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Retail – What is Happening

03 Oct 2008 12:20TraderF

Over time the retail sector has evolved from the small shop on the high street to the larger shopping chains sited in Malls.  This has been brought about by the need to compete on price and to offer the customer convenience with benefits like parking.

This evolution will continue as retailers compete and the public demands a better value proposition. The retail sector will remain under pressure to reduce margins from a public who now have an expectation that goods will fall in price. Retail has been able to absorb higher costs and lower margin by sourcing goods from low cost providers.

Over the recent years China has became the world’s source of low cost mass produced goods.  This has given the retail sector an avenue to procure inventory at ever-lower prices.  Added to retail’s good fortune has been an ever strengthening dollar and strong retail demand. This period of good fortune is over.

If you look at most listed retailers their share price is trending down.  I believe the main reason for this is that the market understands that China as a cheap source of product is exhausted.  There is little scope for China to continue to lower its prices so the retail sector will not gain earnings growth from sourcing cheaper goods from China.  Also while the dollar may remain around these levels, the dollars continued rise is increasingly unlikely from these historically high levels.  Add to this consumer demand remains weak it is ulikely to strengthen in the near term.

Mall owners are legendary for their treatment of retail tenants.  The Mall owners are property developers and as such are seeking to maximise their yield from rents and the revaluation of their asset.  They use ratchet methods of high rents to justify and the capital value of the property and their high capital value to justify rents.  Once one shop pays a rent level they use it to ratchet up all the others at lease rollover.  The malls have a large turnover of tenants and pay no regard to the number of competing outlets they rent to.  Many malls have a large number of competing shops. 

Ever increasing property values are being used to increase rents.  Many tenants leave when their lease falls due and major chain stores threaten to leave as a bargaining method on rent reviews.  It is fair to say that there is a great deal of tension between Mall owners and tenants.

All malls have a finite life and newer malls are superseding older malls. There has been a trend to build ever-bigger Malls and to attach entertainment to attract shoppers. One must wonder what is next for the mall.  It is unlikely to get bigger as a vast mall will loose the convenience factor if the shopper must drive from one side to the other. 

Malls rely on anchor tenants that are typically the branded chain stores.  When the Internet puts pressure on these key chain stores through finer margins the quality of the malls tenants will fall which in turn will lead to few people going to malls.  The mall model will implode.

In the past it has been possible to gain earnings growth from rolling out retail branches.  If you had a profitable model you can increase earnings by cloning it off as many times as your capital and available sites allowed.  This often involved venturing offshore to gain the growth needed.

The chain store tries to gain economies through scale.  This approach has it advantages and disadvantages. There are economies in areas such as advertising and limited savings in procurement.  It is easy of over-state the saving in procurement because the NZ scale is small by Chinese standards and a lot of goods have a global price (gold for example).

The key disadvantage is that all those stores create expensive overheads.  They must be leased, fitted out, staffed and stocked and promoted locally.  This often involves a very large number of part-time staff that leads to enormous staff turnovers. A large number of stores require complex supply-chain management and logistics costs. This leads to a large head-office structure with all its direct overhead costs.  On average chain stores require 15 people per store including head-office support therefore to staff 200 stores requires 3,000 people.  The lease costs on 200 stores are approximately $18 million dollars per year (source Michael Hill). 

The net result of these high costs means that on a per store basis chain stores are barely profitable.  They require very high margins to remain profitable, Michael Hill’s [NZX:MHI] profit while sounding large at $34.9 million on a per store basis MHI makes only $109,000 net per store.  This is barely three people’s wages; the slightest increase in cost or reduction in margin and that profit would evaporate. Pumpkin Patch [NZX:PPL] net profit of $27.5 million represents only $137,000 per store. (This over states their per store profitability because the profit includes revenue from non-company owned outlets)

The outlook for retail is being accurately reflected in their falling share prices.  Shares in The Warehouse [NZX:WHS] and Briscoe Group [NZX:BGR] show the recent performance of leading retailers. These are very difficult times for retail with pressure coming from all sides.  Retail will need to look for more efficient models and this will inevitably involve the internet.  Tomorrow I will write about the affect of the internet on the retail sector.

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