Retailers looking pricey

Recently released economic data is pointing to a significant rebound in household demand. This rebound is being driven by the firming of the housing construction sector and increased consumer spending. The result is faster-than-expected economic growth, concerns of an inflationary spike and, of course, speculation that interest rates will now rise. A 0.25% rate hike will put the cash rate at 6.5%.

The rationale for a rate rise is that inflation is already at the top end of the Reserve Bank’s target range: data for the December quarter indicates the non-farm economy is growing at the rate of 3.5% a year, and analysts are forecasting GDP will fall within the 2.5–3% range for the next 15 months or so.

Household spending has also rebounded to normal rates of growth and is underpinned by strong momentum, after having spent the past few years below trend. This rebound in household demand is occurring despite the record high levels of the debt servicing ratio of household incomes and continued negative (though improving) household savings.

It essentially appears that the strength in the domestic economy, with little excess capacity and a low unemployment rate, continues to underpin consumer confidence. Economic data is now also pointing to an upturn in wages growth.

To date, it appears that the interest rate rises of 2006 have had little, if any, material impact on consumer sentiment. The question remains as to how any further rate rises will impact household spending patterns.

Within this economic environment, we thought it timely to review the economically sensitive retail sector, both consumer staples and discretionary. From a macro perspective, it appears the current economic environment is relatively benign for the retail sector. Further, the economic data suggests that within the category of retail sales, there have been significant increases to growth recorded for food and furniture. Clothing retail also remains consistently strong. However, if the trend to higher interest rates continues, the retailing sector will be one area of the economy impacted, with repercussions into a broader market.

Food and staples retailing

The supermarket retail sector is the most defensive retailing exposure for investors because these companies are largely dealing in consumer staples. The sector is highly concentrated and dominated by Coles and Woolworths, with more peripheral participation from wholesaler Metcash.

Woolworths (WOW), which operates Safeway supermarkets, is the standout company and goes from strength to strength. Investors are rewarding the company’s competent management, which has delivered effective expansion of their private label “Select”, successful integration of the NZ supermarkets acquired from Foodland, increased margins and lowered operating costs.
Woolworths' recent result demonstrates Safeway’s dominance of this market. Highlights included a 16% rise in sales, a 28% rise in net profit and strong cash flow, which resulted in a drop in the net debt to equity ratio from 89% to 47%. Management also upgraded guidance for its full year result.

Coles (CGJ), on the other hand, has been disappointing for a number of years and is constantly playing catchup to Woolworths. Its March quarter result showed a loss of volumes, indicating that it was losing customers. More recently, but somewhat predictably, the company has warned that it will not make the profit forecasts put in place to justify the rejection of the private equity bid in 2006.

It has subsequently downgraded its profit estimate for 2007-08 by 10%. Management has now formally put the company up for sale and it is increasingly likely to be broken up, spinning off the better-performing Target and Officeworks divisions to extract maximum value. Clearly there are significant issues impacting Coles internally, beginning with management and the business model.

This is a shame because the company is comprised of quality businesses that dominate their sectors. Undoubtedly, Coles is an attractive breakup proposition and the pending sale is all that is currently underpinning its lofty share price. Without this sale process, we would expect the share price to be significantly lower. The expected sale price is mooted to be about $16 per share, right where it sits currently.

There is in fact one very interesting and differentiating figure, which explains just why Woolworths is so much better than Coles. It is margins. Woolworths’ supermarket margins stand at 5.9% compared to Coles at 3.7% – a huge difference. Further, analysts are expecting that Woolworths, under its current strategy will be able to further increase margins – possibly to about 7%.

Metcash (MTS) is the quiet achiever of the three. Largely off the radar of retail investors on the eastern seaboard, it has enjoyed a share price re-rating post the takeover and integration of the Foodland business. Metcash operates slightly differently, as a wholesaler and related service provider to independent grocery stores. These independents are performing well, having established a strong niche. They are smaller in size, supply smaller population bases and have a minimal overlap with the larger supermarket businesses.

By comparison, Coles and Woolworths tend to compete head on, with many suburbs or towns being serviced by Safeway and either Coles or Bi-Lo. To add to this competition, there is an additional participant in the form of the Aldi supermarket chain, which has also entered the market, grabbing a 4% share and with plans to double its number of stores and market penetration from the current base.

This is a tough operating environment and price wars would be counter-productive, so these players need to differentiate themselves from each other. Woolworths is proving to be the most creative in this regard.

Where should your money be?

Undoubtedly, these sectors represent significant cogs in the economic wheel and important assets for a share portfolio. A consumer staple, such as Woolworths would represent a core holding. Further, consideration would have to be given to also including a discretionary retailer. If Coles was a better investment proposition, its asset mix would make it a very attractive inclusion within a portfolio. Unfortunately, this is no longer the case. So, on the basis that a portfolio needs exposure to retail and given that there are no bargains, what are the best prospects?

First, Woolworths and Metcash remain the better prospects within the staples category. I rate both Woolworths and Coles as “Hold” (Coles’ share price being underpinned by the sale process). I rate Metcash as “Buy” because it is the most attractively priced of the three and has succeeded in differentiating itself and carving out a successful niche.

In terms of discretionary retailing, finding stocks that rank as an outright buy is difficult, if not impossible, especially given that the Reserve Bank is now likely to increase interest rates to control the increased momentum beneath household demand.

An update on some retailing heavyweights

I have chosen to profile and provide an update on a few companies who are vying for the discretionary dollar. In each case, I see risk profiles increasing. None stand out as outright buys.

Harvey Norman (HVN) operates franchised and company-owned stores throughout Australia and New Zealand and has also opened 10 stores in Ireland and two in Slovenia. It also has a controlling interest in Rebel Sport and Singapore-listed Pertama Holdings. Harvey Norman is strategically moving to offshore expansion, which tends to be higher risk and perhaps indicates that the market in Australia and New Zealand is already quite mature. The challenge will be in maintaining earnings growth.

As a discretionary retailer, Harvey Norman is exposed to the economic cycle, interest rates and consumer confidence. While many retailers, including Harvey Norman, are currently benefiting from consumer interest in electricals, computers and information technology, margins from these types of items are expected to decline. The franchise sales mix is made up of electricals representing 46%, computers 30%, furniture 20% and other 4%.

Harvey Norman is trading on a 2006-07 forecast price/earnings (P/E) multiple of 18.5 times and is probably one of the cheaper retailing stocks. However, I rate the stock as a “Hold” due to the offshore expansion strategy, which has failed for many companies. I would view domestically focused retailers as lower-risk.

David Jones (DJS) operates up market department stores throughout mainland Australian capitals and near major population centres. The company has strategically positioned itself as a top-end retailer targeting an affluent, mature and loyal customer base with a wide range of domestic, international and designer products and a strong focus on customer service. It has succeeded in growing its customer base and market share in recent years and has taken customers from its major competitors, Myer (which is now in private equity hands) and smaller specialty apparel and footwear stores. The company also provides financial services through its store card and general purpose credit card.

The company’s strong performance has been rewarded by a doubling of the share price in the past couple of years. The outlook remains buoyant, although some competitive pressures could emerge with the rejuvenation and potential refloating of the Myer department stores. The company’s fortunes will also be strongly influenced by the economic cycle, interest rates and discretionary spending.

Once again, it is the high company valuation 2006-07 forecast P/E of 21 times that makes me cautious. Can the David Jones story improve from here or is the risk to the downside? On balance, I am inclined towards lightening positions as there is significant room for profit taking in the event of a tougher trading environment or an earnings downgrade.

Interestingly, the provision of financial services is now closely tied with large retailing businesses. It has become a profitable bolt-on business for the larger players, important in maintaining and growing customer bases and enhancing profitability.

JB Hi-Fi (JBH) is a discount retailer of branded home entertainment equipment covering electronics including car sound systems, computers, white goods, music and DVDs. The company does not operate a warehouse setup and all stock is delivered directly to the stores. All merchandise is purchased from local distributors. JB Hi-Fi has been through a period of rapid growth with new store rollouts being the primary driver of forecast earnings growth. The model of minimal carrying cost and high turnover through discounting is good. The issue for investors is whether this model is sustainable. The company aims to double its store network over the next five years.

JB Hi-Fi’s share price reflects its rapid growth profile. The stock is trading on a lofty 2006-07 forecast P/E of 24 times, pricing in the anticipated growth. The danger is therefore that earnings could be impacted if the company cannot deliver on its store rollout timetable and/or there is a downturn in sales and turnover. With a tightening of interest rate policy and a move to rein in inflationary pressures, the risk profile of these types of growth stocks is increasing. I feel the company is fully priced at current levels of $7.80 and recommend investors “Sell/Avoid” for now. There is significant potential on this stock for profit taking if news were to disappoint the market.

In summary

Increased interest rates may at some point begin to impact consumer spending patterns, though perhaps not in this election year, which is shaping up to be hard-fought. Tax cuts and the like may well continue to support the current sound retailing environment, which will in turn support share prices. Having said this, I do not see potential for significant upside especially given that the Reserve Bank’s comments on monetary policy have been hawkish and favour a tightening bias. For now, I remain neutral on the discretionary retailing sector. I am not a buyer in the current environment.

The current profit reporting season has illustrated that corporate earnings do support the current level of share prices. This, combined with the liquidity in the market, is serving to underpin current valuations and, subsequently, current pricing appears sustainable. However, the reporting season also served to confirm earnings expectations rather than producing surprises on the upside. Earnings margins are currently at historically high levels and, interestingly, are expected to expand further for industrials throughout 2007 and into 2008.

So for long-term investors, it is a case of defining what management strategies can be employed to drive share prices higher in the medium term, especially in a tougher operating environment. The clever money will be anticipating where the economy and market will be six months down the track. The clever investors will currently be implementing strategies to place themselves within this forward environment.

In line with my general view on the market at present, I continue to favour a rotation into low P/E, defensive stocks and continue to use the current strength in the equity market to lock in some profits. I am not bearish on the market, but simply await a consolidation phase and I believe some cash reserves will be useful as opportunities emerge from more volatile trading conditions.

Lisa Baum is a senior adviser with Investstone Wealth Management and is a regular contributor to the The Investing Times newsletter which is published by Investstone. This article first appeared in The Investing Times issue of March 31.