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.

City Chic’s sales run-rate stepped down materially in 2H23e with sales for the half likely to be $128-$132 million, down 29% on the pcp. Elevated discounting is the primary driver. The quality of inventory does also worry us. The company’s guidance that gross margins are down 18 percentage points, suggests that almost two-thirds of its sales drop is a function of lower realised prices. We expect weak sales to continue in 1H24e as discounting continues. Sales should recover in 2H24e onwards. However, the sales base is likely to settle around $316 million in FY25e, far below aspirations of $400 million only six months ago

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.

Harvey Norman reported a 7% drop in FY22 EBITDA. However, 2H22 EBITDA rose 4% given better sales trends across most divisions. The stronger sales trends are likely to help 1H23e earnings as well. However, the sales environment is likely to be more difficult across calendar 2023 and we forecast earnings to fall. We are also more cautious given Harvey Norman may continue to hold elevated inventory levels.

City Chic reported FY22 EBITDA of $47 million (pre AASB-16), up 11%. The result was characterised by very strong revenue growth, but margin dilution from lower margin acquisitions and higher fulfillment costs.  We expect sales growth to slow in FY23e to 6% as online demand normalises globally. We see further downside in gross margins given higher fulfillment costs seen in 2H22. We forecast FY23e sales of $392 million and EBITDA of $50 million. We have lifted our EBITDA forecast slightly from $49 million previously.

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.

JB Hi-Fi provided a FY22e trading update with consistently strong sales and better gross margins in 2H22e. EBIT was 9% ahead of our forecast. The strength in sales, tightness of inventory and price rises make us more bullish in the near-term (FY23e) but more cautious on FY24e. With a net cash position, good dividend yield and low PE, we expect the stock to perform well.

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.

City Chic provided a trading update about sales and EBITDA for 2H22e. Sales growth is 25% so far in 2H22e, which is 4% below our estimate. The lower than forecast sales were more pronounced in the Americas business. We expect a small pick-up in sales growth for the remainder of the half with 28% growth forecast for 2H22e. The company expects 2H22e EBITDA to be slightly ahead of 1H22. We forecast 2H22e EBITDA of $23.7 million, compared with $23.5 million in 1H22.

Wesfarmers reported a 12% fall in 1H22 EBIT. While the company flagged a drop in group earnings, the fall in Bunnings earnings and higher cost growth raises concerns. We expect earnings to fall in 2H22e as well. The bigger picture is Wesfarmers is lapping very strong earnings across its retail businesses from FY21. We are not concerned about price inflation creating a headwind because Wesfarmers operates in rational markets. However, higher operating costs are likely, including additional investment in digital capabilities as the company competes for a more viable position online.