There is a sector on the ASX whose risks include, but are far from limited to, exposure to the slowing construction-activity cycle. That sector is retail and consensus is not considering the headwinds.
Take JB Hi-Fi, the owner of the eponymously-named music and electronics retail franchise and The Good Guys, as an example of a company whose share price reflects the indifference to the risks that typify the sector. Its share price is down 21% from its recent high but it remains more than 300% higher than its lows of 2008.
In 2016, the company reported earnings per share of $1.52. Consensus estimates currently anticipate earnings per share rising to $2.17 in 2019, a compounded average annual growth rate of 12.6%. And while this growth produces a worrying decline in return on equity — to about 18% in 2019 compared to over 48% in 2009 — it does not contemplate any exogenous disruptions, some of which we are confident management is seriously worried about.
Crane count signals trouble for construction industry
Before touching on what we believe is a concern of JBH’s management, it is worth stepping back to address those exogenous shocks about to confront much of the retailing industry in Australia, and by extension their listed A-REIT landlords.
In the past few years, Australia has experienced a boom in high-rise residential construction. That boom is perhaps best illustrated by the revelation in October 2016 by construction consultants Rider Levett Bucknall, in its biannual crane-count survey, that a record 528 cranes were working above apartment blocks in Sydney, Melbourne, and Brisbane. This was more than the total number of cranes operating in New York, Boston, Chicago, San Francisco, Los Angeles, Toronto and Calgary combined.
That an oversupply in apartments has been created is not in dispute; witness the discounting already underway by developers to clear stock. Around Australia, incentives ranging from frequent flyer points to holidays to free electric cars and 10-year rental guarantees are a signal that all is not well.
Slump ahead in construction
Debt brings forward purchases but once the debt binge has run its course, a slump typically ensues. That observation is as true for retail consumption (and we note record credit card debt in Australia of $32 billion) as it is for the business cycles of almost all industries, construction included. Epochal low interest rates fuelled a debt binge that found a willing recipient in the form of property developers who now form the largest customer base for Ferrari and Lamborghini dealerships on the eastern seaboard.
But between 2000 and 2016, household debt-to-GDP rose from 70% to over 124%. In the same period of time, residential construction completions grew from 40,000 dwellings per year to an estimated 220,000 this year and next. After that the slump begins. Approvals have already declined from an annual rate of 250,000 in October 2016 to circa 200,000 today. The expectation is that failed settlements combined with actions by regulators, as well as jawboning by politicians, will produce further declines in the desirability of high-rise property as an investment and, therefore, further declines in construction activity.
The construction industry employed over one million workers in February 2016, according to the ABS, and developers say any slowdown would ‘easily’ see them lay off 20% of their full- and part-time workforce. When Australia’s monthly trend employment numbers move up or down by 10,000 individuals, a slowing in the construction industry would have a serious impact on consumer sentiment, if not on the statistics and spending.
In short, it is reasonable to expect a slowdown in residential construction activity, with second-order implications for employment. Of course, the toxicity and term of any bust are related to the level of debt upon which the prior bubble was fuelled. Given the record levels of debt, it can be assumed that financial stress will rise accentuating a problem already highlighted by the significant increase in calls to the National Debt Helpline.
Combining the employment and debt picture, it is not a stretch to believe the growth in revenues and profits enjoyed by the likes of JB Hi-Fi, Harvey Norman, Bunnings, Reece, Adairs, and even the automotive retailers, in recent years may be hard to replicate in the next few years.
Amazon arrival heralds end for some
The other risks for retailers are more dangerous changes that are structural rather than cyclical.
The arrival of foreign brands such as Uniqlo, Zara, and H&M signalled a significant change in the required competitiveness of local franchises to survive. Already brands including Marcs, Rhodes & Beckett, Pumpkin Patch, David Lawrence, Howards Storage, Payless Shoes, and Herringbone have succumbed to the more competitive environment. And there’ll be more. I say this with confidence because it is the arrival of Amazon in Australia that will mark the end for many more businesses whose only offer is assortment and range. Think JB Hi-Fi, Harvey Norman, Big W, Target, K-Mart and Temple & Webster.
Amazon launched its IPO two decades ago and now generates about US$4.2 billion in profits (although highly variable). At a market capitalisation of US$400 billion, it is the world’s fifth-largest company, receiving 50% of all new spending online.
Unlike our listed retailers, the company has been given latitude by its shareholders to place an emphasis on long-term viability of its services over short-term profits. Its learn-adapt-grow approach to entering and growing in a country, as well as its heavy investment into all facets of logistics from truck trailer and aircraft ownership to warehousing, AI and robotics, gives Australia’s incumbent retailers a great deal to worry about.
Amazon’s pricing policy is what justifiably worries most retailers. Margins for retailers of the same product vary by as much as 1000 basis points (10%). Amazon uses an automated pricing engine which analyses trends and online product searches, then selects the products selling well and sets prices to match the lowest price offered by a reputable seller or just below. For example, if the lowest price offered is $100, Amazon will set prices at $99 or $95, with free delivery, too.
Competing on price with Amazon places a company in an ‘automated’ pricing death spiral that Amazon will always win. The only way to survive is to invest in offering a better experience, training staff to be experts, focusing on specialty brands that don’t want their product on Amazon and be hyper focused on local markets, while offering in-store pick up and advice.
Unfortunately, the result is still a niche business whose further growth may, in fact, depend on Amazon’s third-party Marketplace platform, putting Amazon in control.
With clouds brewing on so many fronts for retailers, a perfect storm seems to be developing and investors don’t appear to be attuned to the risks.
Roger Montgomery is Chairman and Chief Investment Officer at Montgomery Investment Management. This article is for general information only and does not consider the circumstances of any individual.