Who'll Be the New King?

Who will be the next Gerry Harvey? Australia’s greatest retailer has managed yet again to spring back over the past six months as Harvey Norman stock has powered ahead from $2.90 in January to $3.90 today.

But unlike previous rebounds, Harvey Norman has not retraced the dizzy heights of the 1990s when the share price tripled in a decade and Harvey, now 67, became a hero to a legion of private investors.

The Harvey Norman empire is a $4 billion colossus built from a float in 1987. The challenge now for professional and private stock investors is to identify retailing’s new generation of chief executives who will match Harvey’s record in the longer term.

And it’s not easy. First, despite low unemployment and relatively strong consumer spending '” with year-on-year growth of 7% '” retailing faces very mixed conditions in mid-2006 as rising interest rates and higher petrol prices take a toll on discretionary spending.

Moreover, the sector has produced a string of disappointing floats '” including Repco, Retail Cube and SuperCheapAuto '” that have spooked investors who had become used to very strong returns elsewhere on the stockmarket.

But retailing specialists are savouring this market. As Craig Woolford, a research analyst at Citigroup suggests: "Retailing sales have recently returned to long-term trend patterns and that means it’s a more level playing field: Under these sort of conditions, it's very much a contest between the best management inside the retailing sector."

A closer look at the macro figures also reveals that retailers of computers and consumer electronics face better conditions than those selling such basic goods as footwear or bedding. In the 12 months to March 2006, computer sales grew by 24%, food sales grew by just 1.2%.

Still, even with soaring sales volumes in computers and consumer electronics, retailers at this end of the market are not being offered a free ride as they fight price deflation. The price of consumer electronics such as plasma televisions is dropping so quickly the imperative is to get them off the shelves as quickly as possible or risk acute inventory problems.

Professional investors suggest successful retail companies must have faultless supply chain and inventory systems, but that success hinges on the management regime. Cynthia Jenkins, manager of the Australian Smaller Companies fund at Invesco Australia, says: "Take somebody like [David Jones chief executive] Mark McInnes, who we have invested in. He has managed to create a new culture at David Jones. His team has managed to turn it around.”

Perhaps more than any other industry the retailing industry regularly offers the prospect of the ' management turnaround’;. Unlike the resources sector where huge capital expenditure can not be done quickly or financial services where turnaround opportunities are rare, retailing’s wide selection of small to medium sized companies regularly offer dramatic opportunities. Today’s disappointments '” Colorado, OrotonGroup, Country Road '” can become tomorrow’s winners. David Jones spent almost a decade drifting close to its float price before McInnes was appointed chief executive in 2002, aged 37, and began sprinkling his stardust on the upmarket retailer. Its shares have since jumped from about $1 to $2.85.

If management is the magic ingredient in retail, who are the stars of tomorrow?

The three leading contenders for Gerry Harvey’s crown as Australia’s top retailer are Stephen Heath of Rebel Sport, Mark McInnes of David Jones and Richard Uechtritz of JB Hi-Fi. Like Harvey, all three have worked their way from the shopfloor to the chief executive’s job. Just as Harvey started out selling vacuum cleaners door-to-door, each of the three is a “born retailer” who has matured into a retailing strategist.

Stephen Heath, 37, was personally selected by Harvey to run Rebel Sport after Harvey Norman acquired it in 2001. (Rebel Sport is a listed subsidiary of Harvey Norman.) Heath had been one of Harvey Norman’s standout franchisees, an industry “lifer”. He has since taken Rebel Sport’s share price from about 85¢ to $3.60.

Heath, who last week said soccer merchandise sales were up 100% after the World Cup, is expected to drive strong growth at Rebel Sport and is seen as a leading contender to take the reins at Harvey Norman if Gerry Harvey and his partner Katie Page decide to withdraw from day-to-day operations at the company.

Mark McInnes started his career as a cadet at Grace Bros. His ability to build a top team and to reposition the luxury store group as a glamourous retailer has turned around a chain that had at one stage seemed in danger of following Brashs or Gowings into financial history.

As McInnes told Eureka Report: "It's not that we've been significantly more successful (than our rivals), it's just that others have failed to manage their business. So we've stood out as a result of just being steady." (LINK)

The influence of Gerry Harvey is felt just as keenly at JB Hi-Fi, the music and consumer electronics group. Its managing director, Richard Uechtritz, is a long-time admirer of the Harvey Norman model and is overseeing a nationwide store roll out program that looks remarkably similar to the Harvey Norman’s 1980s expansion, when the company doubled in size in seven years.

Uechtritz '” a long-time retailer who made his first fortune with Rabbit Photo '” runs a chain with a strong brand that has grown from turning over $135 million a year from 10 stores in 2001 to a $1 billion operation today.

Still, despite their strong reputations none of Harvey Norman's potential successors trade on reasonable price/earnings multiples. As the ASX trades around 14 times earnings, Rebel is on 14.9, JB Hi-Fi is on 15 and David Jones on 21.

Separately, on conventional measures of return on equity (ROE) '” a better guide to the true ability of management than the vagaries of stock price '” the three companies are also running impressively high numbers: Rebel Sport has an ROE of 18.7%, David Jones’ is at 15.4% and JB Hi-Fi 33%.

As Roger Montogomery, of Clime Asset Management, suggests: "With retailers, ROE is always important and you also have to watch important items such as borrowings per share because retailers can have liabilities such as long-term leases. We like to see low borrowings per share and high returns on equity. On that basis, Harvey Norman itself looks good, so do some smaller stocks such as Noni B and even Colorado, although Colorado it is without a chief executive at the moment. At the same time, JB Hi-Fi does not look so strong."

(Clime Asset Management supplied the table below. The ROE figures are created by Clime using a proprietary system that includes franking on dividends paid, which the group says reveal a more realistic figure linked with the returns provided to the owners of the business.)

MGerry and the Pacesetters
Reject Shop	2002	2003	2004	2005	2006	Borrowings/share
Return on equity	49	41.8	42.8	46.7	45.3
ROE distributed as dividends	30.7	0	18.9	24.5	31.3
Payout ratio	62.65%	0.00%	44.16%	52.46%	69.09%	$0.09
JB Hi-Fi	2003	2004	2005
Return on equity	28.8	45.3	49.3
ROE Distributed as dividends	0	44.8	21.6
Payout ratio	0.00%	98.90%	43.81%			$0.75
Noni B	2001	2002	2003	2004	2005
Return on equity	16.4	18.9	21.6	23.4	31.8
ROE Distributed as dividends	12.6	13.5	18.8	15.1	26.1
Payout ratio	76.83%	71.43%	87.04%	64.53%	82.08%	$0.01
HARVEY NORMAN	2002	2003	2004	2005	2006
Return on equity	25.9	26.6	28.3	20.3	22
ROE Distributed as dividends	10.4	9.4	8.6	9.8	9.5
Payout ratio	40.15%	35.34%	30.39%	48.28%	43.18%	$0.69
Rebel Sport	2001	2002	2003	2004	2005
Return on equity	7.1	24.5	33.4	31.9	25.2
ROE Distributed as dividends	9.6	2.9	4.2	16.3	14
Payout ratio	135.21%	11.84%	12.57%	51.10%	55.56%	$0.01
David Jones	2001	2002	2003	2004	2005
Return on equity	10.2	10.9	-3.6	21.1	24.3
ROE Distributed as dividends	11	9.8	8.8	13.1	18.1
Payout ratio	107.84%	89.91%	n/a	62.09%	74.49%	$0.00
Fantastic Furniture	2002	2003	2004	2005	2006
Return on equity	63.2	73.2	80.5	67.5	44.8
ROE Distributed as dividends	25.3	36.1	41.8	39.9	37.5
Payout ratio	40.03%	49.32%	51.93%	59.11%	83.71%	$0.05
Nick Scali	2004	2005	2006
Return on equity	122.5	126.9	87.7
ROE Distributed as dividends	157.3	62.9	75.5
Payout ratio	128.41%	49.57%	86.09%			$0.00

The three heirs apparent all occupy top jobs in “big-cap” stocks. Rebel Sport is capitalised at $279 million, DJs as $1.2 billion and JB Hi-Fi at $491 million.

There are other contenders, in smaller-cap stocks, most of which are not covered by stockbroking research departments.

Stockbroking analysts suggest that some of the best value '” and best superior long-term investments '” will be among niche stocks such as Noni B, the women's wear specialist, which is capitalised at $120 million. Even thought Noni B and its highly regarded chief executive Alan Kindl are in the notoriously fickle fashion business, they have consistently outperformed the rest of the retail market.

Another executive who is constantly applauded by processional investors is Barry Saunders of The Reject Shop. Recruited from the Big W division of Woolworths, Saunders is another retailer who has defied the “tough trading” conditions that have brought down many of his peers

Honorable mentions must also go to furniture retailers Anthony Scali of Nick Scali, even though the company recently let down investors with a profit warning; and Julian Tertini of Fantastic Furniture. Both get regular mentions in dispatches from leading fund managers such as Ben Griffith of Eley Griffith, who spends much of his time looking for value outside the ASX 100. .

Griffith says his fund has been encouraged by the retracement of price/earnings multiples in retailing following the recent correction. However, he is waiting to see how the listed retailers fare in the reporting season, starting in August, before he starts accumulating. “We think value is emerging across the sector '” for the moment we are only invested in DJs '” but there are a range of stocks we like and for me it comes down to a handful of managers who have that retailing flair, where you know they are innately attuned to their chosen business."