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Retail sector wrap: One opportunity and plenty of worry

By John Addis founder of Intelligent Investor

The failure of electronics retailer Dick Smith taught many investors that buying stock in a private equity-led float might not be such a good idea. There have been exceptions, of course - Seek, JB Hi-Fi and Invocare spring to mind – but as a general rule, avoiding private equity IPOs will save you money.

But there’s an even more important lesson to take from Dick Smith’s collapse: retailing is hard, and speciality retailing is even harder.

In Australia, for every JB Hi-Fi and Harvey Norman, there’s a Brashs and a Strathfield Car Radio. In the US, the success of Apple’s retail stores is offset by the failures of RadioShack and Circuit City. Electronics retailing is a tough game. Without significant competitive advantages to deliver ever lower prices, customers will shop elsewhere, leaving a declining business full of old, unsaleable stock.

Fashion retailing doesn’t possess the same, relentless decline in pricing as electronics but it’s still a competitive, low-margin game. The growth of online retailing has made things even worse, as has the arrival of well-known international chains like Zara, H&M, Sephora, Michael Kors and Uniqlo. The fall in OrotonGroup’s profitability and share price coincided with the arrival of these newcomers.

Billabong’s troubles at the start of this decade are simply evidence of the difficulties of successfully growing a retail brand with an international footprint. Businesses with little market power, operating in competitive, low-margin sectors don’t make for great investments.

Electronics and fashion retailing is especially difficult because the real power lies not with the company but with its customers, suppliers and landlords. There’s no room for management to make mistakes. When things go awry, small problems quickly become big ones. That’s the real lesson from Dick Smith’s failure and the reason we rarely find bargains in the sector.

In fact, over the past two years The Reject Shop was the only specialty retailer that made it onto our Buy List. That’s not to say you won’t uncover opportunities, just that you need to look beyond the rats and mice in the sector to find them. The best investments are in companies with lots of market power, not an absence of it. Right now two stocks meet that description - one on our Buy List right now and one we’d like to purchase if the price were to fall another 20% or so.

Although the rise of Aldi is increasing competition, supermarket retailing is characterised by two major players with pricing power over their customers, suppliers and landlords.

Woolworths is the most troubled of the two, but also the bigger opportunity because of it. Since hitting a high of $37.74 on 21 April 2014, the share price has fallen over 40%. Woolies’ margins were too high, leaving the door open to a resurgent Coles. The headlines and results have been atrocious, with sentiment turning against the company, delivering what we think is an attractive opportunity.

It will take time to turn around same-store sales growth, and it’s likely to lag behind Coles for a while yet, but Woolworths has now at least thrown down the gauntlet. We’re expecting more bad news and further profit declines. A lower share price is quite possible, as is a price war.

If you’re thinking of stepping in, remember that Masters and Big W are not the main game. First and foremost, Woolworths must fix its food business. In recent months it has taken decisive action. The company now has a well-regarded managing director, a new head of Big W and a replenished board. Soon, it will also be free of the Masters distraction.

It will still take time to reverse the 0.8% decline in same-store sales that food, liquor and petrol reported in the last half, but there are already signs of improvement. Right now the market is in no mood to cut the company some slack, which is why Woolworths trades on an underlying 2016 price-earnings ratio of around 16 and an enterprise value to EBITDA multiple of 8.

With more than $60 billion in sales and 960 supermarkets around Australia, this is a substantial, ultra-high quality retail group. The company’s shares aren’t screamingly cheap but they are good value for patient, long-term investors. Right now, Woolworths is the only retailer on our Buy List and if it gets cheaper, we’ll probably be buying more.

Our second pick isn’t classified as a retailer at all, but is dependent on other retailers for its income. The name Scentre Group may be largely unknown by the nation’s shoppers, but its Westfield brand is iconic. Scentre is a giant of the Australian retailing scene. With the release of its first full-year result since the 2014 restructure of Westfield Group, this owner of Australian and New Zealand Westfield shopping centres again demonstrated its strength.

In 2015, Scentre’s Australian shopping malls generated around $20.6 billion in retail sales. Using one recent estimate, this means around 6% of Australia’s total retail activity took place in a Westfield mall. Its New Zealand malls generated another $1.9 billion in sales. The crown jewels are its Bondi Junction and Pitt Street Mall properties in Sydney. Both generated more than $1billion in total sales in 2015 and the latter’s retail complex and office towers are now valued at more than $4.1 billion.

Like other major shopping centre landlords, Scentre has moved away from acquiring new sites and is instead focusing on improving returns from its existing properties through development. In the current market of low capitalisation rates (and hence high prices) for existing shopping centres, this strategy should deliver a better return on investment.

Table 1: Scentre annual result 2015

12 months to Dec 15

2015

Total revenue ($m)

2,868

Borrowing exp. ($m)

499

Distrib. Profit ($m)

1,199

Distribution (cps)*

20.9

Gearing (%)**

34.7

NTA per share ($)

3.32

*10.45c final distribution, unfranked,  ex date already past 

** Gearing = net debt/(total tangible assets - cash)

Note: no prior period data due to 2014 Westfield Group restructure

Scentre started $830 million in development projects in 2015 and another $495 million in 2016 (of which its shares amount to $580 million and $425 million respectively), with a further $3 billion worth of development in the pipeline.

Unfortunately, owning many of the finest retail properties in the land is something that hasn’t escaped investors’ attention. Scentre’s shares trade at a significant premium to net tangible assets (NTA), even after capitalising its management and development income. With an attractive yield, this is a company we’d love to own but right now, it’s too expensive.

The same could be said of the entire A-REIT sector. The search for yield means most A-REITs are selling at a premium to NTA, a figure inflated by property values being pushed up by low interest rates and declining debt costs. Even the mediocre yields are unattractive, which is why our sweep of the sector last year uncovered no Buys, six Holds and a truckload of Avoids.

Scentre remains the pick of the bunch. So, how much would we be prepared to pay for this outstanding business?

In the latest result, NTA per share came in at $3.32. With around $380 million of development due for completion this year, that should increase this figure. At around $3.50 a share, there’d be sufficient margin of safety to protect investors from unexpected events like rising cap rates, declining retail activity and development delays. That would be the trigger price to get on board.

Disclosure: Staff members may own securities mentioned in this article.

This article contains general investment advice only (under AFSL 282288). Authorised by Alastair Davidson. To unlock Intelligent Investor stock research and buy recommendations, take out a 15-day free membership at http://landing.intelligentinvestor.com.au/asa

 

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