Two retail stocks to consider holding

The share market’s capacity to rally in surprising places never ceases to surprise. As investors are spooked by unrelenting media doom and gloom, the smart money looks forward, buying undervalued stocks.

Consider the supermarket giants, Coles Group and Woolworths Group. Coles is up almost 20% from its opening price in November 2018, after Wesfarmers demerged the business. Woolworths has a one-year total return (including dividends) of 35%.

I nominated Coles as one of the top stocks for 2019 in The Switzer Report in January. Coles has rallied from about $12.50 to $14.84 since then.

Nominating a retailer as a top stock for 2019 was hard. A chorus of commentators last year warned that retail Armageddon was imminent amid a weakening economy, Amazon’s arrival in Australia and immense competitive pressure – supermarkets would suffer from slowing sales growth, price deflation and the rise of Aldi and Costco.

They were right, to a degree. Lousy consumer sentiment and retail sales growth contributed to Australia’s economy growing at the slowest pace in a decade. Several smaller retailers went bust, profit downgrades were rife and most in the sector felt the pinch.

Having a top down view on a sector, particular one as cyclical as retail, is important. But relying solely on macro data to inform stock decisions is dangerous. It can blind investors to value and imply that every stock in a sector should be avoided, when some are outperforming.

Worse, it can fixate investors on the past, when money is made by looking ahead.

Global economic indicators have stabilised a little in recent weeks, the United States and China have advanced trade talks and even Britain’s exit from the European Union is making progress. We might have hit a cyclical trough in the global business cycle, with better conditions next year.

In Australia, tax and interest rate cuts will eventually stimulate the economy, although not as much as in previous years given household debt. Population growth is another plus for retailers, as is rising housing prices and their effect on spending through the “wealth effect”.

Not for a minute am I suggesting that a retail recovery is imminent or that it is time to buy retail stocks aggressively. Rather, that sector conditions might be a little better this time next year and a small group of high-quality retailers could continue to make strong gains.

JB Hi-Fi is an example. The electronics retailer has a total return of 70% over one year and is trading near its high. Contrarians who bought it at its 52-week low of $20.30 now own stock worth $36.91 and it remains a core portfolio growth stock.

Premier Investments, owner of the Smiggle and Peter Alexander chains, soared in September after beating market expectations with its FY19 results. The stock is up from a low of $13.61 to $19.00. I have written favourably on Premier several times for this report in the past few years, mainly because of its overseas growth potential. My positive view on Premier remains.

Supermarkets

Glimmers of retail hope came from the supermarket giants this week. Coles reported a 1.8% increase in first-quarter FY20 sales to $8.7 billion.

Comparable store sales growth of 0.1% in supermarkets was the worst in 12 years but ahead of bearish market expectations of a sales contraction. Importantly, Coles said early results in the second quarter of FY20 suggested sales growth was tracking higher.

Grocery sales offered a few green shoots with a slight lift in price inflation in grocery and dairy, offset by price deflation in produce. The market liked the result, driving Coles shares higher.

A few days later Woolworths announced 7.2% growth in first-quarter sales for FY20, to $15.9 billion. Its Australian same-store sales grew a record 6.6% – far above Coles’ growth. Clever marketing promotions aimed at kids and online growth boosted the result.

Woolworths expects sales growth to moderate over the year, probably to around 4 per cent judging by analyst expectations. Even at that rate Woolworths continues to outperform Coles on same-store sales growth, as it has done for 11 of the past 12 quarters.

Overshadowing Woolworths’ soaring sales growth was its admission this week that it had underpaid 5,700 staff by an estimated $200-$300 million over nine years. That bombshell tempered the sales news – and shone a light on Woolworths’ labour practices.

The underpayment issue could linger: it relates to wages errors around enterprise bargaining agreements and Woolworths self-reported it. The problem made front-page news on major websites and the market’s muted share price reaction to Woolworths’s strong quarterly result suggests investors are concerned. The stock fell 1.4% on the news.

I suspect the market will focus more on Coles and whether it has paid staff correctly after Woolworths’ news, given the similarity of their operations. Any negativity could create a buying opportunity for long-term investors if takes enough wind out of the retailers’ stock gains.

Woolworths -v- Coles

I would not put new money to work in Coles or Woolworth at current prices after their rallies this year. In broking parlance, both stocks are a hold. Consumer spending remains weak, price deflation is an ongoing threat and competition from Aldi and Costco is rising.

An average share price target of $29.42 for Woolworths, based on the consensus of 12 broking firms, suggests it is overvalued. Even the highest broker price target ($37) is below Woolworths’ current $37.20. 

Chart 1 - Woolworths

Source: ASX

Coles also looks overvalued based on consensus forecasts of 12 analysts. An average share price target of $13.05 for Coles compares to the current $14.84. If you believe the consensus, Coles and Woolworths are about 15-20% overvalued.

Prospective investors should watch and wait for better value. Both stocks are due for a share price pullback or consolidation after gains this year and Woolworths in particular looks vulnerable as the market digests the news on wages underpayment.

I prefer Coles. Its new store fitout and move into “grocerants” – casual-dining restaurants within the supermarket – impresses. My local Coles has had a huge makeover with new gourmet food sections and a trendy in-store diner and sushi shop. I cannot recall seeing the supermarket as busy as it was last weekend, with people flocking to its in-store cafes.

Coles is finally getting its act together on store innovation. Boring, generic supermarkets are slowly being replaced by more appealing stories. It is early days for the new fitout strategy, but it promises higher margins, greater in-store traffic and brand rejuvenation.

Coles will also benefit in the medium term from being demerged from Wesfarmers. I follow demergers closely. Often, the “child” company struggles in the first year after listing as it has to reinvest in the business (due to its parent-company neglect) then outperforms.

That could be true of Coles, which seems to have renewed energy as a standalone company and is lifting investment in its stores and marketing. It never ceases to surprise how quality businesses get a lease of life when they no longer compete for capital in their former parent.

Longer term, Coles and Woolworths can make bigger inroads into higher-margin, prepared food and out-of-home eating. They need to. In the United States, consumers now spend more on eating out and takeaways than on groceries and Australia is heading in the same direction.

Coles’ grocerant strategy has its critics, but to me looks a clever way to get people buying their coffee and lunch in a supermarket, rather than in a competing store in the shopping centre. Done well, it should revitalise interest in pre-prepared meals made by supermarkets.

Stronger growth in the supermarket’s home brands is another potential earnings driver. Coles has made good gains in increasing the percentage of home-brand items on shelves.

At the current price, Coles should yield a little over 3%, fully franked, on Macquarie numbers. The investment bank has a 12-month price target of $15.

Look to buy Coles below $14 or closer to the consensus analyst target. In an uncertain, slowing economy, Coles’ defensive qualities appeal, at the right price. Gains will be slower from here but the supermarkets have shown they can keep growing in a patchy economy.

Chart 2: Coles

Source: ASX