Having lived through a period of over-consumption are we now facing a consumption hangover?
As the dust settles on another festive season the mind very quickly moves to the year ahead. Any portfolio manager will tell you that one’s portfolio is never far from the front of their mind. Even during this seasonally quieter period for company updates and broader news flow we at Chester approach 2023 with a healthy level of anxiety.
As investors it is the sense of unease about the companies that we own that motivates us to continually review and test the assumptions that underpin our investments. A portfolio manager is forever seeking additional information that either strengthens or challenges the investment case they hold for companies.
Arguably no segment of the market embodies this time of year like the retail sector. From Christmas gifts and family celebrations to new year festivities and back-to-school preparations, the importance of this period for retailers can’t be understated.
As we await the annual barrage of updates over the coming weeks as companies and various industry participants offer their assessment of the all-important December-January trading period, there is no escaping the fact that 2023 offers a decidedly uncertain outlook for domestic retail.
Did that really happen…?
The level of disruption felt by retailers over the last three years is well understood. By necessity traditional spending patterns and behaviours went out the window as the impacts of lockdowns, store closures, travel restrictions, stimulus packages and global freight disruption all contributed to a retail environment no one could have anticipated.
Personally, the reminders of this unprecedented period are all too many. From the constant emails of retailers purchased with during the pandemic to the frequent online grocery orders that continue to arrive and of course the far too many streaming services that continue to be paid for (but less frequently watched) there is no doubt consumers and retailers alike adapted to the conditions.
Highlighted below (Chart 1) and notable for the extreme volatility caused by the changing Government rules through the period, the net result is that Australians spent at a very healthy rate in recent years. Buoyed by historically low interest rates and the confidence gained from record house prices, together with restrictions on things like travel and entertainment, retail consumption grew well in excess of historic rates. The challenges faced by retailers sourcing enough product to keep up with the extreme demand also saw discounting materially reduced from historic levels resulting in the expansion of gross margins as consumers became less concerned about price and very focused on availability. (See Table 1)
Chart 1. Source: ABS, Macquarie
At a category level some of the ASX’s largest retailers were amongst the biggest beneficiaries from the strong consumption through the period. Viewing the below chart (Chart 2) it’s easy to see why the likes of JB Hi-Fi (JBH), Harvey Norman (HVN), Wesfarmers (WES), Metcash (MTS), Nick Scali (NCK) and Adairs (ADH) all saw their sales rise significantly through the period. Throw in the likes of Super Retail Group (SUL) with their key outdoor brands Rebel, Super Cheap Auto and BCF, plus the likes of Domino’s Pizza (DMP) and Collins Foods (CKF) whose customers valued the convenience of their fast-food offerings when dining options were restricted the list of ASX retailers to benefit from the changing consumer behaviour in recent years is quite extensive.
Chart 2. Source: ABS, Macquarie
Of course, achieving sales remains just one part of the equation for retailers and the ability to convert sales to profits and ultimately cash flow hasn’t been without its challenges. Across these measures the performance of domestic retailers has been decidedly mixed. The huge spikes in online demand during the pandemic challenged the supply chains and fulfilment capabilities of businesses like never before. Managing inventories has remained amongst the greatest challenges for retailers as extended delivery times from overseas suppliers has increased working capital requirements at a time when customer demand has remained highly volatile.
Covid winners... Where are they now?
The share prices of some of the earliest pandemic ‘Winners’ certainly highlights the challenges businesses have faced over the last couple of years (Chart 3). For the likes of Kogan.com (KGN), Redbubble (RBL), City Chic (CCX) and Adore Beauty (ABY) whose IPO was perfectly timed in October 2020, their online business models (with the exception of CCX who maintain some store presence in Australia) meant they were huge early beneficiaries of the consumer move to online shopping through the pandemic. Ultimately each has struggled to manage the costs associated with their rapid business growth as they’ve attempted to invest in stock and business infrastructure at a time when forecasting customer demand has been extremely difficult. In the case of KGN’s founder Ruslan Kogan’s predictions that having introduced millions of new shoppers to his site during the initial stages of the pandemic Australia would experience a permanent step-change in online shopping behaviour this hasn’t materialised. For KGN, this bet has been both expensive and painful as high supply chain costs have been absorbed as demand has slowed and excess inventory cleared at large discounts.
Chart 3. Source: Bloomberg
Returning to the outlook for 2023 there is no question that the conditions for domestic retailers are more challenging now. With inflation firmly embedded and central banks jolted to belatedly commence raising interest rates in 2022 household budgets will almost certainly be under more pressure. Cost of living pressures across key housing categories (including rents, food and utilities) and social services like healthcare and education look likely to remain elevated in the near term at least.
For homeowners, much has already been made about the approaching fixed rate mortgage reset horizon and it remains hard to predict how households will prioritise their spending as interest repayments rise. Savings levels remain higher than historic levels but the extent to which consumers will be prepared to further reduce their savings to continue to spend on goods and lifestyle items remains to be seen. Highlighted below (Chart 4), of the approximately 35% (~$740 billion) of household mortgages that are currently being serviced at fixed rates about two thirds are due to expire in the next 12 months and well over 80% by the end of 2024. Whilst subject to change, currently a mortgage holder would be looking at a >3% increase on their interest repayment rates. This is clearly material.
Chart 4. Source: RBA, Barrenjoey
Combined with the outstanding balance of variable mortgages that have already seen significant re-pricing higher since the RBA commenced the current rate hiking cycle in May 2022 it’s clear home owners are going to be allocating more of their income to servicing mortgages in the periods ahead. The below chart (Chart 5) offers an estimate of the size of increases households will face in the next couple of years as the interest repayments on their mortgages and other personal credit lines rise.
Chart 5. Source: ABS, Macrobond, UBS
Naturally, equity investors have already attempted to factor in the more challenging outlook for consumer stocks. Reviewing the best and worst performed ASX sectors of the last 12 months below (Chart 6) it’s clear that expectations for stocks within the ‘Discretionary’ basket in particular have been lowered as the approaching headwinds have risen.
Chart 6. Source: Bloomberg
Amongst the best performed ASX retailers through the pandemic affected 2021 and 2022 financial years (shaded grey below) it’s clear that some level of reversion toward historic sales and margin trends is anticipated over the next couple of years.
Perhaps the most reasonable conclusion to draw from the current consensus forecasts is that the Australian consumer is expected to prove pretty resilient over the next 18 months at least. To our mind, this possibility sits amongst the more optimistic scenarios that could unfold.
Table 1. Source: Bloomberg (f = Consensus forecasts)
What to expect in 2023?
Speaking to numerous management teams across the ASX retail landscape pre-Christmas there was a relatively unanimous expectation that Australian consumers were keen to enjoy their Christmas’ and spending was therefore likely to remain pretty healthy over the holiday period. While suggesting there were some signs shoppers were becoming a little more reluctant to transact without deeper discounts through the November ‘cyber’ sales period for the most part executives we spoke to remained cautiously optimistic.
Beyond the Christmas/new year period however, most management teams recognised the likelihood that some collective ‘belt-tightening’ was probable in 2023 as the challenges highlighted earlier materialise. The scene is therefore set for potential positive earnings surprises in February if as expected consumers continued to spend throughout 2022 and profit margins remained resilient. Recognising that this appears the consensus view we’d expect the market will be more focused on the outlook with the key areas of focus likely to include: Initial sales performance in the new year, inventory levels and associated working capital and cash flow performance and finally gross margin trends and discounting behaviour.
Beyond near-term trading expectations much of our recent discussions with listed retailers has centred around the extent to which the recent disruption to the sector is likely to prove permanent and how this stands to benefit or challenge their businesses. Hardly surprising, most management teams were naturally optimistic that they would emerge from the last few years in a better competitive position.
The working from home movement remains topical and not surprisingly the likes of JBH, HVN and BRG are optimistic that the persistence of this trend should be an additional tailwind for their businesses as consumers continue to invest and upgrade their home offices. The belief that the pandemic only further consolidated technology as a central component of one’s lifestyle is hardly surprising. A slightly more off-centre take on the potential tailwinds more working from home would deliver a business was offered by Premier Investments (PMV) chairman Solly Lew in 2022 when he suggested people (himself included) are spending more and more time at home in their pyjamas. Recent results from the group’s best performing brand Peter Alexander suggest he may well be right.
Retailers such as SUL and KMD Brands (formerly Kathmandu) whose stable of brands includes Rip Curl, are optimistic that the pandemic has supported a shift in lifestyle priorities that will see people continue to favour more time outdoors beyond the major cities, a potentially favourable trend for these companies.
The importance of digital engagement with customers and the role of online in the overall retail experience will continue to remain very topical for the sector. For the many ASX retailers that maintain large store networks across Australia their performance over the last couple of years has largely supported their conviction in the ‘omni-channel’ retail model that offers customers maximum flexibility about how they buy from them. With recent feedback suggesting major shopping centres saw foot traffic very close to the levels experienced pre-pandemic it seems likely that predictions the pandemic would rapidly accelerate the demise of bricks and mortar retailing were misguided. The below chart (Chart 7) highlights that entering 2023 online purchases as a percentage of total retail sales has more or less returned to its recent growth trajectory.
Chart 7. Source: ABS, Macquarie
Amongst a number of ‘omni-retailers’ it has been noted that a positive outcome from consumers increasingly using technology to research and compare products online is that stores have become more productive in recent times. That is, shoppers are increasingly arriving at stores ready to spend because their “browsing” has already occurred online. Together with more favourable lease terms achieved through the pandemic by several retailers these factors should offer some offset to potentially more challenging retail conditions ahead.
The experiences of the major supermarkets over the last couple of years sets the scene for an interesting period ahead. Despite the sales benefits enjoyed by each of Woolworths (WOW) and Coles (COL) throughout the pandemic the challenges of servicing significantly higher rates of online ordering and managing national supply chains regularly disrupted by staffing challenges and volatile customer demand has seen profit margins come under pressure. Noting the different strategies and partnerships WOW and COL are employing to service online shoppers how the respective management groups balance their considerable investment across store networks, online and customer loyalty programs, and their supply chains will be closely watched.
For MTS, as a wholesaler to the grocery sector (amongst others), while their model certainly offered it some protection from the cost challenges faced by the majors over the last couple of years it remains to be seen if it can retain the incremental market share gains it enjoyed as shoppers shopped more regularly at their community stores. A potentially more value conscious shopper over coming periods would certainly open the door for Aldi to recover the market share it ceded during the pandemic as it struggled with its international sourcing, especially for its popular general merchandise offers.
The role of the online ‘Marketplace’ in the retail landscape is another keen area of focus for management teams. In an increasingly crowded segment of the market the acquisitions of Catch Group (by Wesfarmers in June 2019) and MyDeal by WOW last year suggest competition will likely remain strong at a time when online shopping trends have moderated materially from pandemic peaks (Chart 7). For WES, despite their scale and expertise as one of Australia’s leading retailers, the widening losses they are now incurring in the Catch business as they invest in key eCommerce functions such as fulfilment and customer acquisition/retention suggests further pain may lie ahead in a weakening consumer environment. Interestingly, feedback suggests Amazon’s growing scale in Australia appears to be largely coming from other online players including eBay and Kogan rather than traditional players with large store networks at this stage.
So where do we sit?
As always, the range of possibilities for both the Australian economy and listed equities in 2023 remains wide. How the RBA responds to a slowing economy and current inflationary challenges will certainly flow through to household confidence and consumer behaviour.
For Chester, the unemployment rate looms as a key variable in 2023 and something that will be closely watched. Australia’s historically low current unemployment (Chart 8) offers some optimism that should Australia manage to avoid large scale job losses the Australian consumer may prove more resilient than has been witnessed in numerous offshore markets in the past 12 months as consumer behaviour has quickly adjusted to tougher economic conditions. This would appear to offer some upside to the current consensus thinking and is certainly something we remain cognisant of.
Chart 8. Source: ABS, Goldman Sachs
That said, there is little doubt Australians are facing some tough choices as to what they value most as household budgets are squeezed. Having lived through a period of over-consumption the very real possibility that we are now facing a consumption hangover can’t be ignored.
While acknowledging some of the anticipated challenges faced by ASX retailers in 2023 is clearly factored into current share prices Chester begins 2023 with limited direct exposure to the consumer sectors. Amongst the ASX’s ‘Discretionary’ names in particular we remain cautious that margins will come under greater pressure than is being forecast. Expectations by some management teams that at least some of margin expansion achieved over the last couple of years can be retained in a tough economic environment seem dubious. Consistent with Chester’s investment process (see appendix) that has seen the fund allocate a relatively consistent part of the portfolio to stocks most exposed to the economic cycle (specifically; ‘Cyclicals’) we currently see better opportunities elsewhere.
Whilst current portfolio positions such as The Lottery Corp (TLC), News Corp (NWS) and Brambles (BXB) are clearly exposed to not only domestic consumption, but offshore too, we remain optimistic of the resilience of these businesses and their cash flows in tougher economic conditions.