Thinking about retailers right now?
Australian consumer-facing companies have faced unprecedented challenges and undergone significant transformation since the bushfires of 2019. From the profound impacts of the COVID-19 pandemic to violent mix-shifts from goods to services, and digital advancements, the sector has navigated a complex landscape.
Economic outlook and consumer spending
Australia’s GDP growth in Q1 slightly underperformed expectations, with a modest increase of just +0.2 per cent quarter on quarte and +2.3 per cent year on year. Notably, GDP per capita experienced a decline during this period, signalling challenges in the broader economic landscape. Furthermore, consumer spending growth exhibited slight weakness, falling marginally below anticipated levels. However, amidst these complexities, domestic demand displayed resilience and recorded solid growth in Q1, but this was primarily driven by robust business and public investment.
With the RBA raising rates again last week, it is likely further pain, for discretionary retails in particular, is on the horizon.
Inflation, labor costs, and wage increases
In Q1, inflation remained elevated, with services inflation retaining its strength while the goods price deflator remained unchanged. Additionally, labour costs in the retail sector are set to rise by 5.75 per cent as per the Fair Work Commission’s annual wage review for the year starting July 1, 2023. This increase, higher than historical levels, poses a challenge for Australian retailers and the impact on their financial performance, is a major concern for analysts. The wage increase primarily affects the lowest-paid workers, combining an administrative reclassification and a 5.75 per cent increase in the national minimum wage.
Evaluation of labour costs and impact on retailers
Investors must consider the proportion of a retailer’s labour costs to sales, gross profit, and cost of doing business (CODB). Retailers with lower labour costs as a percentage of these metrics are better positioned. For all retailers, it will be crucial to consider ongoing cost-saving initiatives and productivity measures that can offset the impact of higher labour costs. Investors should probably steer clear of retailers that fail to address this issue or communicate it to their shareholders. Additionally, the flexibility of labour costs and the ability to optimize them, such as shifting the mix of full-time casual staff, will be essential. Store size and the nature of products sold, particularly essential goods with resilient demand, are factors that may mitigate the impact of rising labour costs for same retailers.
Australian retailers
Retailers such as Woolworths (ASX:WOW), Wesfarmers (ASX:WES), and Coles (ASX:COL) are relatively better positioned due to their lower labour costs as a percentage of sales, larger store sizes, and their focus on essential products. These companies have implemented cost-saving programs, productivity initiatives, and ongoing efficiency measures to offset rising labour costs.
Retailers like Premier Investments (ASX:PMV), Accent Group (ASX:AX1), Universal Store (ASX:UNI), Lovisa (ASX:LOV), Harvey Norman (ASX:HVN), Super Retail Group (ASX:SUL), and JB-Hi-Fi (ASX:JBH) may face relatively higher labour costs as a percentage of sales, smaller store sizes, and an emphasis on discretionary products. These retailers may find it more challenging to offset the impact of rising labour costs, thereby increasing the risk to their earnings before interest and tax (EBIT) margins.
Of course, the challenges need to be assessed against market prices. If prices are cheap enough, the benefits that accrue from an eventual recovery in the consumer, and the economy more broadly, may offset the negatives currently being experienced at an operational level.
Valuation and other considerations
Trading updates from several key players suggest softer trading conditions. Universal Store, City Chic (ASX:CCX), Treasury Wine Estate (ASX:TWE), and AP Eagers (ASX:APE) all reported challenges recently, with excess stock and increased promotional activity creating headwinds. As a result, most stocks in the sector experienced significant declines.
There have also been some positive developments, with the travel and accommodation subsector experiencing an increased share of wallet at the expense of household goods.
Webjet’s update confirmed as much, indicating that travel spending remains robust for now. This reflects our predicted mix-shift from goods to services (including travel) amid what I called ‘the economics of enough’ (consumers just bought too much stuff during the pandemic) bumping up against reopened borders.
From a macro perspective, overall employment conditions continue to be strong, but cost pressures and low consumer sentiment influence spending patterns. The duration of employment strength in the face of decelerating spending is a key question that remains unanswered. Will the RBA’s rate rises begin to translate into rising unemployment or recession? Most think it will.
Interestingly, Commonwealth Bank’s iQ’s analysis in early May provided surprising insights into consumer behaviour across different age groups and categories before the recent weaker trading updates. The analysis revealed that younger age brackets had exhibited the softest spending, likely due to rising inflation in rent.
Consequently, and perhaps less surprisingly, the apparel category has experienced the largest decline in spending among the under-35 demographic. That explains why Universal Stores took a serious share price hit; its CEO surprised analysts by confirming the age of its target market was much higher than analysts had assumed. Its share price is down 50 per cent since January 30 this year.
Universal Store’s share price decline of 40 per cent in May, was not unique. Other ‘youth’ brands such as Lovisa and Accent Group, the latter being the owner of Hype DC and Platypus shoe stores, declined 22.5 per cent and 30 per cent in May, respectively.
With cost pressures expected to rise further in the coming year, thanks in no small part to twelve RBA rate rises, it is expected trading updates will continue to soften. Forecasting the performance of retailers is challenging due to their significant operating leverage. Small changes in sales and gross margin assumptions can have substantial impacts on earnings, considering the inflationary pressures on staffing and rents.
For that reason our domestic investment teams are maintaining a very cautious posture towards most retailers.
The market however tends to focus on short-term headwinds in valuations, often overlooking long-term prospects, even in cyclical sectors like consumer discretionary.
There will eventually be a price at which higher-quality retailers become very attractive even amid the doom and gloom. Identifying alpha opportunities within this sector is an activity that shouldn’t be ignored over the next twelve months. Factors to consider include earnings expectations relative to the macro backdrop, valuations in relation to sustainable earnings, management’s strategies for different macro scenarios, and each company’s positioning with regard to inventory and cost-base contingencies.
Conclusion
For investors considering the Australian consumer sector, it is important to acknowledge rising labour costs, interest rate increases, declining consumer savings, and recessionary fears. While these challenges pose complexities, they also present opportunities.
When assessing potential retail investment opportunities over the next twelve months, it’s going to be crucial to consider their ability to effectively manage labour costs in relation to sales, profitability, and operational expenses. Companies with lower labour costs as a percentage of key metrics may be better positioned to withstand near-term economic uncertainties, maintain their competitive advantage and even take market share. Evaluating their strategies for cost-saving initiatives, productivity improvements, and operational efficiencies can provide valuable insights into their potential for resilience and profitability.
And then there’s the growth outlook for store openings. Retailers with a long runway for expanding their store footprint may see more share price volatility in the short-term, especially if they are selling discretionary goods, but any share price weakness may simply serve to boost future returns when the market regains its appetite for risk and growth.
For now, investors need to consider the impact of rising interest rates on retailers’ borrowing costs and consumer spending and their effect on sentiment towards owning retail stocks. In the past, P/E ratios have fallen into the mid-single digits before and during the early stages of a recession. Companies with prudent capital structures (less debt) may be better equipped to navigate higher borrowing costs and adapt to changing market conditions.
The Montgomery Funds own shares in Woolworths and Treasury Wine Estates. This article was prepared 13 June 2023 with the information we have today, and our view may change. It does not constitute formal advice or professional investment advice. If you wish to trade these companies you should seek financial advice.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
