This article was originally posted in the August edition of the ASX newsletter.
Solomon Lew makes making money in the retail sector look easy. Lew took over his father's small retail business in 1964 at the tender age of 18 and turned it into a $1.7-billion fortune. On the cusp of his 70th birthday, Lew recently extracted a $17 per share bid from South African retailer Woolworths for his 11 per cent stake in Country Road. The stock traded at just $4 a few months earlier, but it gave Woolworths 100 per cent ownership of Country Road and cleared the path for its acquisition of David Jones.
For others, the retail sector can be perilous. Just ask Gerry Harvey or Gordon Merchant, who founded Harvey Norman and Billabong International respectively. Harvey Norman's share price is down nearly 60 per cent since it peaked above $7 before the GFC and Billabong's share price is down 99 per cent. The sharemarket is a tough place to learn and it doesn't offer refunds.
Despite Australia's last recession being 23 years ago, most listed retail stocks have performed relatively poorly since the GFC. Australian investors are also at a disadvantage. There are only a few large grocery retailers listed on ASX, mostly mixed with a bunch of discount retailers that mature quickly because of Australia's small, concentrated population.
I generally steer clear of Australian retailers. Fashion changes, fads come and go, the internet is offering superior choices, a flood of global competitors have opened their doors in Australia recently, the sector is highly cyclical, and it seems only landlords, such as Westfield Corporation and GPT Group, consistently make money.
One reason Intelligent Investor prefers the internationally focused Westfield Corporation to local shopping centre landlord Scentre is because we wonder how much higher Australian rents can go. Scentre's specialty rents as a percentage of retailer's sales has increased from 12 per cent to nearly 16 per cent over the past 12 years.
With companies such as Solomon Lew's Premier Investments threatening to close stores without rent relief, Scentre is no longer simply assuming rents will continue to march up by 3 per cent a year if it wants to keep its centres full. That means distribution growth could also fall.
Australian retailers face increased competition and some business models are obsolete - meaning that no matter what price you pay, you are likely to lose money. Also, Australia has some of the highest consumer debt levels in the world, interest rates are already at record lows, and unemployment is expected to increase as Australia's massive energy and mining projects are completed over the next couple of years. That means retailers cannot just sit around waiting for spending to increase. Spending has actually been quite strong over the past year but few listed retailers have benefited.
It is not all doom and gloom, though. Unemployment remains low, interest rates will probably stay low for some time, and Australians are still spending freely.
Let us analyse some stocks to highlight the issues for the sector and where there might be some value.
(Editor's note: do not read the following ideas as stock recommendations. Do further research of your own or talk to a licensed financial adviser before acting on themes in this article).
Big is beautiful
Woolworths has been a staple of our model portfolios for several years. Its ability to roll out new stores, refurbish existing ones, squeeze suppliers and cut supply chain costs has produced a remarkable track record of increasing profits, cash flow and dividends. Despite increased competition from Coles (owned by Wesfarmers), Aldi and Costco, the company continues to improve.
Woolworths' massive size is an issue, though. Forget about Masters; it's inconsequential but is indicative of a larger problem. Woolworths' growth options are limited. New stores are cannibalising old ones and attractive sites are rare. Management is feeling the heat and if it decides to make a large acquisition overseas, we will consider selling the stock. For now, we are happy holders with a recommendation to buy up to $36.
Wesfarmers is a business we would love to own at a price below $35, all things being equal. Unlike Target, which is besieged by problems just like many discount retailers battling increasing competition and the internet, stalwarts Coles and Bunnings continue to perform well as they dominate their industries.
Ian McLeod was headhunted from the UK to invigorate Coles, which he did with aplomb, and he recently accepted a new but unspecified role. With Wesfarmers recently selling its insurance business to Insurance Australia Group for $1 billion and showing interest in Healthscope, which recently listed on ASX, a large acquisition seems inevitable. Wesfarmers is an excellent business but we are prepared to wait for a cheaper price to ensure it is an excellent investment.
Metcash's share price has fallen 50 per cent since it peaked above $5 in 2007. The company has been squeezed by Woolworths and Coles, which are offering cheaper prices on key items such as milk and bread, and increasing convenience as they open new stores. Shopping at Coles or Woolworths is also more pleasant following billion-dollar refurbishments that IGA store owners can only dream of.
Metcash's competitive position was damaged by not responding with an advertising blitz, owners refusing to invest in their shops, and a tortuous regulatory battle in NSW that led to a loss of market share.
On a 6.9 per cent fully franked dividend yield, Metcash looks cheap, but eventually the dividend may have to be cut again, in our view. Management's approach to acquisitions also shows the IGA supply business is no longer the sole focus and we are not sure the IGA business will reclaim market share as it has done historically, given the popularity of Aldi and Costco.
We have not had a buy recommendation on Harvey Norman or JB Hi-Fi for several years. Their share prices oscillate with short-term expectations about retail spending and profits, while the internet silently eats away at their competitive positions. And how many more Harvey Norman or JB Hi-Fi stores could Australia possibly need?
If these stocks get cheap enough we will consider adding them to the buy list, but there are better options for your money, in Intelligent Investor's opinion. Given Harvey Norman is no longer a growth company, it should also pay a higher dividend.
We recently published a comparison of The Reject Shop and Super Retail Group, as their respective share prices have fallen around 50 per cent and 35 per cent. We are still avoiding Super Retail Group but have recommended The Reject Shop as a buy below $11 for several reasons.
First, The Reject Shop's everyday products should be more resilient in a recession. Sales of $500 kayaks at Ray's Outdoors are likely to be delayed before the fortnightly supply of toilet paper is. A recession may even convert shoppers previously uninterested in saving pennies.
Second, The Reject Shop should be more insulated from the threat of online competitors, as the average customer only spends $10. Postage costs too much to justify opening an online store.
Third, the company has no debt. It has long-term leases that are quasi-debt, and rolling out new stores requires investment that reduces cash flow in the short-term, but it should not come under pressure from lenders to make short-term decisions at the expense of its competitive position. The recent failure of Retail Adventures has also reduced competition slightly.
Lastly, current earnings are artificially low because of the costs of the current store roll-out. There is a question mark over the company's strategy following the recent announcement of new CEO Ross Sudano, but provided recent profit downgrades do not reflect cannibalisation of the company's stores or a permanent loss of market share, the company should be worth more as new stores ramp up sales over the next few years.
More speculative retail ideas
If you are looking for a speculative idea, check out Pacific Brands and Noni B. Pacific Brands owns many iconic Australian brands, such as Bonds, but sales have been trending down for years. The share price is also down around 40 per cent in the past year. If a new CEO can stabilise the business and sell some underperforming brands for a half decent price, the stock may offer value.
Noni B is in a state of flux as the majority family owner fishes for a buyer. With the share price getting chopped in half recently, it could make an interesting speculation, but we recommend small portfolio limits and/or taking a portfolio approach so that one retail failure does not damage your portfolio.