Super Retail Group reported FY22 sales up 1% and EBIT fell by 18% (52-week basis). While a fall, earnings are still well above pre COVID-19 levels and sales trends have started FY23e strongly. We expect a good 1H23e but weaker 2H23e as broader retail spending trends slow. Gross margins are likely to fall a little further and negative operating leverage could be evident in FY24e.

PE ratios are depressed across consumer stocks reflecting concern about an earnings decline. However, bears will need to wait at least another six months for evidence. FY22e earnings are likely to surprise on the upside for just about all retailers, trading updates will be strong and inventory should be down on February levels. It’s less clear cut how stocks will react, but any downturn is unlikely to be evident.

There is much to debate about when retail sales slow, how far sales drop and how much margin downside will be associated with the sales weakness across the sector. We think the central driver of the debate is how quickly and far interest rates rise. In our base case (67% probability), the RBA reaches 2.5% cash rate by December 2022. In our downside case (33% probability), the cash rate reaches 4.5% by June 2023. There is downside risk to earnings for retailers over the next 18 months. We expect a volatile 12 months and advocate caution.

Super Retail Group’s trading update shows largely consistent sales trends over the past 10 weeks, with LFL sales up 3.4%. Supercheap Auto remains the standout segment. Gross margins are steady and the company is more optimistic about store openings. Super Retail’s PE ratio has derated on concerns about its inventory position. We think those concerns are misplaced given the challenges in securing inventory that will continue throughout 2022.

Australian households and companies have not dealt with an interest rate increase for more than 10 years. However, higher rates are imminent. In Issue 3 of The Retail Mosaic, we assess the impact that higher rates may have on spending, company earnings and share prices. It takes, on average, 18 months for a rate hike to impact spending, but for furniture it can be in as little as six months. We expect housing churn will slow as rates rise, placing further downside risk on household goods. Retailers have limited debt and some hedging that will moderate the earnings risk from higher rates. However, PE ratios could derate by 10-20%, particularly for high PE defensive stocks such as supermarkets and conglomerates.

Super Retail Group reported 1H22 sales down 4% and EBIT down 33%. The process of normalisation in earnings has begun. We expect 2H22e sales to rise 1.3% and EBIT to fall 11%. The company’s elevated inventory position is largely skewed towards Supercheap Auto, which in inherently lower risk than its other segments. Operating cost growth will continue in 2H22e given data and digital investments, but there is some flex to manage labour costs to sales.

The prospect of higher price inflation could significantly impact a retailer’s sales, earnings and valuation over the next three years. In Issue 2 of Price Watch, we analyse the impact price inflation has on supermarkets and non-food retailers and assess the likely volume response to price rises. The good news is even in non-food retail, price inflation 2-3 percentage points higher than average will lead to better sales, earnings and a PE re-rate.

Our feedback from a range of contacts is that Christmas 2021 trading was solid, particularly given the high base from 2020. The strongest feedback comes from the furniture sector. Whitegoods were strong and supermarkets had a late rush in sales. While a good festive season, the debate is going to shift quickly to the impact that COVID-19 has had on January 2022 trading. Sales could be down 10%-20% for the month leading to 3%-5% full year EPS risk in our view.

Australians like to holiday both locally and overseas. With locked borders over 2020 and 2021, reduced tourism spend has been a source of savings and some of the spare cash has also made its way into retail. As tourism recovers, will retail sales slow? In Issue 2 of The Retail Mosaic, we analyse the change in tourism spending over recent years and assess the possible recovery path and its impact on retail. The good news for retailers is that any recovery in tourist spending is likely to be gradual and centre on domestic trips. Given almost half of spending by tourists while on domestic holidays is in retail stores, then the recovery in holidays may prove to be a smaller drag on retail than some fear

We expect Super Retail Group will have a good Christmas trading period and gross margins hold up relative to strong levels from 2020. However, the company does face rising import costs and higher operating cost growth that is likely to lower EBIT margins in calendar 2022.