Rising cost of living pressures have deterred both consumers and investors from discretionary retailers in recent months, but opportunities may be emerging in the sector, according to a new industry report from Morningstar.

The latest retail Industry Pulse report suggests that the gap between essential and non-essential retailers is widening, based on the average price-to-fair-value ratio (P/FV) in each sector.

The P/FV shows if a stock is trading at a discount or premium to Morningstar’s assessed fair value estimate. If the P/FV is above one, then the stock is trading at a premium to the fair value estimate and if it’s below one, then the stock is trading at a discount.

Over the last few months, the average P/FV ratio for consumer cyclical stocks has fallen below 1.00, meaning the sector is now, on average, screening as “undervalued”.

retail stock graph

Meanwhile the average defensive retail stock in Morningstar’s coverage universe remains above 1.00, meaning the sector remains broadly “overvalued”.

This trend arrives as cash-strapped Australians continue to shift a greater share of their spending towards services and away from goods, according to Morningstar equity analyst Johannes Faul.

“Consumers across all income brackets are hunting for more value and trading down,” he says.

As a result, Faul says sales growth between discretionary and non-discretionary retailers has bifurcated in recent months, with the former sector hit hardest.

But despite the tough near-term outlook for non-essential spending, Faul says some discretionary retailers have been oversold.

retail stocks bar graph

More than half of Morningstar’s retail sector coverage is now trading at a discount to their respective fair values, with most of those undervalued stocks belonging to the consumer cyclical subsector.

With that in mind, Faul says he sees significant value in three discretionary retailers.

Harvey Norman (HVN)

  • Star rating: ★★★★
  • Fair value estimate: $3.90
  • Uncertainty rating: Medium
  • Economic moat: None

Well-known consumer electronics and home appliances retailer Harvey Norman is currently the third cheapest stock in Morningstar’s retail sector coverage.

Shares in the discretionary retailer have plunged almost 20% since the start of the year.

Faul says sales and profit margins are anticipated to weaken further but adds that Morningstar remains optimistic about the company’s medium-term outlook and is forecasting pre-tax margins to stabilise by fiscal 2025.

“From then, we estimate earnings to increase at a maintainable annual rate in the low single digits, in line with top-line growth,” he says.

“We expect Harvey Norman’s solid balance sheet to withstand a cyclical slowdown and support dividends.”

Shares in Harvey Norman last traded at a 15% discount to Morningstar’s fair value estimate of $3.90.

Kogan (KGN)

  • Star rating: ★★★★★
  • Fair value estimate: $10.70
  • Uncertainty rating: Very High
  • Economic moat: None

Pure play online retailer Kogan spent much of May as the most undervalued stock in Morningstar’s ASX coverage universe.

Over the last four weeks, however, shares in the company have rallied another 12% to be up more than 40% year-to-date.

Despite the rally, Faul says shares remain at a discount to Morningstar’s assessed fair value.

“We ascribe share price weakness to a material decline in sales and earnings from boom-time levels. We expect revenue growth to reignite as consumer spending growth moves to online,” he says.

“We also anticipate margin expansion, as operating expenses normalise. There are early signs of improvement with a return to EBITDA profit in the March quarter 2023.”

Shares in Kogan last traded at 55% discount to Morningstar’s fair value estimate of $10.70

Domino’s Pizza Enterprises (DMP)

  • Star rating: ★★★★
  • Fair value estimate: $68.00
  • Uncertainty rating: High
  • Economic moat: Narrow

Shares in restaurant operator and franchiser Domino’s Pizza Enterprises (DMP) tumbled further last week after the company revealed it was closing stores in a re-structuring effort aimed to drag up earnings.

The poor market reaction added to the stock’s already substantial year-to-date decline, with shares in the company now down more than 30% since the start of the year.

However, despite the recent selloff, Morningstar has held firm on its $68.00 fair value estimate for the stock, with Faul calling Domino's “a high-quality company with a long growth runway”.

“Domino’s sales growth has been volatile and the share price tends to reflect near-term trading conditions rather than longer-term potential,” he says.

“The near-term outlook is uncertain and hinges on a moderation in elevated inflation. However, we believe the market is overly discounting Domino’s intact and significant long-term growth potential."

Morningstar currently forecast the Domino’s network to grow to 6,200 stores by fiscal 2032, from around 3,700 as of December 2022.

That forecast comes in below forecasts from Domino’s management, which put the long-term target at 7100. Faul notes that if management’s target was accounted for, it would lift Morningstar’s fair value estimate by a further 11%.

Shares in Domino’s last traded at a 33% discount to Morningstar’s fair value estimate of $68.00.