Retailers get the axe

Note: 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. That means ceasing coverage of many stocks to make way for new ones in the year ahead. If you're only interested in Buy ideas then you can skip articles such as this one, otherwise read on to find out why we've got one lonely recommendation in the discretionary retail sector.

'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.

The only retailer on our Buy list is The Reject Shop for the 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. We'll now explain why we're discarding a mix of other retailers.

Harvey Norman

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 (see JB Hi-Fi: Result 2014 from 12 Aug 14 (Avoid – $17.47)).

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. With the stock flat since Retail round-up: Results 2014 from 9 Sep 14 (Sell – $3.77) and sitting on a price-earnings ratio of 19, we don't recommend participating in the offer and we're CEASING COVERAGE.

Pacific Brands

In recent months, Pacific Brands has discontinued or sold several poor performing yet iconic brands including King Gee, Hard Yakka and Volley shoes. As we explained in What would you pay for Pacific Brands? on 22 Apr 14 (Hold – $0.54), 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 so, with the share price up 16% since Pacific Brands under review from 14 Oct 14 (Under Review – $0.44), we're CEASING COVERAGE.

Oroton

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 (see Oroton: Result 2014 from 22 Sep 14 (Hold – $4.53). Same-store sales are increasing but the new brands face a litany 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. The stock has fallen 15% since 22 Sep 14 (Hold – $4.53) but given that its market value is currently more than 120% of sales, there's little to get excited about. CEASING COVERAGE.

Retail Food Group

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. With the stock up 56% since 3 Apr 13 (Hold – $3.60) and now well above our previous Sell price we're CEASING COVERAGE.

Domino's Pizza

Domino's stock price has increased 54% since Domino's downgraded to Sell from 20 Dec 13 (Sell – $15.64) 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 as the stock is priced for perfection we're CEASING COVERAGE.

Billabong

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. In Billabong: reflections on a wipeout we recommended members sell due to the deteriorating business and because 'a capital raising or some kind of restructuring is now far more likely. That means existing investors are likely to be heavily diluted'. It's ironic then that our fears came true – 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 7 Jun 13 (Sell – $0.22) 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. CEASING COVERAGE.

Though the companies above are now officially off our coverage list, we'll still keep an eye on them in case our view changes and there will still be plenty of retail-related news and commentary on our blog.