Billabong sale tells of trouble in Australia's retail sector

Retailers are fighting a Darwinian battle against two enemies – low consumer confidence and digital disruption.
The Billabong brand synonymous with surf and Australia will soon be owned by US interests
The Billabong brand synonymous with surf and Australia will soon be owned by US interests

News of an American company buying Billabong, Australia’s beloved surfwear supplier, shocked its home country, where beach culture runs deep. The iconic brand is being sold to California-based Boardriders – owner of Billabong's competitor Quiksilver – in a A$380 million (US$214 million) takeover that would see Billabong delisted from the Australian Securities Exchange by April.

Affairs turned sour for Billabong when it changed strategy from selling clothing through third-party surf retailers to opening a string of its own high-street shops. The subsequent blowout in fitout and rental costs, as well as poor sales through these stores, saw the company post a full-year loss of A$77 million in August last year, three times its net loss for 2016.

This is an all-too common story for Australia’s retail traders and raises some gnarly questions for investors in the sector as they scout for companies that can best cope with rapidly changing customer habits. A Darwinian battle of survival is under way, not helped by a backdrop of weak consumer confidence, high household debt and low wage growth. Retail sales for the all-important month of December were lower than in the previous month – down 0.5%, despite widespread pre-Christmas discounting across stores.

Smaller, niche-product players are the hardest hit. In the past 18 months brands like Maggie T, Payless Shoes, Dick Smith, and Oroton have been placed into receivership, while others like Pumpkin Patch and Diana Ferrari have shuttered bricks and mortar stores in favour of selling only online.

“We have initiated a project looking at the impact of disruption on our retail holdings,” Sam Sicilia, the chief investment officer at A$30 billion retirement fund Hostplus, told FinanceAsia.

Sicilia said the issues facing the sector were “complex” and that the scope of the project would be far reaching. “I don’t want to pre-empt our findings,” he said.

Brad Potter who manages Nikko Asset Management’s Australian equity portfolios in Sydney, said disruption is a constant concern for his fund. “When we look at Australian retailers we always assume long-term sales growth will moderate and margins will fall as competitors come in to the market,” he told FinanceAsia in an interview.

Many retailers are struggling to offer the right format to today’s generation of new spenders that value loyalty programmes and want instant feedback on whether products are available in different sizes or models. Most customers start their retail journey with a digital search.

“If your business model is not providing what customers want and you aren’t prepared to modify then you are not going to survive,” Potter said.

HERE COMES AMAZON

The playing field altered radically in November last year when Amazon opened its first Australian fulfilment centre – a 24,000 square metre warehouse in Dandenong outside Melbourne. Amazon excels at delivering the latest shopping experience and while early predictions that its arrival would bring Armageddon to Australian traders didn’t materialise, analysts say local companies are under pressure to implement a change strategy before Amazon Prime launches sometime early next year.

The Amazon Prime subscription service promises one-click payments and same-day delivery. Nearly 60% of American households have signed up to it.

All retailers listed on the ASX have some sort of online offering, though none offers the same variety or speed as global giants Amazon or Google. According to figures published by UBS, the most prolific local online seller is homewares company Adairs, which sold 8.9% of its products across the internet in financial year 2017. By comparison, department store Myer sold 4.8%, Harvey Norman 4%, and JB Hi-Fi 3.8%.

Data from the Australian Bureau of Statistics (ABS) shows online penetration has been growing steadily over the past four years (see table). In 2017, 4.2% of all purchases were conducted online, compared with 19% in the UK and 24% in China – suggesting there is plenty of room for growth.

Ben Gilbert, an analyst at UBS in Sydney, said if past experience is any guide the arrival of Amazon should accelerate this growth. “In all 11 of Amazon’s market entries, online penetration has more than doubled within five years,” he said.

“This is generally positive for retailers because it generates larger basket sizes and allows them to reach a broader audience. On the other hand, it brings price visibility and, in most cases, is less profitable,” Gilbert said. Amazon’s presence also tends to drive consolidation, with inefficient or smaller players being left high and dry, he added.

The challenge for Australia’s listed retailers will be finding an online strategy that doesn’t burn money. Amazon Prime loses millions of dollars a year on shipping expenses and still manages to keep shareholders happy.

“These digital-only companies operate under different metrics,” said Potter at Nikko Asset Management. “As long as they can show revenue growth then investors are satisfied. They don’t have to show profits and return on equity like traditional bricks and mortar retail companies.”

The biggest losers in this Darwinian battle are likely to be department stores Myer and David Jones. Sales at department stores across Australia have fallen in 12 of the past 14 months, according to the ABS.

Myer’s most recent full-year earnings in September 2017 showed its profit plummeting by 80% to a lowly A$11.9 million. At David Jones, sales growth is taking a beating, edging up just 1% in 2017 compared to growth of 8.4% in 2016, and causing parent company Woolworths Holdings of South Africa to revalue the business downwards.

Competition in this segment of the market is coming from international players H&M, Uniqlo, Zara, and Sephora, which each offer inexpensive homeware and fashion that moves quickly from the catwalk to stores. As trendsetters they operate on the idea stock is only held for a limited time and if shoppers don’t visit stores regularly, they miss out.

BANG TO REITS

If not addressed, the troubles experienced by Myer and David Jones could have broader implications for investors in the ASX. Department stores are large tenants in retail malls and these malls are often owned by local real estate investment trusts, or A-Reits, such as Stockland, GPT, Vicinity and Scentre Group (the holder of Westfield’s local assets).

Indeed, A-Reits make up 8% of the market’s total capitalisation, compared to 6.5% represented by retail companies themselves.

Pension funds and asset managers love A-Reit stocks for the handsome yields and stable cash flows. Australian malls charge some of the highest rents in the world and can demand five- to 10-year leases. The leases come with a fixed annual escalator of inflation plus a percentage of turnover – but only on the upside. There is no cut in rent if sales drop during the year.

For some retailers, onerous rents can suck up to 40% of sales. And the long leases make them look like highly leveraged businesses, even though they carry very little actual debt.

Despite all this, the malls enjoy average occupancy rates of 99% – well above rates in office and industrial properties. Westfield’s occupancy rates are the highest at 99.5%.

When vacancies arise there is “a conga line of retailers ready to move in”, said Potter at Nikko. “Operators like Scentre are almost delighted when there is turnover. They want poorer performers to move out and be replaced by stores that attract new shoppers.”

Potter said talk about a rationalisation of rental prices in Australia has been circulating for 15 years. “But, the malls still hold most of the power, particularly the high quality malls.”

This could change drastically, however, if large cornerstone tenants such as the department stores were to fold. The floor space left vacant by their departure would be difficult to fill, particularly if international brands like H&M and Zara are already entrenched.

“This could be the tipping point,” Potter said.

Matthew Moore, an analyst covering A-Reits for Moody’s in Sydney, believes there are signs that the dream run experienced by Australia’s A-Reits may be slowing to a jog. “Turnover is under pressure and mall owners are adjusting the tenant mix in the weaker-performing malls to attract more customers,” Moore told FinanceAsia.

Of the eight retail A-Reits covered by Moody’s, only one – SCA Property Group – saw an increase in net operating income in 2017 versus 2016. Three reported flat growth and four saw a decline in growth. Moody’s expects net operating income growth of approximately 2.5%-3.0% in fiscal year 2018 versus the 2.7% recorded in fiscal 2017.

“If retail sales don’t improve tenants may be in a better position to negotiate with landlords for more flexibility in their leases, such as shorter durations. We also expect re-leasing spreads will get tougher,” Moore said, referring to the change in rent per square metre between new and expiring leases.

To boost footfall mall owners are spending big on upgrades and adding more leisure and dining precincts to the mix. The sector has allocated A$1.6 billion for capital expenditure in 2018 with Scentre, Vicinity, and Stockland boasting the largest pipelines.

The sector is also recycling non-core assets and transitioning to properties in high-income, high-growth population centres. “Last year the A-Reits Moody’s rates made a total of A$2.7 billion in acquisitions versus A$4.6 billion in disposals,” Moore said. “That makes them net sellers and we expect this trend to continue into 2018.”

A drop in rental costs would take significant pressure off Australian retailers and give them space to work on their reinvention strategies.

For some it could mean the difference between survival and death. When fund manager Will Vicars promised to bail out Oroton following its slide into insolvency in December, he said the deal was conditional on the luxury handbag brand renegotiating its lease contracts.

Whether landlords come to the party and adjust rents is the billion-dollar question.

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