Retailers and recessions: opportunities in the aisles if the market loses its cool

Investors operate under the wisdom that consumer staple stocks are among the safest places to be in a recession because their noncyclical nature means there will always be demand for the goods they produce.

Wesfarmers is considered by some to be a “recession-proof” stock because of its stable of household names such as Bunnings, Officeworks, Kmart and most notably supermarket Coles.

However, since Wesfarmers spun out Coles last year, Morningstar equity analyst Johannes Faul suggests such thinking may be short-sighted and a Paul Keating-style “recession we had to have” could spell trouble for once defensive retailer, and in particular its flagship hardware brand Bunnings.

Faul’s hypothesis hinges on historical trends, which suggest that a recession characterised by weakness in the Australian housing market could hurt Bunnings’ earnings. House prices in Sydney and Melbourne have fallen more than 10 per cent in the past year, according to CoreLogic.

His new research examines the performance of 10 Australian retail chains during the early 1990s – a time of 17 per cent interest rates and 10.8 per cent unemployment – to understand how a similar downturn might affect retailers today.

Faul says Wesfarmers' earnings from Bunnings would not be defensive were a recession – defined as six consecutive months of no growth – to strike today.

"Out of the four categories we analysed, the earnings before interest and tax margins of the hardware peer group were impacted the most by the 1990 recession," Faul says.

"Against a widely held belief, the evidence suggests Wesfarmers' profits from its Bunnings hardware business aren't defensive.

"If a recession were to happen today, we anticipate the weak housing market could be a headwind to the firm's core Bunnings hardware chain in fiscal 2020."

Faul examines the Australian scenario in light of the experience of the two largest US hardware retailers, Home Depot and Lowe's, during the 2008 global financial crisis. 

Both brands suffered fading operational performance. Home Deposit endured a 16 per cent fall in sales over the three years to fiscal 2009, while profits dropped 46 per cent. Lowe's operating income fell 40 per cent over the same period, while sales were flat at 1 per cent.

Morningstar analysts now consider the Wesfarmers conglomerate to be a consumer cyclical rather than a consumer defensive stock.

Growth in groceries

It's not, however, all doom and gloom if a 1990s-style recession was to hit. Faul says consumer staple retailers Coles and its supermarket rival Woolworths are defensive, with virtually no impacts to their intrinsic values, and could even benefit from consumers shifting more spending towards groceries – as they did in fiscal 1989 to 1993.

"Consumer staples have a reputation to be defensive investments for a reason," he says.

"In the four years most impacted by the recession, Woolworths materially grew market share in the food and liquor, department store, and speciality retailing categories as well as its group operating profits."

However, Faul is alive to the Aldi effect and argues that during a recession the German discount grocer could steal the show. It has increasingly taken market share from the Coles/Woolworths near-duopoly since it opened its first store in Sydney in 2001.

"Elevated hardship among consumers could drive more traffic to Aldi, and away from full-service supermarkets Woolworths and Coles," he says.

Taking an example from history, Faul says Coles Myer discount supermarket Bi-Lo reported nominal sales growth of 25 per cent in fiscal 1991. Relative to the Australian food and liquor category, Bi-Lo sales growth outperformed by 17 percentage points and increased market share by 50 basis points.

Faul adds there could be longer-lasting, structural effect of a recession such as cost-cutting, industry consolidation or changes to a company's market share.

"A successful strategy has been to increase sales by aggressive price cutting," he says. "A retailer with a strong balance sheet has the financial flexibility to sacrifice today's profit margin for tomorrow's market share. It can more easily fund acquisitions of weaker competitors, consolidating the market and potentially building an economic moat from cost advantages and scale."

Discounts on the shelf

Overall, Faul says most leading Australian retailers could present as opportunities to fundamental, long-term investors if a sell-off in retailing stock, spurred by cyclical earnings weakness, occurs.

A recession in unlikely to materially impact the intrinsic value of most leading Australian retailers, he says. "The reduction in longer-term sales revenues isn't large enough to dramatically reduce valuations.”

However, there are exceptions, in this case department store Myer, which is carrying debt.

"A recession might spell disaster for the long-standing department store, due to one of its debt covenants. Myer's current bank facility matures in February 2021."

No two recessions are the same

Faul’s research was prompted by growing concern among investors about what would happen to the Australian retail sector in the event of a pronounced decline in consumer spending because of the weakening housing market – and consequently a more widespread slowdown.

The structure of the Australian economy and the retailing sector have transformed in the three decades following the 1990 recession – most notably the economy has experienced 28 years of interrupted growth.

And as the Coalition’s election win shows, there is a renewed desire to safeguard this record. Faul argues that investors should be vigilant not only about the likelihood of a downturn but also how they differ and their effects on different sectors at different times.

"Not only has there been changes in the composition and number of the existing market participants, their respective strategies, market shares, and product ranges, but consumer demands and shopping habits have evolved," Faul says. "We are also aware no two recessions are the same."

Price check on Woolworths: the clear standout

Looking back, Faul was surprised to see sales in some product categories excelled during fiscal 1991, which included three quarters of negative GDP growth.

Adjusting for inflation, he estimates food and liquor sales volumes increased over the period, highlighting the defensiveness of consumer staples during an economic slowdown.

But digging deeper – Faul points out not all retailers were created equal, with Woolworths the undisputed winner among grocers during the early 1990s.

"In the food and liquor category, Woolworths took market share during the recession and continued its growth in the following three years," he says.

"Coles lost share in fiscal years 1991 and 1992, struggling to grow in line with the overall market in the subsequent two years.

Like today, Faul says price was a key differentiator for retailers, and attributed Woolworth's success to its price-cutting.

In the department stores category, Woolworth's discount department chain Big W outperformed its competition and used price-cutting to dominate market share. Discount store Kmart, owned by Coles Myer, was the worst performer, while Target, Myer and Grace Bros had mixed results.

"Trading conditions were undoubtably tough for all four department store chains, compounding the impact of the structural decline in Australian department store sales which began in 1985," he says.

"We ascribe the outperformance of discount department stores Target and Big W in fiscal 1991 to price cutting."

Faul says hardware retailing businesses had it tough during the 1990/91 recession – particularly the trade businesses of the retailers which were more exposed to the housing downturn.

When in comes to share price movements in the post-1991 recession period, Coles Myer performed strongly, Faul's analysis shows. Woolworths lived up to its defensive reputation during the global financial crisis with barely discernible declines in stock prices.

Recession unlikely

While trying to predict the next slump is a "futile exercise," Faul doesn't expect retailers to face a recession anytime soon. He expects the Australian retail sector will grow sales at midcycle rates of about 4 per cent in the near term. 

Ultimately, he puts the risk of a recession at less than 25 per cent, noting that neither the International Monetary Fund, the Organisation for Economic Cooperation & Development, nor Westpac are forecasting a near-term decline in Australia's GDP.

"There are some visible cracks in the Australian economy – real income is declining and building approvals are weak – but offsetting factors are low unemployment and corresponding high consumer confidence," he says. "We aren't forecasting a cyclical decline in our base case."

Morningstar Premium subscribers can access the full special report  'The Morningstar Time Machine Revisits Australia's Last Recession: Opportunities could present if the market loses its cool'