutely dedicated to the success of retail shopping centres but gradually their money has shifted from the actual ownership of the centres to the holding company Westfield Corporation, which does the management and develops new centres.

Ensuring management is on board

Just a final point. If retail does swing to internet shopping, then it will cause job losses. One of the growth industries that comes out of this is home delivery. The Toll Group is now building up its online retail home delivery business. Australia Post dominates this market, with about 80% market share. At the moment it is a relatively small part of Toll’s operation, but watch it closely in the full-year profit statement. If it does start to make substantial progress it will give Toll a great drive.

And when the retail shopping centre owners in our table report their profit, look very carefully at how they are adapting to the net and what they are doing with their centres. If it is not mentioned as a possible threat, then that is a sign that it is best to exit because it indicates the directors are not focussing nearly enough on what is indeed a threat. Similarly, in looking at retail shares, look carefully at what the directors and managers are doing internet wise and remember that the margins on internet sales are not nearly as good.

Additional research for this article was conducted by Simon Dumaresq.