Weekly Reports | Mar 25 2022
This story features WOOLWORTHS GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: WOW
This week brokers delved into the impact of inflation on supermarket sales, rising costs for online businesses and the impact on retail landlords as shoppers return but interest rates rise.
-Inflation impact on supermarkets
-The rising cost of online
-The impact of a return to in-store shopping REITs
-Broker stock preferences
By Greg Peel
Inflation and Supermarkets
Grocery inflation is building, notes Ord Minnett. Cost pressures on suppliers are driving double-digit headline price increases which, in turn, grocery retailers are passing on to customers. While this represents a near term sales tailwind (as measured in value of sales), the broker remains cautious around shoppers being forced to “trade down”, leading retailers to increase promotions.
There is a natural lag between increased wholesale prices and prices on the shelf. Ord Minnett expects inflation to peak in the September quarter at around 6%. This will initially push supermarket sales growth higher through FY22 and into FY23.
The broker expects Woolworths ((WOW)) to outperform Coles ((COL)) in the June quarter, before the business cycles last year’s large market shares gains and online penetration slows. Coles posted a strong first half FY22 result by controlling supply chain cost pressures, but costs were deferred rather than avoided, Ord Minnett notes, and investment plans were pushed out to the second half and FY23.
While supermarket online penetration increased sharply in the past two years’ lockdowns, online sales are more costly than in-store sales, exacerbated by the high volume, low value nature of products, and the perishability of fresh products. Ord Minnett expects online penetration to recede in FY23, taking the pressure off margins.
But however the consumer chooses to shop, the recent spike in fuel prices only adds to grocery inflation (transportation of goods to stores) at the same time as reducing household spending capacity. If this is not enough, rising interest rates will further impact.
Ord Minnett notes the savings buffer built up by households during lockdowns will help to limit downside risk for retailers, however, the broker expects these savings to be used for bigger ticket items such as holidays, rather than everyday items.
While rising mortgage rates will impact only the one third of Australian with mortgages, notes Ord Minnett, fuel price increases impact everyone.
[I disagree on the mortgage front – higher rates translate into higher rents. The only households thus not impacted would be those who own their home outright.]
As noted, Ord Minnett prefers Woolworths (Accumulate rating) over Coles (Hold). The broker also has an Accumulate on Metcash ((MTS)), for which hardware earnings are expected to overtake food earnings in 2022 and grow at a faster rate.
The Cost of Online
The impact of the lockdowns and subsequent rapid growth of online (which some US brokers suggest has dragged forward previously anticipated online growth of four to five years) indicated that retailers fell into three rough categories – those without an online presence, which had to scramble to catch up, those with an existing mix of in-store and online, and online-only “disruptors”.
There was talk at the time that the physical store may now be dead. But while many new online customers have discovered the benefits for the first time, this generalisation ignores the fact consumers simply enjoy “going out shopping”.
Jarden believes online will continue to grow from here, but at a slower pace. Stores are not dead, but omni-retailers (offering a wide range) are best placed. The cost of operating online retailing has increased with respect to marketing (via Facebook, Google and Amazon), consumer expectations regarding delivery times and return policies, and the need for scale, via range and fulfilment capacity (having products in stock).
Exacerbating the marketing issue is the crackdown on first-hand data collection after Apple decided to protect consumer privacy. This upended the concept of specifically targeted marketing so valuable to retailers, making advertising spending choice more difficult, and advertising more hit-and-miss.
Jarden has investigated all of the above and concluded those stocks best positioned in retail are Woolworths, Coles, Wesfarmers ((WES)), Flight Centre ((FLT)), Accent Group ((AX1)) and Super Retail ((SUL)).
The latter group were big “covid winners” in being online-only in the first place, but now the longer-established, store-heavy retailers have for the most part caught up. The cost to operate for these “disruptors” is increasing, notes Jarden, given higher costs involved in acquiring customers, building a brand and distributing product. Scale and networks have become key again.
Jarden estimates customer acquisition cost have risen by 50% since FY20. The top ten websites by transaction (not counting eBay) have extended their lead over the past year.
This is compounded by the need to offer shorter delivery times, free product returns and better prices. The result is the big players such as Amazon, Woolworths, Coles, Wesfarmers and Super Retail are winning share, while smaller players are seeing margin compression and slowing share.
Not to mention consumer desire to return to physical stores.
Among the hardest hit stocks during the lockdown periods were retail and office landlords, in the form of listed real estate investment trusts. The winners were industrial (logistics, ie online distribution warehouse) REITs.
Retail REITs were forced to offer rent reductions/waivers/forbearance lest their shuttered tenants hit the wall, and the balance of landlord survival or otherwise was driven by their mix of essential (thus remaining open, such as supermarkets) and non-essential (thus shut down) tenants.
The rising cost of online, coupled with the scale and proximity to consumers of well-known retail chains with hundreds of stores, should benefit retail REITs from here, Jarden suggests. Mall retail in particular should benefit in particular given the sector currently trades at a deep discount to book value.
Since you asked, “daily needs” simply implies expanding out from neighbourhood and large format retail into health and other services tenants.
But there is another aspect of the REIT story to consider.
Since inflation began to bite early last year, analysts have been recommending investment in inflation-beating sectors, including commodities (rising prices) and REITs (rising rents). The offset for REITs nevertheless is that rising inflation leads to rising rates, making “defensive” REIT dividend yields less attractive compared to risk-free government bonds.
Morgan Stanley has examined this issue, but admits that given there have only been three periods of sustained RBA rate hikes since 1994, there’s not a lot to go on.
Looking at the rate hike runs of 1999-2000, 2001-08 and 2009-10, the analysts found real estate price/earnings ratios (PE) generally de-rated, but only to a mild degree. Moreover, most of the de-rating occurs in the period leading up to a rate hike cycle, given anticipation thereof, but once the cycle begins, de-rating eases off.
To that end the current ASX real estate PE stands at 17x, Morgan Stanley notes, down from 19x in August 2021.
The analysts note further that de-rating of REITs during rate hike periods is typically deeper than that of the average market, but re-rating returns as soon as bond yields stop increasing.
The broker concludes that from a sector top-down perspective, real estate is facing headwinds. But from a bottom-up (individual stock) perspective, Morgan Stanley’s top picks remain Goodman Group, for its diversified growth and leverage to industrials, Stockland Group ((SGP)), for its valuation and new strategy, and Dexus Property ((DXS)) for the return-to-work theme and hence bottoming of the office market trade.
The broker remains cautious on the retail names, keeping an Equal-weight rating on Scentre Group and an Underweight on Vicinity Centres, suggesting that if all covid impacts were to vanish tomorrow, earnings could still be -10-15% below expectations pre-covid.
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