Your retail form guide

PORTFOLIO POINT: Entrants in Australia’s retail sector range from nippy thoroughbreds to tired donkeys.

Watching the retail sector in Australia sometimes reminds me of nature documentaries – of witnessing the vulnerable and hapless being devoured by the leagues of strong and ravenous.

Other traps for bright-eyed retail enthusiasts include everything from the twin-speed economy, a string of natural disasters, soaring oil prices, growing personal savings and higher interest rates, which all threaten to stop even the world’s best retail strategy from getting off the ground in Australia.

On top of all this you have to consider Australia’s small population, which means retail concepts mature in just a few years and a population that is increasingly adept at sidestepping local retailers and going straight to the internet to avoid the markups charged by local retailers to cover their world class rents and higher-than-world-class salaries.

When it came to the recent reporting season, however, most retailers appeared to be singing from the same hymn sheet, with the most trotting out the old line, that “given these difficulties and uncertainties, the company is unable to provide updated profit guidance at this stage”.

And the icing on the cake? The soon-to-be imposed changes to accounting standards that will see leases included as a liability on the balance sheets of retailers and thus making the sector appear even less appealing the true value investor.

Hands up if you want to be a retailer.

And yet despite the many forces conspiring against our merry band of retailers, there is plenty of money to be made in developing brands if not also in “selling stuff” in shops. I, for one, am attracted to retailers at the right price and the right stage in their life cycle.

The business is relatively easy to understand, the best managers are easy to spot and it is relatively easy to separate the businesses with earnings power from those without. But generally speaking they aren’t companies you want to hold forever.

Because barriers to entry low, there are always new concepts with young, intelligent and energetic entrepreneurs eager to develop a new brand and offering. That forces retailers to constantly reinvent themselves or to go through periods where sales are sacrificed to defend brand value.

This week I would like to give you a form guide for retail stocks, which you can use to identify the good, the bad and the ugly amongst the listed retailers. I could go on forever but for the sake of brevity I have left out RCG (the owner of The Athlete’s Foot) and Country Road because, well, both are seriously expensive.

I have also left out Cash Convertors, a niche A2 business, with bright prospects for intrinsic value growth but also slightly expensive at present. So, for now, here’s my overview of the major players in the Australian retail sector.

Legend:
ASX: ASX code. MQR: Montgomery Quality Rating. HVC: Historical valuation change over the past 12 months. FVC: Forecast valuation change over the next 12 months. MOS: Margin of safety between current price and forecast.

Harvey Norman

Imagine we inherited a business in 2001 with $342 million of retained profits and injected an additional $142 million into it. All up we have contributed $484 million. That was how things looked at Harvey Norman a decade ago. Now suppose in that year, we earn $105 million profit. Including the other aspects of equity, the return is about 19%. Fast-forward to 2010 and we’ve injected another $117 million and have retained an additional $1.5 billion in the business.

Despite this tripling of our commitment, however, profits have little more than doubled to $236 million. Return on equity has fallen by a third and is now about 12%. The impact on the intrinsic value of the business is similar and over the past decade the intrinsic value of the company has barely changed. This is arguably a retail offer that needs revitalising and updating. It is also a business that is mature in Australia. I don’t know how to fix it but Harvey Norman is what JB Hi-Fi and The Reject Shop would see if they used a telescope to look forward through time. A touch expensive.

Oroton

With a brilliant retailer at the helm, Oroton is an example of what can be achieved if founders let go. Since 2006 – the year of Sally MacDonald’s appointment, loss making stores have been cut free, overheads have been sliced, range has been improved and revenue has surged. As a result the intrinsic value of the company has growth six-fold. Prior to that, intrinsic value (and profits for that matter) did nothing for five years. Return on equity has quadrupled, debt has fallen by 80% and cash flow has improved. Even brighter prospects await Oroton in Asia and the current offering is sufficiently attractive and appealing that the company has the ability to weather the retail storm and protect its brand. Meanwhile, its competitor, Mimco, is doing the opposite. Trading around intrinsic value.

Woolworths

The largest retailer in the country and one of the 20 largest retailers on the planet. It has a utility-like grip on consumers in Australia, with earnings power that would put any utility to shame. The latter can be seen in the near 30% annualized increase in intrinsic value.

Competitive position and size means suppliers and customers fund the company’s inventory.

It enjoys several competitive advantages with varying levels of sustainability. The current doubts about its ability to succeed in hardware are valid and present risks but they also need to be weighed up against the company’s track record in pubs, petrol, liquor and private label strategies. Trading around intrinsic value.

Myer

According to Myer’s $5.4 million a year CEO, Myer is a business that “is well placed to benefit from any increase in consumer confidence and discretionary spending when retail conditions improve”. Really? Wow!

Myer is a mature business whose strategy of cutting costs and creating efficiencies (a short-term one) was muddied by the arguably ridiculous price paid for Sass & Bide. The share price is expensive and imagining the company earning materially and sustainably more in five or 10 years, requires a future without the many other options for shoppers including David Jones, Just Jeans, Kmart, Target, Big W, JB Hi-Fi, Fantastic Furniture, Captain Snooze, Sleep City, Harvey Norman, Nick Scali and Coco Republic.

Coles

A business for which the current owner, Wesfarmers, paid far too much. If the market wasn’t merely a popularity contest in the short term Wesfarmers share price would be a lot lower. It is artificially inflated by the fact Australian fund managers have a constant inflow of funds equivalent to 9% of every working man and woman’s salary and have not been able to find any better places to invest it apart from Wesfarmers and Telstra. The company’s aggressive pricing strategy will cost Australia dearly in the long run but that doesn’t matter if you are heading back to England in five years, like its largely imported management team. Expensive.

Noni B

Founded by Alan Kindl in 1977 (who bought a store in Newcastle from Noni Broadbent) and now run by his twin sons, Noni B has more than 200 stores across Australia with a long-term aim of expanding to 250. The Kindl family holds 40% of the company. It is a women’s fashion brand aimed at over 40s, “focused on selling frocks, pants, jackets and jewellery.” The company floated in 2000 at $1 and four years ago the shares were trading at $5.20.

Today they are less than a dollar. This is because Noni Bs intrinsic value for 2012 is the same as the year it floated '¦ as is the return on equity. Shares on issue, however, have increased 50% and profits are essentially unchanged. Serious operating leverage and cyclicality is revealed by the most recent half-yearly results, where sales fell 1.7% to $6.3 million but net profit plunged 58% to $1.5 million. Given the high level of competition and low barriers to entry, combined with its lack of traction, I cannot imagine the company earning materially more in five, 10 and 20 years. Expensive.

Kathmandu

With half its stores in Australia, Kathmandu is one of the few retailers to buck the weak trend in retailing. A newly installed intranet should streamline store-to-store communications, reducing costs and creating inventory-related efficiencies for the 90-store chain. But investors should curb their enthusiasm: rarely do such systems produce sustainable competitive advantages because the out-of-the-box system can be easily replicated by any of its rivals. The company has also restructured its balance sheet and lowered debt levels, enabling it to carry high stock holdings, which will be necessary when the range is broadened. Longer term, the company will require traditional weather patterns to ensure its largest annual promotional event – Winter – is a success each year. The second half of the financial year accounts for 60% of revenues. Pre-float concerns that founder Jan Cameron was preparing to launch a cross-Tasman rival have been premature. Expensive.

JB Hi-Fi

Record sales and earnings are par for the course with this category killer. In the future as maturity looms, competition from local and offshore retailers will result in more volatility in sales and earnings. Another 13 stores were opened in the first half of the year and a further 11 will be opened by year-end. The product offering is more diverse than many “ivory tower” analysts think and it has helped the business absorb price cuts in flat-panel TVs and lower sales of games and Sony and Nintendo game platforms. The shares are cheap but profit growth may slow as the mix of stores changes, and more stores with less attractive economics are opened. Marketing spending will also rise as the company expands to regional areas such as Wagga in NSW. Maturity is now visible on the distant horizon. Reinvention will be needed at some point because target demographic are internet-shopping savvy. As online offerings increase in scale, cheaper or free delivery options and sales support could chip away at the traditional retailing model.

Fantastic Furniture

A once exciting concept. Furniture retailing is tough in such a small market and being the lowest cost provider is the best competitive advantage if it can be sustained. Most strategies are easily and quickly copied. New competitors in online retro furniture suppliers like Milan Direct and Matt Blatt are forcing the traditional players to reinvent the way they display, price and stock inventory. These are the reasons the share price today is the same as it was in 2003. See also Harvey Norman and Nick Scali.

Nick Scali

Anthony Scali is one of the best furniture retailers in the country and has nearly doubled profit in six years. Unfortunately, the equity required to produce this result has tripled, meaning return on equity has almost halved. Intrinsic value has only risen 15% since 2004 but has been volatile. Not surprisingly, the share price today is exactly the same as it was in May 2004. The intensely competitive environment in furniture retailing requires constant adherence to a low cost philosophy. The company’s launch of sofas2go – which is aimed at first-home buyers and renters – will depend on it. Any weakness in the Australian dollar will also have considerable impact. See Fantastic Furniture.

The Reject Shop

CEO and former CFO Chris Bryce is reinvigorating the strategies installed by Barry Saunders. It is currently facing the headwinds of higher inflation exported from China and the impact of floods on its distribution centre in Ipswich, which will not be operational again until early next financial year. The latter is a temporary rather than permanent feature. More permanent is that many of the best store sites have been taken and just as cost savings start to take effect, like JB Hi-Fi, the impact of maturity on the economics of the business may be felt.

Billabong

Really tough sector because its customers are highly fickle, trend conscious, anti-establishment youth. Oh, and it’s a seasonal business as well. Yes, they have summer and winter ranges but cool summers and warm winters make life tough. The tsunami and earthquake in Japan, where the company has 44 stores, has had a major impact. Eighteen stores remain closed due to damage but more importantly the company will be adversely affected by the devastation. In New Zealand three stores remain closed in Christchurch due to the earthquake there. With 80% of revenues from offshore, every one-cent rise in the Australian dollar has a half percent negative impact on net profits.

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