At our recent December investor briefings held around Australia, we highlighted many issues that investors needed to consider for 2016. In particular, we forecast that many import based retailers would be adversely affected by the devaluing $A. We felt that the bulk of the problems would develop by mid-2016 and so we were surprised when Lovisa Holdings had a downgrade last week that specifically highlighted the $A as a problem.
In our view the revelation by Lovisa Holdings Limited that its December half profit would be lower than market expectations is significant. This is because the issues highlighted by Lovisa are symptomatic of problems that lie ahead for many importing retailers. In the main, many retailers like Lovisa who import stock will suffer increasing working capital requirements and lower gross margins as currency hedges roll off.
Most treasurers and financial controllers of retailers would have aggressively covered their exchange rate commitments for imported inventory throughout 2015. In particular, we suspect that most listed retailers had inventory for the Christmas trade covered by forward exchange hedges in the US 78 to 82 cents level. However, moving into 2016 we suspect that hedges will rapidly deplete and forward cover will drift to the low US 70 cent level by mid-year.
So investors need to consider the ramifications of the declining $A. We can summarise the effects as follows:
- The cost of imported inventory or stock will rise. The bulk of discretionary retail stock will come from China and other Asian countries but it is generally settled in USD or Chinese currency pegged to the USD;
- The cost increase will have an effect on working capital and we will see many retailers draw on increasing debt to cover stock holdings. Higher debt will mean higher interest charges through the profit and loss account;
- The cost increases of imported inventory will necessitate an increase in retail prices for retailers to maintain gross margins. However the ability of retailers to pass on price increases will be tested by the low inflation environment and volatile consumer sentiment. Unfortunately 2016 will be a testing year for households with an election, a major tax debate and a difficult Federal budget. We suspect consumer sentiment will not be conducive to price increases.
However, the difficult trading position for retailers will have some respite from an unlikely source. From 1 January Australia’s Free Trade Agreement (FTA) with China has kicked in and many Chinese originated imported goods no longer attract duties.
The estimated effect is about 5% off the cost of imports (prior to the currency) and this will be a welcome offset to the increasing costs due to the currency.
Overall we estimate that the currency impost for imported inventory will be between 10% to 15%, whilst the FTA will slice this to between 5% and 10%. However, the affects will be different for each individual retailer and much will be determined by the trading terms negotiated with suppliers in China. It will certainly be prudent for investors to check outlook statements posted by retailers in the coming interim reporting season.
Our conclusion is that the biggest effect will be on retailers dealing in low price or discounted lines. Lovisa’s downgrade is a timely warning to investors to review their exposures to retailers who have poor pricing power.