Originally published by Cuffelinks
Change can be an investor’s worst nightmare. Fast-changing industries are often accompanied by equally dynamic competitive landscapes making the prospects for each player almost impossible to predict. Even more challenging, 70% of the gain in the S&P500 and 85% in the MSCI World index between 2012 and 2016 was due to P/E expansion. Investing requires navigating industries where an asymmetric barbell forms with a handful of massive winners at one end and virtually everyone else losing at the other.
Australian retail downgrades: permanent or temporary?
Investors in the Australian retail sector are perhaps the first to experience the effects of this ‘barbelling’ of outcomes locally and many are yet to fall into value traps. Some analysts believe that which is in fact permanent and structural is merely cyclical or temporary.
The arrival of Amazon has put the fox in the henhouse. In a recent note to its clients, Citigroup (NYSE:C) wrote:
“Amazon has confirmed their plans to enter the Australian market. Analysis of US, UK and German retailer performance around Amazon Prime market entry and our survey of price differentials results in downgrades to our long term earnings forecasts for JB H-Fi by more than 40% and Harvey Norman by more than 30%, following the expected launch of Amazon Prime in FY19e. We downgrade JB Hi-Fi to Sell and cut our target price by 35%. We maintain our Sell rating on Harvey Norman and cut our target price by 33%.” (My emphasis).
Another broker has performed a similar amputation to valuations for some of Australia’s retailers:
“We expect that Harvey Norman is approaching peak-cycle sales and earnings growth as the tailwinds from a prolonged housing cycle begin to moderate. The company also faces substantial competitive headwinds as Amazon prepares to launch in the Australian market …”
And,
“Whilst near-term earnings are likely to surprise on the upside, we think that structural and competitive changes in the Australian electronics industry, particularly from Amazon, will put pressure on long-term earnings. Whilst we expect JB Hi-Fi could extract greater synergies from its purchase of The Good Guys, it is likely that EBIT margins will remain under pressure.”
In the United States where fully 52% of households have an Amazon Prime account – that’s more than the number of households that own a gun or have a landline – the retail landscape may have irretrievably altered.
Foot traffic to shopping malls there has fallen by more than 50% in the last six years, reversing the experience between 1970 and 2015, when the number of malls grew at double the rate of the population.
Not only retailing but major brands
Amazon is not only putting a knife into the traditional model of retailing, it is starting a war with brands themselves.
It is now argued that brands earn an undeserved premium in return for offering consumers a short cut to the due diligence that would be required to identify varying levels of quality. The supporters argue that Amazon, through the use of technology and millions of consumer reviews, will serve customers better by removing the brand premium that is just compensation for advertising, in store promotions and shelf space deals with retailers, none of which adds value to the consumer.
Investors who have seen global brands as some of the most powerful economic franchises are on notice.
It may also surprise that the fixed-price tags found on goods in stores today is historically a relatively recent phenomenon, created to remove the need for owners of the once-new department stores to train staff in the art of haggling. Amazon (NASDAQ:AMZN) has dynamic pricing. Prices change by the minute and depend on your geographic location as well as your previous search behaviour. Check www.camelcamelcamel.com where Amazon product prices are tracked by the minute producing patterns like intraday stock charts. It is doing away with fixed price tags and permanently and simultaneously changing the price discovery power of consumers.
Through Amazon’s virtual personal assistant Alexa, Amazon offers cheaper prices, incentivising consumers onto the echo smart speaker and removing the important visual aids brands use to differentiate themselves. Unsurprisingly, Amazon offers up those products that it makes the best margin on and takes some brands completely off its shelves. It’s a strategy that suppliers to Coles and Woolies know only too well.
Retail collapses commonplace
For landlords of retail property and landlords of retail brands, the outlook has changed seismically. Witness for example the litany of recent retail collapses overseas this year, with dozens of major companies, thousands of stores and massive numbers of employees affected. Large retailers in the US have filed for Chapter 11 bankruptcy and Sears is expected to do so after July 17, to avoid the US bankruptcy code’s two-year look-back period.
Fashion retailer Bebe Stores closed all 180 of its stores and may file for bankruptcy to get out of the store leases, selling only online, while 44-store luxury fashion chain Neiman Marcus/Bergdorf Goodman, owned by Ares Management and the Canada Pension Plan Investment Board, announced it will not pay interest on a $600 million 8.75% bond issue in cash, but ‘in kind’.
The excess supply of retail space must kill growth in capital and rental yields for a long time and the shift from brands to homogeneity will decimate the margins for manufacturing, and down the track, innovation through research and development.
In Australia, struggling retailers including David Lawrence, Marcs, Payless Shoes, Pumpkin Patch and Herringbone were recently joined by Top Shop. The barbell emerges as retailers cop it on the chin, not only from Amazon’s arrival but from the projected 23% decline in attached dwelling starts, including the 38% decline in attached dwelling starts in NSW alone.
Construction and retail industries are the two largest employers in Australia and that makes navigating the next cycle even more challenging.
Ask whether lofty valuations are justified
The key is to come back to valuations and ask if current market prices are offering future returns that are unappetising? Remembering the higher the price you pay, the lower your return, one must wonder at the lofty valuations at which most assets are traded at today, especially those that produce no income.
Witness for example the Basqiat painting that sold for US$110.5 million, a record for an American artist and a record for a painting created after 1980. Closer to home, Shannons auctioned the NSW number plate ‘29’ with expectations of $450,000-$550,000. It sold for $745,000.
In equities, companies in the firing line need to be avoided for the time being, as well as the unicorns that earn no profit. Dangers in here at both ends of the barbell. While some commentators call “Loss the New black” and cite the market capitalisations of Uber, Snapchat, Wework and Amazon as evidence of a new world order, investors must remember the tech bust that followed talk of a previous ‘new paradigm’.
For Australian investors, changes will be cyclical for some but structural and permanent for many more. The expected decline in the construction and retailing sectors will also produce opportunities. A likely fall in the Australian dollar will boost profits for companies that export such as CSL (AX:CSL) and Cochlear (AX:COH) as well as those providing services to foreign customers locally such as Idp Education Ltd (AX:IEL).
But most importantly investors need to be cautious and consider the incorporation of the asymmetric barbell metaphor into their framework.