It is inevitable that Australian retail sales growth will be much weaker in 2023 compared with 2022. We forecast industry sales growth at 2%, down from 11% last year. Many are anticipating that retail spending will fall off a cliff. However, volumes are already weak. It is price inflation that is supporting above trend spending. We expect inflation to taper off gradually, which means a more visible downturn in retail sales in the July-December 2023 period in our view. The categories most vulnerable to an earlier slowdown are furniture, hardware and recreational goods where we forecast a decline this year. In the food sector, elevated inflation will support growth of 5% in 2023. The risks to our retail forecasts are to the upside if inflation is higher and households dip into their excess savings built up over the past three years.

We expect Christmas retail sales to surprise on the upside with a partial offset in lower profit margins. The strongest feedback comes from department stores, electronics and supermarkets. However, not all have done well. Off-premise liquor looks to be in decline and womenswear feedback is weak.

City Chic has provided another trading update showing slowing sales in Australia. We think it is best to describe the company’s sales position as normalising. We doubt there is a rebound in FY24e. With a reversion in sales, the company’s inventory position is far too high and hence profitability will be largely wiped out in FY23e. The real question is to what level do profit margins recover? We forecast long-term EBITDA margins of 10% and a return to net cash by the end of FY23e. While it is a difficult 12 months and there are many risks, we reiterate our Buy rating with a target price of $0.85 per share (prev $1.25).

Sales trends deteriorate

City Chic’s sales trends have slowed in the past four weeks. At its AGM for the first 20 weeks, sales were down 2% FYTD, now for the first 24 weeks, sales are down 7%. Some of the weakness can be explained by the normalisation of sales in Australia given the reopening last year boosted November 2021. Sales are likely to be down 7% for 1H23e and we estimate a drop of 10% in 2H23e given less of a currency tailwind. Our FY23e sales estimate is $337 million, which, on our forecasts, means that Avenue dropped back towards its acquisition level and there is only modest growth in EMEA. Such a reset reframes its growth. While sales growth should resume, it will be costly to continue to acquire customers. We expect sales growth of 5%-12% going forward.

Gross margins down given excess inventory

City Chic has flagged an EBITDA loss for 1H23e. We forecast -$1.1 million with +$7.7 million in 2H23e. Our 2H rebound reflects a likely reduction in marketing costs and smaller headwind from fulfillment costs vs the pcp. We highlight two things about near-term earnings. Firstly, management has an incentive to make a small positive EBITDA across FY23e. A cash realisation above 1.5x will trigger short-term incentives. Secondly, management has an incentive to drop inventory. An inventory level of $125 million leads to full payment of this short-term incentive.

Can it get to net cash and where do margins settle?

With the share price as low as it is, the market is clearly sceptical about its ability to lower inventory and return to a net cash position. Given financial incentives for management, we expect inventory reduction is a major motivation. We forecast a net cash position of $10 million in 1H23e, rising to $42 million by FY23e. The company has historically targeted 15% EBITDA margins. We assume 10% on the basis that the company will have higher marketing, advertising and fulfillment costs in order to grow sales.

Earnings revisions

We lower our sales forecasts by 3%-5% over the next three years. We reduce our EBITDA (pre AASB-16) for City Chic to $7 million for FY23e from $19 million previously. A small loss across the full-year is possible. The swing factors for us are the level of discounting in 2H23e and the willingness to lower marketing costs.

Our view

City Chic’s sales performance suggests to us that the boom in sales over the past two years is in a large part a function of lockdowns. As a result, the company has far too much inventory and a financially painful 12 months to clear the product. However, fundamentally the company has a good market position in the plus-size market and its balance sheet should have a net cash position. We reiterate our Buy rating with a 12-month target price of $0.85 per share.

Woolworths has announced a majority stake in Petspiration Group for $586 million, at an EV/EBITDA of 11x. This is a full price, particularly given Woolworths will deliver the majority of the synergies. We are concerned that industry-wide revenue may recede given the COVID-19 pet boom added more than 2.5m dogs and cats to households. Woolworths is building out its “ecosystem” and Petspiration is a natural extension. However, the more important share price driver is Australian Food, which needs to demonstrate that previous capex is delivering a return on investment.

The shape of the recovery in Australian tourism remains a tailwind, not a headwind for retail. As at December 2022, Australians are still over-indexing on local stays. This tends to boost sales in supermarkets, liquor, apparel, pubs, restaurants and cafes. In addition, recent data also shows net migration is recovering rapidly. If current trends hold, by June 2023, population growth could be 1.5%, compared with 1.0% for the year to June 2022. This step-up in population will partly cushion the impending downturn in retail spending. We expect any downturn in retail sales is more likely around June 2023, not earlier.

Many Australian retailers have a presence in New Zealand. However, not all are successful in that market. In Issue 5 of The Retail Mosaic, we analyse the consumer, retail structure and profitability of retailers in NZ. Even though the consumer has similar attributes, growth rates diverge often. While some retail segments are more consolidated, many Australian retailers with operations in NZ lack scale.

Australian retail is setup for a good Christmas this year. The growth rates leading into Christmas has been far stronger than last year and while supply chains are not seamless, they are functioning better. Our feedback indicates low single digit sales growth for many with some stronger anecdotes. Given the timing of Omicron last year, sales feedback should strengthen further into Christmas and January 2023. We expect strong trading to lead to upside risk in near-term earnings for retailers.

For all Australians, it is welcome news to hear that the drivers of excessive rainfall may be easing. The Bureau of Meteorology is suggesting La Nina may be over by January or February 2023. In addition to more favourable weather, there is a silver lining for everyone because growing conditions will improve around the world. La Nina creates dry conditions for many northern hemisphere countries and tends to lift prices for soft commodities like wheat. As shown below, the wheat price tends to be higher when the Southern Oscillation Index is high (La Nina) and wheat prices tend to be lower when the Southern Oscillation Index is low (El Nino). Some of the drivers of inflation should diminish as La Nina eases.

The National Accounts highlights the pinch from higher interest rates starting to show through. Household income rose 3.6% in the September 2022 quarter, down from 6.5% in the June quarter. However, savings rates are the cushion that will continue for the next six months, preventing a retail sales downturn till mid next year.  Savings dropped from 8.3% in June to 6.9% in September. The stored up savings in the bank over past 2.5 years have not been used, which keeps consumers personally confident despite a multitude of macro-economic headlines that spooks sentiment. We expect a good Christmas for retail and even decent March 2023 quarter. Retail sales will slow meaningfully, just not yet.

Australian retail sales growth for October 2022 was 12.0% year-on-year. This is still elevated given part of the month was impacted by lockdowns last year. Once again, three-year CAGR growth rates are more relevant. On that basis, recreational goods, liquor and department stores slowed. It is important to note, we will be back to single-digit industry sales growth in November given the very high base line from 2021. A more noticeable slowdown will be evident in the June quarter 2023.