Australian retailers have begun to experience a slowdown in retail spending and it’s going to get tougher over the next 4-6 months. We expect FY24e retail industry sales to rise 1.5%, a slowdown from 9.0% growth in FY23e. While this may sound gloomy, a glass half full perspective is overall sales may not slow any further from the trends as at June 2023. The glass half-empty view is that we may not return towards trend sales growth until 2025. The willingness of households to tap into excess savings shapes our view that the downturn will be shallow. We also note that food inflation will prop up that sector until early 2024. The path of price inflation is likely to have a greater bearing on sales outcomes more so than retail volumes, which are already in decline.

Like most countries, Australian retail price inflation is elevated, but looks to be peaking. In Issue 6 of Price Watch, we uncover the key lead indicators of retail price inflation. We find that price changes are well correlated globally in electronics and food. Sea freight rates are a good predictor of retail prices alongside some input price indices. The spot observations on all of these indicators suggest Australian retail price inflation is likely to fall meaningfully over the next 12 months and contribute to a slowdown in retail sales growth. We may even see deflation in categories like electronics and apparel.

Woolworths hosted a tour of its Melbourne South Regional Distribution Centre (MSRDC). This highly automated DC opened 2019 but COVID-19 delayed any inspection of the site. Woolworths spent over $560 million, including capitalised lease costs, and we estimate the return on investment at 7%-9%. While Woolworths has a different partner to Coles, we expect a similar outcome in terms of cost per case in the automated DC and a similar return on investment. The shift to automation comes at an important time for the supermarkets given escalating wage cost growth. While these DCs are impressive, they are more likely to offset to wage pressures than lift profit margins.

Costa Group has received an indicative acquisition proposal at $3.54 per share including potential dividends. Due diligence by Paine Schwartz, the potential acquirer, will conclude on 1 August. We see a 90% probability of a takeover proceeding. The indicative offer is 35% higher than where the shares were trading just prior to a news article speculating on a potential takeover and the multiple is well ahead of its average over the past three years. There is an argument that the margins are depressed, and past capital investment and acquisitions are yet to bear fruit (pun intended), but the company has inherent earnings volatility and there is an oversupply in blueberries and avocados keeping a lid on margins.

Australian retail sales rose 4.3% in May 2023, which is a solid run-rate and propped up by food categories. The declines in electronics and furniture actually eased off a little. Our barometer of the consumer’s willingness to spend remains very strong with café & restaurant sales up 15%. Retail spending has not fallen of the cliff, but volumes are weak and demand is likely to continue slowing right through 2023 and the first-half of 2024.

Harvey Norman provided an earnings guidance range for FY23e with the mid-point at $670 million profit before tax (pre revaluations and AASB-16). The guidance suggests 2H23e earnings have halved, which doesn’t bode well for FY24e. Harvey Norman’s earnings drop is likely to be more severe than rivals given its elevated inventory and franchising model. The company has also lost market share. We expect a trough in margins in FY24e with a partial recovery in FY25e.

Metcash reported FY23 EBIT up 8% and 2H23 EBIT up 5%. While there has been some concern about a drop in demand, Metcash has demonstrated good sales trends relative to industry growth in all its segments. The company may not buck broader industry trends going forward, but its valuation provides a margin of safety relative to peers.

Harvey Norman’s share price is trading below book value of $3.55 per share. In this report, we analyse its property value and Franchise margins. The company has over $3.7 billion in property and an enterprise value of $4.7 billion.  The last reported cap rate on its investment property was 5.4% in FY22. By FY24e, we see the cap rate rising to 7.5%. We expect its property value to drop by more than $800 million and Franchise margins to fall below 2019 levels.

Tobacco may be somewhat inconspicuous in supermarkets but it has a meaningful impact on sales and margin outcomes given demand has dropped significantly in the past year. Metcash faces the biggest headwind given tobacco could account for 15% of group sales. The drop in tobacco is partly driven by the rise of illicit tobacco and vaping.

Retail prices may be the first to contribute to lower inflation. Recent data from the ABS shows the impact that sea freight costs had on certain retail categories through COVID-19. The chart below shows freight costs as a share of the total product cost for imported product categories. Furniture freight went from 6% of the total cost in 2019 to 19% in February 2022.  It was a similar story for appliances.  The unwind of retail inflation is likely to vary greatly by category and is happening already in highly imported categories. In our view, these retail segments are likely to report the weakest sales trends as inflation unwinds quickly. For more click here Report on retail outlook