CHRIS REDDY: SA Retail — sifting the wheat from the chaff

“Only when the tide goes out do you discover who’s been swimming naked.” — Warren Buffett

This quote from Warren Buffett is apt in describing the outlook for the SA retail sector’s outlook. While initial lockdowns were significantly disruptive to retailers, the entire sector has benefited since then from factors that have boosted earnings.

It is not surprising then that over three years retail shares have returned  compounded average growth rate of slightly more than 15% a year, which was second only to basic materials at 23%.

Government grants were one of the key factors that contributed to higher retail sales in certain market segments. These included the Covid-19 TERS payments and social relief of distress grants of R350 a month. There were also sizeable retrenchment benefits paid out as many employees were laid off which led to higher spend in discretionary categories such as home improvements and other bigger ticket purchases. 

Other positive factors that supported companies’ profits included rental support from landlords which came in the form of rental holidays, negative reversions and lower escalation rates. Monetary policy also provided support with the reduction in the repo rate from 6.5% to 3.5%. This coupled with firms reducing their dividend payouts led to many retailers coming out of the pandemic in a much stronger financial position and a significantly lower interest expense bill.

However, those positive forces are dissipating and retailers are now facing a raft of headwinds, particularly from a revenue and cost perspective.

Consumers are under pressure with lower disposable incomes given the higher interest rates due to rising inflation driven by fuel, food and energy costs.  This is translating into lower retail spend and retailers that are unable to grow their revenues are facing negative growth as costs continue to rise ahead of revenues. This coupled with a normalisation of capex spend and higher interest rates is putting pressure on margins.

Many retailers increased stock levels leading to Black Friday and the festive season. Should we not see sufficient sales over the festive period, we would expect 2023 to bring on greater promotional activity and higher stock provisioning, which would further depress earnings.

A significant tail risk for retailers is Eskom, with increased load-shedding having a material negative impact on trading. Mr Price, for example, in its recent six months update, reported that it lost 80,000 trading hours due to load-shedding, most of this was felt in September with sales down  6.7%. Unfortunately, load-shedding has continued in October and November with Eskom warning that the situation is unlikely to change in the next 12 to 18 months.

There is, however, light at the end of the tunnel. Taking from Franklin D Roosevelt who said “a smooth sea never made a skilled sailor”, this environment is creating opportunities for skilled retail management teams to differentiate themselves from the pack and still drive market share gains and deliver returns to shareholders. 

An example of this is the current, albeit short term, tailwinds from retailers extending credit. We note that while TransUnion, who captures credit data for the country, is indicating a marginal deterioration of the SA Consumer Credit Index from 49 in Q2 2022 to 48 in Q3 (50 is the break-even level between improvement and deterioration), the percentage of new accounts in arrears continues to decline. 

This highlights the conservative nature of how credit is being extended by some of the credit focused retailers. Retailers such as Lewis, Truworths and The Foschini Group are seeing an increase in the number of applications but their approval rates have remained low. Thus, over the short to medium term, we are likely to see credit extension being a tailwind to these retailers as they grow their interest income revenue and ancillary costs (insurance, delivery costs and other associated sales) before a tipping point is reached and bad debts start to rise.

Another plus for retailers is that input cost inflation looks to be peaking as freight costs, cotton prices and the Rand are all moving in the right direction.  This provides support for the gross profit margins to expand.  But concerns around excess inventory in apparel remain, and this will come down to consumer demand for the fashion ranges and pricing points. However, in general, SA executives are resilient and have managed to navigate challenges such as these in the past.

Most balance sheets are in a much stronger position after Covid, with almost all retailers active in share buybacks and healthy dividend payouts. This coupled with the discount that many trade at versus our assessment of intrinsic value provides investors with an asymmetric return profile which makes some companies in the sector very attractive.

• Reddy is an analyst and portfolio manager at All Weather Capital