Value in retailers hard to find
I always enjoy writing about retailers. Partly because one uses the retail sector most days and can factor those experiences into investment decisions. And because investing in emerging retailers relies on spotting management that excels at anticipating consumer needs.
Also, the “herd” tends to oversell or overbuy retail stocks, based on top-down trends. Fearful of declining retail sales growth, the market thumps retailers en masse, even though there are always winners (think Aldi) and losers (think Myer Holdings) when consumers struggle and change spending habits.
Some retail stocks have delivered soaring returns this year despite never-ending gloom about consumer weakness and rising competition. Electronics retailer Kogan.com has a 163 % total return over one year. Fashion jewellery retailer Lovisa Holdings is up 61%.
They and other retailers are reminders that the sector has plenty of life and that strong management and an excellent retail concept can create rapid shareholder wealth.
But it’s too soon to take an aggressive contrarian view on beaten-up retailers. My sense is the sector will get cheaper in the next few months as the market turns its attention to poor first-quarter trading updates in the upcoming Annual General Meeting (AGM) season and a weakening outlook.
Retailers face three big headwinds. The first is the consumer, who is under pressure from rising energy, health and education costs, as well as record-low wages growth. Consumer sentiment is in the doldrums, even though business sentiment is improving. That bodes poorly for the all-important Christmas trading season, which looks like being a shocker this year.
The second headwind is price deflation. One retailer after another is having to lower prices or discount to win business, amid rising competition from local and international players and sluggish consumer demand.
It’s hard to see an end to price deflation in retail, particularly in fashion, anytime soon. Retail profit margins in Australia, high by standards in larger developed markets, have further to fall. Lower margins and lower sales volumes can be a fatal combination in retail.
Disruption is the third headwind. Amazon paranoia has gripped the market with fears that the online retail giant will smash local retailers as it ramps up operations this year. The fears are overdone in some cases: I can’t see pet owners deserting Greencross’ PetBarn for Amazon or Bunnings’ enthusiasts giving up their Saturday sausage sizzle to buy hardware online.
Retailers in the latest profit season were at pains to highlight how Amazon is not a major threat and that their defences are in place. My view? The Amazon threat to retail, generally, is understated rather than overstated. Avoid retailers that are selling largely undifferentiated, commodity-style products or do not have a compelling service proposition feature.
These three trends shape my thinking on the sector. As outlined previously for the Switzer Super Report, my preference has been for retailers with strong overseas growth prospects and less leverage to the Australian consumer. Lovisa is an example: I identified it in this report in September 2015 at $3.20 and it now trades at $5.24.
Chart 1: Lovisa Holdings
Premier Investments has been another long-term retail favourite because of the international growth prospects of its Smiggle brand and the strength of its Peter Alexander chain.
Premier has fallen from a 52-week high of $16.31 to $12.83 amid signs that its Australian-focused retail chains are struggling and because of its ill-timed purchase of Myer shares.
The sell-off looks overdone, but Premier could fall further in the next few days or weeks as the market digests its latest result. I still believe stationery chain Smiggle is one of the great Australian retail concepts and has years of international growth ahead.
Chart 2: Premier Investments
I have also written favourably this year on Breville Group and cosmetics supplier BWX. Both fit my approach of investing in retailers (or wholesalers, in their case) with strong international growth prospects. Breville’s one-year total return (including dividends) is 30%. BWX has delivered 21%. Both stocks have good prospects and still look a touch undervalued.
Chart 3: Breville Group
Chart 4: BWX
Fast-food franchiser Collins Food is another favoured stock. The owner of KFC outlets is expanding in Germany and The Netherlands through cautious acquisitions. I wrote favourably about Collins Food for this report in April 2017 at $5.17 a share. It is now $5.87 and likely to head steadily higher over the next few years as its offshore footprint expands.
Chart 5: Collins Food
My worst retail ideas for this report veered from the offshore-growth formula. OrotonGroup and Myer Holdings were included in this report’s takeover portfolio because they looked cheap at the time and were M&A candidates. Both have disappointed.
Chart 6: OrotonGroup
In addition to offshore-focused retailers, look for those that dominate a niche or provide a product that is not easily replicated online. Kathmandu Holdings is an example. Every second fashion retailer, it seems, has jumped on the athleisurewear theme by selling puffy sports jackets or other outdoor wear. Yet Kathmandu continues to grow.
The FY17 result, released this week, was high quality and slightly better than the market expected. The shares jumped 8%. Kathmandu reinforced the value of management that oversees and improves product range, inventory and store management. The New Zealand-based company is performing well because of micro rather than macro factors.
I nominated Kathmandu as a retail turnaround idea for this report in September 2016 at $1.93 a share. It is now $2.10 and likely to head higher over the next 12 months as an improving operational performance boosts confidence in new management and the strategy. Kathmandu has a fantastic brand and loyal customer base to leverage.
Chart 7: Kathmandu Holdings
Another retail idea in that September 2016 report, cosmetics provider McPherson’s, is up 43% over one year (including dividends). It is among the more interesting micro-cap stocks on ASX as consumers buy its “affordable luxury” cosmetics.
Chart 8: McPherson’s
Motorcycle Holdings is a new addition to my favoured retail stocks, and fits the bill of companies less threated by digital retail disruption. I can’t envisage large volumes of motorcycle enthusiasts avoiding dealerships – and the service that comes with it – to buy online.
The company listed on ASX through a $46 million Initial Public Offering in April 2016 at $2 a share and now trades at $4.24. Motorcycle Holdings, operating for almost three decades, is Australia’s largest motorcycle dealership with 27 outlets.
Chart 9: Motorcycle Holdings
Record sales growth in FY17 underpinned 16 % growth in profit to $9.3 million. The 17% growth in motorcycle sales stood out in a challenging retail market.
Motorcycle Holdings’ 17% growth in new motorcycle sales compared to 2% rise for its industry. The business is clearly outperforming and taking share from rivals.
I like Motorcycle Holdings’ prospects to consolidate a fragmented dealership market through acquisitions and organic growth. It bought three dealerships in FY17 and funded them from existing cash instead of debt or equity capital raisings. That’s always a good sign.
Motorcycle Holdings can become more entrenched in the total motorbike purchase process. It sells new bikes, used bikes, accessories and parts, provides servicing and repairs, and offers finance, warranties and insurance. More touchpoints increase “switching costs” when customers considering moving to rivals and make it hard for online competitors.
Top car dealerships use this formula: open more outlets to create economies of scale, funnel extra products and services through each and lock in customers by servicing a range of upfront and ongoing purchase needs. We’re yet to see this type of model used as extensively in motorbike dealerships as it has been in cars, meaning Motorcycle Holdings has a valuable first-mover advantage that it appears to be exploiting well through good management.
The main issue is valuation. Motorcycle Holdings traded on a forecast Price Earnings (PE) multiple of about 14 times on some broker forecasts, and a trailing PE of 15.5 times. That is a decent valuation for a micro-cap stock with limited history as a listed entity.
But the company’s performance since listing and promising outlook warrant a premium. Share-price gains will be slower from here, but Motorcycle Holdings has a bigger opportunity than most comparable retailers and is less affected by the threat of digital disruption.