Rising from the retail ashes

PORTFOLIO POINT: If the economic dominos fall over and push down the Australian dollar, the retail sector could be in for some takeover activity and rise once again. Watch the retail space.

Buying a pair of Italian hand stitched leather shoes online last week, I couldn’t help but think that yet another nail was being hammered into the coffin of Australian retailing.

Seeing the price of €200, I initially baulked at handing over my credit card details, remembering that €200 was almost A$400. A quick check however on one of the currency converter websites revealed that my purchase would cost no more than A$240. Quick Betty, grab the hammer.

While the Australian dollar remains strong and Europe and the United States are in depression and recession respectively, Australian retailing is going nowhere in a hurry. JB Hi-Fi’s share price – trading at the same level as it was during the very depths of the GFC – is testament to that.

As long-term investors however, we are charged with the responsibility of thinking longer term and of businesses, rather than stocks. To date this approach has served our investors well and the Mercer survey of 98 Australian funds to June 30, 2012 revealed that, had the Montgomery [Private] Fund been included, it would have been ranked number 1. See Figure 1.

Fig 1. Australian Fund Performances

Click to enlarge

Source: Montgomery Investment management, Mercer.

Part of the reason for this relative outperformance and positive return has been some ability to identify, in particular, when stocks or a particular sector simultaneously enjoyed and suffered the impact of irrational exuberance. We have not for example exposed investors to BHP nor have we irrationally held on for longer than we should to the shares of mining services companies. By April these were enjoying the effects of having every analyst in the country, and similarly many fund managers, slapping buy ratings on even the most capital-intensive examples like Macmahon Holdings.

As I see TPG bid yet again for the shares of Billabong, I’m starting to soften my view on the outlook for Australian retailers. My emerging view of the retail sector, believe it or not, is partly the product of my view on iron ore.

You see, quite simply, I don’t believe the Australian dollar can stay as strong as it is against both the US dollar and the euro forever. It may take a long time, but eventually the euro and the US dollar will reach their nadirs. And indeed, if my long-held and widely reported view on iron ore prices continues to play out, then the Australian dollar could also see a meaningful decline.

The meaningful decline in the Australian dollar would not, however, make consumers spend more or save less-as they are currently doing, but it would improve the relative value of Australian retail offerings. Those Italian hand stitched leather shoes would not look so cheap and would not attract so many Australian dollars. And perhaps, just perhaps, the current downturn in Australian retail would in hindsight look more cyclical than structural.

Turning back to the bid for Billabong, TPG has offered $1.45 in cash for every Billabong share. This values the company at $695 million. Five months ago TPG bid $842 million and was rejected. Looking at the total value of the bids however may give you a false impression of the buyer’s enthusiasm for Australian retail assets – albeit a retailer with a global footprint. You see, while the $1.45 is less than half the $3.30 a share TPG offered previously, there has been a $225 million rights issue since, so the number of shares on issue has grown from 258 million to 479 million. The company has also announced a downgrade to its earnings of $27 million, and so TPG is effectively still paying around eight times FY13 earnings.

Ok, so that’s another reason I think retailing may yet rise again.

Now, we suspect that Solly Lew must be sharpening his pencil as he builds his Australian retail dream team. This team however has a particular set of experiences in department store retailing. I note also John Singleton appears to have brought the old team together with Mark Carnegie and Geoff Dixon, who are presently overseas either for the Olympics or to maybe have a good look at how department store retailing should be done, or both? All of these fellows are longer-term strategic investors and have seen enough cycles to know that there’s money to be made when the outlook appears bleakest.

Could a bid emerge for Myer? With the share price down to $1.69 from its $4.10 float price (a float I warned you to avoid here) don’t rule it out.  See Figure 2. 

Fig 2.  Myer Share Price and Intrinsic Value Chart

Click to enlarge

Source:  Skaffold.com

While I don’t think a marriage between Myer and David Jones would work – thanks to the long-term leases, I do believe a bid for either could be cobbled together.

So my thesis goes like this. Iron ore falls, Aussie dollar falls, Australian retailers receive a few bids and, abracadabra, hey presto – retailing rises like a phoenix from the ashes. Sharpen your pencils.

Roger Montgomery is an analyst at Montgomery Investment Management and author of Value.able, available exclusively at rogermontgomery.com.