Which retailers will survive? Part II

In Which retailers will survive? Pt I we made an emphatic call to action. Online retailing presents a permanent—and imminent—threat to incumbent retail models. Existing retailers need to adapt or face irrelevancy.

Global fashion label Zara shows what the new kind of retailer might look like. It runs a world-class online store with useful mobile apps but what makes it really stand out are the number and class of its traditional stores. Just Jeans has over 200 stores in Australia. In Spain, where Zara is based, it has over 300 stores serving 48m people. The stores are typically larger than a traditional fashion store, are in key city locations, and have a focus on experience rather than just sales.

The clothing is designed in-house and the strong Zara brand draws in customers and helps create pricing power. Its ability to design, manufacture and distribute new lines within weeks is legendary. This tight, adaptive retailing operation is backed by a well-resourced and debt-free parent company, Inditex.

There are plenty of lessons in this for local retailers. First, they tend to have too many stores. Second, their online presence should be treated as central to the future success of the business, not as an afterthought, or a way of generating traffic for the store network. Third, the stores themselves need to be seen as experiential rather than merely distribution-led. This is the only way they can compete with the online proposition. And pricing needs to be competitive. In other words, the entire customer proposition needs to be rethought.

So, which local retailers are up for the challenge. Table 1 assesses the local discretionary retailers on the ASX300 for ‘online readiness’. Most are alarmingly unprepared. Only ARB Corp and Oroton Group receive a ‘high’ rating.

Of course, this is a blunt tool. Discount retailers such as Super Retail Group can support a wider store network than a fashion-based group like Premier Investments. Super Retail stores act more like mini-distribution centres and tend to be in lower cost locations. But almost all need to change, and fast.

Unfortunately, these businesses aren’t built for adaptability. The 15-year credit boom delivered easy growth and ample profits. For too long, higher costs were passed on to customers and difficult choices, like renegotiating rents or closing stores, avoided (see Reassessing Westfield—Part 1 from 25 Jan 12 Long Term Buy – $8.31)).

According to a recent study by the RBA, Australian retailers’ distribution margins have grown nearly 10% in the past decade. Rather than whinging about GST exemptions retailers should be focusing on improving operations.

It’s not just online retailers sniffing out fat and lazy competitors. International retailers, which have honed retailing skills in the hyper-competitive US and European markets, see opportunity in Australia.

The past couple of years has seen the arrival of Bottega Veneta, Gap, Ladurée, Mui Mui, Paul Smith, Top Shop and Zara. More are on the way. Abercrombie and Fitch, Hollister, H&M, Marc by Marc Jacobs, Thomas Pink, Williams Sonoma and Uniqlo are about to open stores here.

Even existing international retailers such as Ben Sherman, Burberry, Louis Vuitton, Prada and Tiffany & Co have expanded Australian operations in recent years. Traditional store retailing isn’t dead but this does suggest that most Australian chains are far bigger than they need to be, and that they do need to radically change their approach. Accepting there’s a problem is the first step to solving it (see Think negative).

Limited value on offer

To gain a positive recommendation a stock would need to be cheap enough to compensate for all the risks or demonstrate a genuine chance of adapting and thriving in this new retailing world.  We’ve largely shunned the sector over the past few years precisely because so few stocks passed this test. Unfortunately, as Table 2 shows, not much has changed.

Our sole positive recommendation in the sector remains Billabong International, due to its cheap price and turnaround potential than its retailing prowess. See Billabong’s road to recovery from 25 Oct 12 (Speculative Buy – $0.86) for a detailed explanation. The share is up slightly since 19 Dec 12 (Speculative Buy – $0.85) and remains a SPECULATIVE BUY.

Other fashion retailers are mostly worth avoiding. Premier Investments’ fashion brands—Just Jeans, Dotti, Jacqui E, Jays Jays and Portmans—are particularly exposed to the new international competition from Gap, Zara and TopShop. Premier’s other brands—Smiggle and Peter Alexander—hold more appeal and have been growing strongly in Asia and the company’s balance sheet also boasts net cash of around $300m. But considering its main business is under growing threat, above $4.50 we’re happy to steer clear. AVOID.

Myer, as detailed in part I, is emblematic of the deep problems with Australian retailing. Despite a few positive changes over the past year, including reducing in-store prices, this ex-private equity business is fragile and more exposed to middle Australia’s spending habits than upmarket rival David Jones. The balance sheet, too, brings risks. The share price is up slightly since 22 Nov 12 (Avoid – $2.15) but that view remains. AVOID.  

David Jones is in a similar strategic funk to Myer after suffering chronic underinvestment under former chief Mark McInnes. Even recent attempts to improve its online store have been poor (see David Jones forgets it’s 2012). That said, $600m of city property, a financial services business and a slight fall in the share price since 22 Nov 12 (Hold – $2.43), plus the potential for a takeover means we’re happy to HOLD for now.

Oroton Group does hold some attraction. A robust brand, slick online store, clear overseas expansion plan, and a strong management team means it is less exposed to the sector’s structural changes than most. Trading on a price to earnings ratio (PER) of around 11, it also appears reasonably priced. We’re going to conduct further research. Until then, Oroton is UNDER REVIEW.

Discount retailer The Reject Shop is another impressive operator that will benefit from the recent collapse of rival Retail Adventures (owner of Go-Lo, Sam’s Warehouse, and Chickenfeed). Still, well-resourced big box retailers like Costco, or even Aldi, could increase competition in this sector in the next few years. Whilst well-run, on a PER of around 18 we’re not interested. We’re commencing coverage with AVOID.

JB Hi-Fi’s business appears particularly vulnerable to the online threat. It’s not hard to imagine a scenario where almost all of its business is lost to online rivals such as Kogan over the next decade. It should be building a world-class online store and developing house brands but appears wedded to its existing store network. The foolish move into whitegoods appears doomed. With a share price up 9% since JB Hi-Fi: Result 2012 from 13 Aug 12 (Avoid – $9.84), stay well clear, AVOID.

Harvey Norman suffered same store sales falls of almost 9% for the September quarter. Many have argued, including us, that the company’s $2bn of property assets afford some protection for shareholders. We’re increasingly sceptical of this view, which is why the company will be subject to a more detailed investigation in coming weeks. The share price has risen 3% since 9 Nov 12 (Hold – $1.82) following some positive commentary from Gerry Harvey concerning the Christmas trading period. For now HOLD.

Kathmandu’s recent sales growth in a benign retail environment is impressive, as is its online store. Still, overseas expansion will prove tough where brands like The North Face or Black Wolf are more developed. We also question the logic of continuing to open new stores. Net bank debt, and recent private equity ownership also raise concerns. We’re commencing coverage with AVOID.

Super Retail Group’s BCF operates in a similar space to Kathmandu. It also owns Super Cheap Auto, Amart All Sports, Rebel Sport, Goldcross cycles, Ray’s Outdoors and FCO. Smart sourcing and a tight operation has helped it prosper but it doesn’t own its own brands and sporting and camping goods are quickly moving online. Maybe it can adapt in time, maybe not. It also doesn’t appear cheap, sporting a PER over 20. With a share price up 11% since 4 Dec 12 (Avoid – $8.95), AVOID. 

4WD accessories maker ARB Corp has been an outstanding investment for members over the years. It’s an exceptional business owing to its owner-managers, strong brands and overseas expansion opportunities. It’s better equipped than most to adapt to the changing retailing environment. But on a PER of over 20, it’s looking expensive. The share price too has been rising, up 6% since 24 Oct 12 (Hold – $10.71). For now HOLD.

This analysis also raises a pertinent and related question for Westfield shareholders: If retailers need less stores, what about landlords Westfield Group and Westfield Retail Trust?. It’s a fair concern, and was partly incorporated into our reassessment of Westfield last year (see Reassessing Westfield—Part 1, Part II and Part III). Our general view on retail property was covered more recently in Property sector round up 2012.

Not so fast

Discretionary retailers are inherently fragile—they have limited tangible assets, slim margins and low barriers to entry. Add in the added threat of a fundamental disruption to their traditional business model and Schumpeter had it right.

In Capitalism, Socialism and Democracy he wrote that, ‘In capitalist reality... it is not price competition which counts but the competition from... the new type of organisation... competition which strikes not at the margins of existing firms but at their foundation, and their very lives’.

The foundations of retailing are shaking and legacy businesses are under threat. We should expect a frank and honest assessment from management, and a comprehensive plan to deal with it. But we’re unlikely to get it. With only one or two notable exceptions, this is a sector generally best avoided.

Note: The Growth portfolio owns shares in ARB Corp, Billabong International, Westfield Group, whilst the Income portfolio owns Westfield Group securities.