Retail investments offer little value
Retail is among the toughest industries and, with one exception, there's little value on offer
'Retailing is a tough, tough business, partly because your competitors are always attempting, and very frequently successfully attempting, to copy anything you do that's working. It's hard to establish a permanent moat that your competitor can't cross ... Over the years, a lot of giants have been toppled.' – Warren Buffett.
Retail has always been a fast changing industry. Trends and fashions can evaporate just as quickly as they arrive. You're at the mercy of currency movements, low barriers to entry, fickle discretionary spending and large fixed costs. The influx of global brands to Australia and online competition has only made things harder.
And now traditional retailers are up against an army of online competition. It's not just the shop down the road they need to keep up with – the internet has pegged almost every retailer on earth against each other. And without the added costs of a bricks and mortar storefront, online retailers have a distinct advantage.
The only retailer on our Buy list is The Reject Shop for reasons explained in The Reject Shop: The good, the bad and the catalyst and because it's somewhat insulated from online competition. But even this company posted a terrible first-half result, causing us to lower our price guide and portfolio limit.
As we do at this time every year, we're cleaning up our coverage list to make sure we're focused on businesses that can add value to your portfolio. This calls for a purge of less interesting stocks and, as retail isn't getting any easier, let's sharpen our axe on this sector first.
Oroton (ASX: ORL)
When Oroton Group's exclusive licensing agreement for Ralph Lauren was pulled in mid-2012, most thought it spelled the end for the luxury goods retailer. But management has done a good job plugging the earnings hole with the likes of American brands GAP and Brooks Brothers. Same-store sales are increasing but the new brands face a littany of competitors as more luxury suit brands open their doors in Australia. Oroton was forced to discount heavily this year to increase sales and, with the addition of GAP, which has a high volume/low margin business model, we expect margins to come under increasing pressure. Oroton is pushing ahead with its risky expansion into Asia, where it has no competitive advantage and the competition is even more fierce than it is here. Given that Oroton's market value is currently more than 120% of sales, there's little to get excited about.
Pacific Brands (ASX: PBG)
In recent months, Pacific Brands has discontinued or sold several poor performing yet iconic brands including King Gee, Hard Yakka and Volley shoes. We think it's a sensible move given the company's thin margins and uncomfortable $250m of net debt. Pacific Brands posted a net loss of $225m for the year to 30 June and, while the restructure is positive, new chief executive David Bortolussi freely admits the year ahead will be characterised by a 'continuation of challenging and variable market conditions'. We expect increasing competition and the lower Aussie dollar to keep biting into margins.
Harvey Norman (ASX: HVN)
Unlike most in the sector, Harvey Norman had a pretty solid start to the year with an impressive 49% increase in net profit thanks to the booming housing market. Unfortunately, it was still only half what the company earned in 2007. The years ahead won't be easy with the internet killing Harvey Norman's electronics division and JB HI-FI broadening its offering to include whitegoods.
The company recently announced a rights issue to fund a special dividend to release a small portion of its huge $700m franking credit balance. It's a sensible step for two reasons. First, Harvey Norman is no longer a growth stock and should be paying out higher dividends. Secondly, the proposed decrease in the company tax rate from 30% to 28% next year would reduce the value of the credits. That said, given Harvey Norman needed to raise capital to distribute just 7% of the credit balance means it's unlikely shareholders will bank the full value of the franking stockpile.
Retail Food Group (ASX: RFG)
Retail Food Group, franchisor of Donut King, Michel's Patisserie and recently acquired Di Bella coffee, now has a network of well over 1,000 stores, yet earnings per share have barely budged in five years. The company has had three dilutive capital raisings in as many years, with the most recent being announced in mid-November to purchase the Gloria Jeans café chain. Franchisors tend to be feast or famine (just ask Pie Face) which makes the company's capital intensive expansion into highly competitive markets like pizza and coffee wholesaling risky.
Domino's Pizza (ASX: DMP)
Domino's stock price has increased 54% since this time last year with sales increasing 47% to $1.2bn in 2014 thanks to the continued roll-out of stores across Australia, Europe and Japan. The company has demonstrated what times of 'feast' can look like for a franchisor but it's worth remembering that Domino's is itself a franchisee to US-based Domino's Pizza International which may try to squeeze more from the business when royalty rates are renegotiated in 2028. For now the bigger issue is the PER of 40, which is baking in huge success in Europe and Japan. This business may be on its way to world domination but the stock is priced for perfection.
Billabong (ASX: BBG)
Billabong International went from one of Australia's most recognisable international brands to virtual bankruptcy in just a few short years, epitomising the difficulties facing today's retailers. Weak economic conditions hurt sales in Europe and the US, while the company's gross margin is currently the lowest it's been since 2005. A capital raising in February doubled the share count and operating earnings nearly halved at the full-year result – yet the share price has risen 195% since mid last year as the company's future became more assured. There's still $74m of net debt on the balance sheet and, while there are signs of growth in Asia, the business overall remains unprofitable and faces significant headwinds.
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