Hello again everyone, I’m David Walker from StocksInValue. I cover the retail sector for Clime and StocksInValue and one reason I find it so interesting is the sector is relevant to everyone. We all shop because we all need to buy goods and services, and that will never change. This means that as shoppers, well before we become investors, we already know a lot about what’s happening in retail and we have opinions about which retailers and concepts are succeeding and failing. As investors you’ll then be aware of the big stories in retail, for example Woolworths’ failures and now its turnaround, Wesfarmers’ outperformance in grocery and DIY and its expansion into the UK, Myer’s turnaround and the phenomenal success of Premier Investments and Domino’s Pizza.
Today I’d like to discuss three retail trends you might not have seen in the headlines but which are shaping the future of retail models and earnings. Soon enough you’ll see these in the headlines, so it’s worth considering them in your research. As with any trend your task is deciding how important the trend is, whether it will extend or decay and at what rates.

Disruptive trend 1: The rise of online price comparisons

The first trend to consider is what’s happening in business-to-consumer e-commerce and here we’re seeing the rise of online marketplaces and online price transparency. Australian shoppers have for some years been comparing prices online and the increasing penetration of smartphones, apps and affordable home broadband have made this shopping practice easier and cheaper. Feedback from the retailers I speak to is Australians are now quite sharp in doing their research and comparing prices online before buying. One reason to expect heightened price competition in many retail categories and indeed price deflation in some, like grocery, is everyone has a price deflation machine in their pocket: a smartphone.
This will continue to make it difficult for retailers to manage their margins by lifting prices unless their rivals do the same, but there’s a wider online threat coming around the corner: Australian retailers’ use of online marketplaces like Amazon and eBay to sell their own products, and whatever product lines Amazon itself might bring to Australia. This table indicates the potential for Amazon to become a competitive threat in Australia.

Sold by Amazon.com.au Sold by Amazon.co.uk
Books Books
Movies, TV, Music & Games
Electronics & Computers
Home, Garden, Pets & DIY
Toys, Children and Baby
Clothes, Shoes & Jewellery
Sports & Outdoors
Beauty, Health & Grocery
Car & Motorbikes
Business, Industry & Science

At the moment Amazon.com.au only sells books but in the US and UK Amazon retails an array of personal, household and other goods including groceries, and they do same-day delivery outside city centres. This has been a powerful disruptor to traditional retailers like Wal-Mart, Debenhams and Marks & Spencer. In the UK, macro retail conditions are strong with low unemployment and high consumer confidence but retailers are downgrading and online competition is a prominent reason. Wesfarmers CEO Richard Goyder has rated Amazon a far more serious potential competitor than Woolworths, Aldi and Big W.
So how should you factor this into your retail stock valuations? By not using aggressive equity multiples. For example, when valuing Wesfarmers after its interim result we chose a lower adopted NROE of 16.5% rather than the 18% justifiable had the momentum in that result continued for another two years. Obviously also think carefully about your portfolio weightings to stocks affected.

Disruptive trend 2: Climate change and changing weather patterns

The second disruptive trend is climate change and how it’s making margin management harder for apparel retailers. Australia’s summers are becoming hotter and longer and the old model of having long sleeves, coats and knitwear in shops in February-March, when people don’t want to buy warm clothes, is now broken and obsolete in my view.
Look around the apparel retailers and department stores in your local mall and you’ll see fairly widespread discounting of winter clothes. For example, Portmans had a 25% sale, then they had a surprise 50% sale of everything in the store and now they’re onto another 25% sale on knitwear.

Portmans store, Pitt Street Mall, Sydney, 29 April 2016
Walk into any store and the reason is clear: coats, sleeves and knits when it’s still 25-27 degrees outside depending on where you live. The long hot summer will also affect Myer and Kathmandu. Discounting due to “unseasonal weather” will be a feature of second-half retail results but I’m getting tired of this excuse, which I’ve heard for many years now, because what used to be unseasonal weather is now seasonal and retailers that aren’t adapting to this have their heads in the sand.
The response of apparel retailers in the UK is a guide to what will have to happen here. In the UK, four of the last five winters were very mild, which created havoc for retailers loaded up with winter stock. In response the department store Debenhams is deweighting clothing in its sales mix because the category is simply becoming too risky. Others are reducing exposure to outerwear like coats and are selling more layering products which can be added or removed depending on the temperature. The whole fashion industry will change to longer transitional seasons with corresponding ranges. In Australia this will mean more crossover summer and autumn ranging and a shorter winter season. In short clothing retail is becoming more of an exercise in weather risk management and again it could favour e-commerce brands with fast, global supply chains which can provide inventory matched to local weather conditions. The traditional model of high fixed cost shopfronts with clothes stuck on racks on the floor could emerge as less efficient.

Disruptive trend 3: Currency volatility complicating margin management

Our third disruptive trend is the recent bout of currency volatility, which saw the Australian dollar spike from 68 US cents in January to 78 cents recently.

You might think this is an outright positive for the retailers given much inventory is imported, but it depends on each individual retailer’s hedging policy. Anyone who fully hedged at 70 US cents, say, in January, is now groaning because they’ve missed the subsequent rally which makes imports cheaper. They’re now stuck with dearer inventory and the need to pass on their higher costs through price rises. This will especially be a problem if they don’t have pricing power but competitors didn’t fully hedge and are now importing product more cheaply. We will see these effects in second-half results.
And we could go on for longer but that’s enough for one presentation so thankyou for watching and I’ll see you next time.

Clime Asset Management owns shares in WES and WOW on behalf of various mandates for which it acts as investment manager. David Walker owns shares in WOW.