Which Retailers are exposed to falling Property?

Roger Montgomery

I have been calling an end to the Australian property price and construction boom/bubble for some time. And now property prices appear to be declining and auction clearance rates falling, the latter suggesting price falls are not over yet.

We note that Macquarie Securities and ANZ Bank analysts have both forecast that recent Sydney property price declines will continue for longer than they first anticipated.

ANZ research forecast a 10-15 per cent decline in the size of new loans, which implies a 5-10 per cent fall in property prices.

Given prices have already fallen over 4 per cent – something not many commentators forecast in the first place – the new forecast range of 5-10 per cent suggests that property price declines have ended or could fall another 6 per cent.

If only we could be so precise.

And don’t forget while the average Sydney price is down over 4 per cent, there are several areas that have declined further. In Sydney’s CBD and Inner South, market prices for houses are more than 13 per cent lower than their most recent peak according to Corelogic. Apartments in Baulkham Hills are off 19 per cent, houses on the Northern Beaches are off 7.5 per cent since their peak and houses in the inner west have declined over 10 per cent.

Our experience with asset price declines, following record debt-fuelled appreciation, is that they tend to feed on themselves and fall further and for longer than expected. Housing as an asset class is no different. What is important to keep in mind is that the falls Sydney property owners and investors are experiencing, just like the recent boom, is not geographically unique. Falls have also recently been seen in New Zealand, Hong Kong, London and New York. The bigger picture – a shift from Quantitative Easing to Quantitative Tapering – rather than local domestic factors is what is driving prices globally.

Local factors can accelerate prices on both the way up and the way down, but the main trend will be out of the hands of local promotors and regulators.

Having said that, with bank boards, under Scott Morrison’s threat of “jail time”, tightening lending standards, increasing required deposits and limiting investment loans and interest-only loans we can be confident that a lower volume of loans should have a negative impact on price.

Further, migrating more borrowers to more expensive Principal & Interest mortgages, taking longer to approve loans and expanding the list of banned suburbs has dashed hopes of quick capital gains.

When combined with lower loan growth and tighter conditions for existing borrowers, dashed hopes for capital gains suggests an illiquid asset class like property has yet to see prices fully factor-in the new weaker conditions.

It is also the case that the most recent buyers, particularly those with higher Loan to Value Ratio (LVRs) could fall into negative equity, which is the biggest explanatory variable for defaults.

If a wave of defaults were to transpire, prices could fall more rapidly. The banks will of course be all over this at the moment to try and avoid or arrest any panic.

Nevertheless, further declines are not only possible, but probable.

All of this has important implications for the brick & mortar retail sector and helps to explain why we have not invested directly in discretionary retailers in recent years.

The discretionary retail sector could be materially impacted by the negative wealth effect from falling property prices. And don’t forget households are the most mortgaged they have ever been. That generally means difficulty for consumers.

One bright spot for consumers is an anticipated acceleration in wages but even that may simply be absorbed by debt repayment. A higher savings rate, and the expansion of Amazon Prime, could also spell the start of another leg of weakness for a retail industry already challenged.

We currently think earnings risks are mounting for listed discretionary retailers. In addition, we know that some company share prices, such as JB Hi-Fi, are highly correlated to house prices.

There are a variety of retailers whose shares should be considered in the context of the underlying company’s ‘mature’ status in the Australian market (and therefore limited absolute growth potential and exposure to the business and economic cycle) and their direct or indirect exposure to household formation, renovation demand and consumer health.

Companies that we believe have some exposure to the risk to the downside for house prices include:

MYER (ASX:MYR) – When Myer relisted in November of 2009 at a price of $4.10 and a market cap of almost $3 billion, we warned investors to think carefully about its prospects and estimated value. In one newspaper article I wrote of a valuation many dollars below the IPO price. Today, with the price at 40 cents, the outlook is not getting any better. Competition continues to intensify, and no strategy has been articulated to increase the store’s relevance or to improve foot traffic. On top of that issue, consumers may actually be tightening their belts because their heavily indebted home is not going up in price.

JB Hi-Fi (ASX:JBH) – Since JB Hi-Fi’s acquisition of The Good Guys we have maintained that the purchase was poorly timed at best and misguided at worst. When the company downgraded earnings guidance in May, it suggested that unfavorable weather had hit sales of air conditioners and heaters at The Good Guys. But it also revealed that price cuts to maintain market share had crimped margins. We currently do not expect the forces on margins to relent any time soon and a company generating an operating profit of $235  million on sales of almost $7  billion is not one we would be writing home about. Back in 2016 Tim Kelley, portfolio manager for The Montgomery Fund, pointed out here that the fact that the ACCC let through the acquisition of the Good Guys by JB Hi-Fi hinted that the ACCC was not concerned with any monopolistic pricing behavior subsequent to the two companies becoming one. Indeed, exogenous pricing pressure remains and the slowing housing market may mean that the acquisition of the Good Guys marks a medium-term peak in consumer confidence. Indeed, since the acquisition JBH’s share price high has not been exceeded.

Super Retail Group (ASX:SUL) – The Company’s brands include Amart Sports, which provides leisure sports products; BCF and Macpac, outdoor retailers; Rays, an outdoor entertainment and camping leisure retailer; Rebel, which provides branded sporting and leisure goods, and Supercheap Auto, a specialty retail business. Following a sharp rise in the share price, there appear to be relatively few catalysts to drive the share price beyond its peers in terms of classic share price valuation metrics. Meanwhile there are risks to the downside from the weaker housing sector and the launch of Amazon Prime.

Nick Scali (ASX:NCK) – Nick Scali is a company that has been generating strong growth and high returns in recent years, and it currently appears to be trading on undemanding earnings multiple. It is worth noting that we currently believe there remains a reasonable opportunity for reinvestment in new stores with 50 per cent growth in store number forecast by the company in the long-term. It is however difficult for us currently to identify sufficient tangible and sustainable competitive advantages for the business in order to classify it as the highest quality business. The company’s high margins for example appear to stem more from high gross margins (premium pricing for example) rather than low operating costs. Additionally, margins and earnings growth have benefited significantly from strong like-for-like sales growth driven by the recent property cycle in NSW and VIC. As we have articulated, we do not believe this is sustainable at the moment. Indeed, the property cycle already appears to have turned. With high gross margins and a relatively high cost of doing business, operating leverage in the business model is high enough that potential investors should be looking at it closely. They could amplify any impacts from cyclical sales. Falling residential housing construction data and housing turnover in key markets increase the risk of a mean reversion in margins in the medium term, potentially undermining earnings growth.


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spiro

Hi Roger, I am surprised you didn't mention Harvey Norman. Would this be number 5?

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Roger Montgomery

Yes, Spiro. There is little that is sufficiently unique to preclude any domestic retailer of whitewoods, furniture and kitchen and electrical appliances from being included in the list.

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Roger Montgomery

Spiro you may also be interested to know back in 2015 we offered the following observation on the blog; “Young people are ditching their television sets even faster than in previous years, according to new data, with traditional TV usage falling among viewers age 18-34 falling at twice the normal rate in the recent September to January season."

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