BKI INVESTMENT COMPANY LIMITED only | ||
BKI INVESTMENT COMPANY | ||
ABN: 89 615 320 262 | ||
July 2022 | ||
BKI is managed by Contact Asset Management | ||
AFSL 494045 | ||
QUARTERLY REPORT | ||
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Consumer Staples in an Inflationary Environment |
Welcome to the 34th edition of the BKI Quarterly Report, prepared by Contact Asset Management ("Contact").
Rising global inflation and ongoing supply chain disruptions are just two of the compounding challenges that are testing the resilience of corporations and investors alike. Indeed, inflation has become the dominant topic of our daily news. We believe the main issue for investors as we head into FY2023 is the monetary policy tightening underway by Central Banks. There seems to be a "whatever it takes" attitude to combat inflation. It appears that Central Bankers remain convinced that economies are strong enough to handle the perceived rate increases. The pace of rate hikes remains an overhang as does
personalthe level at which interest rates settle. The RBA, which increased rates again in early July to 1.35%, is hoping that it can burst the inflation bubble and settle rates below 3.5% by mid-2023. While this is a significant percentage increase from the pandemic low-rate environment, a rate of 3.5% is still very accommodative in a historical context.
In this Quarterly Report, we consider the likely impact on the Consumer Staples sector, which has historically been a relative safe haven in times of inflation. We revisit our store walk survey from seven years ago and discuss our positive view on Metcash Limited.
The Australian Consumer is Facing Headwinds
In May 2022, the RBA increased the cash rate target by 25 basis points to 35 basis points. It was the start of an RBA strategy to remove the "extraordinary monetary support" that was in place during the pandemic. This was a major U-turn from the rhetoric that rates were unlikely to rise until 2024. The move has caught many Australian households off-guard.
At the time of writing, the cash rate target was 1.35% with bond market expectations that it will settle around 3.5% by the middle of next year. In the RBA's mind, there are two considerations which justify the change in tack on monetary policy:
- the economy has been very resilient, unemployment is low and economic growth is expected to be strong this year; and
- inflation has picked up more quickly, and to a higher level, than was expected and there is evidence that labour costs are increasing more quickly.
ForThe RBA is of the view that the average household can withstand tighter financial conditions in the battle against inflation. In the July Statement on Monetary Policy, the RBA noted that recent household spending data "have been positive", "the household savings rate remains higher than pre-pandemic" and "many households have built up financial buffers". The following charts illustrate some of the key data points that the RBA Board consider in setting monetary policy.
Charts 3 and 4: Interest rates are low by historical standards and there have been large increases in house prices
only The challenge is that most of the data that the RBA considers is backward looking. Primarily, inflation has become the big useissue for the RBA, and in turn Australian households and corporates. Until inflation is under control, we can expect a period
of rising rates.
In the recent Metcash Limited FY2022 result briefing, the word "inflation" was mentioned 26 times. At the FY2020 briefing, "inflation" was mentioned 5 times. On a positive note, "Covid" was only mentioned eight times at the FY2022 briefing versus 40 times in FY2020! The Managing Director noted "Of course, inflation is here and has accelerated. Getting into a little detail, you'll have seen that H1 and H2 numbers for inflation have changed from the first half to the second half. If you exclude - if you look at inflation on an excluding tobacco and produce basis, wholesale inflation in the fourth quarter was 3.4%, in April it was 5.3% and in May 4.5%. And as we pointed out, an increasing number of suppliers are asking for price increases." And "It's also worth noting, we will continue to invest in inventory while supply of product remains uncertain and whilst inflation
personalremains high. This approach has served our retail members well as well as our investors." Simply put, the inflation being felt by the supermarkets will be passed on to households. As depicted below, a lot of the inflation is in non-discretionary items.
For
The good news is that Household Net Wealth is robust, and unemployment is at multi-decade lows. Thus, there is some credence to the RBA argument that Australia has buffers. Nevertheless, households are facing an increased impost on monthly cash flows and expenses. Many will need to change spending habits as a result.
In an attempt to quantify the headwinds being faced by Australian Households, we have looked through ABS and recent Census data to establish a hypothetical scenario to illustrate the hit to budgets. In it, we assume a $500k mortgage (which is less than ABS data suggests new average mortgages are currently), a tank of petrol per week for a mid-size vehicle (60L tank) and then we have increased an average weekly household grocery bill and other eating out expenses (sourced from Canstar Blue). The scenario does not cover every household expense but is illustrative nonetheless.
onlyuseThe median monthly household income in Australia is $7,391 before tax and other deductions. One can understand why the latest Consumer Sentiment data has turned down sharply.
Chart 7: ANZ-Roy Morgan and Westpac-Melbourne Institute Consumer Sentiment Survey personalFor
Revisiting our store walk from seven years ago to test inflation
In June 2015, we walked the floors of several Sydney supermarkets. At the time, Coles was still embedded within the Wesfarmers (WES) conglomerate and Aldi was rapidly taking share with many calling the death of the big Supermarkets. Our thesis was to test the perception that the Aldi offering was significantly cheaper than Woolworths (WOW, Woolies) and Coles (COL). In the report, we noted the Japanese proverb that "One look is worth 100 reports".
onlyIt wasn't. Our conclusion (based on us buying three identical baskets of goods) was that Woolies was not broken but it has a distracted Management team (recall the Masters Hardware fiasco) and was mispricing its Woolworths Select (home brand) offering. It was failing to compete with Aldi for the low value customer. Following an assessment of WOW across our fundamental factors, including Principal Activity, Income, Balance Sheet and Valuation, we started buying WOW for the BKI Portfolio below $20. While it took a few quarters to turn around, the investment in price and customer experience finally reversed the customer perception. WOW has since outperformed the broader market by 25%.
usepersonalThe table above is also interesting to highlight the pace of inflation over the past seven years. While there are some outliers, it is clear that the cost of living has been running above the RBA's 2-3% inflation target for some time.
Recent store walk anecdotes
Two weeks ago, the Contact Asset Management investment team headed out to visit several Consumer Discretionary stores and sellers of Household Goods. We visited Artarmon, Macquarie Centre and the Northwest of Sydney. Our last day trip of this nature was in June 2020 as we emerged from the initial Covid-induced lockdown. Australian households had just been handed stimulus cheques. We were blown away by the level of activity in stores such as Harvey Norman, Beacon Lighting, Nick Scali, ARB and Super Cheap Auto. Of note, was our visit to Nick Scali Penrith where the Store Manager noted that she
Forhadn't had a lunch break for weeks because the store had been so busy. It was a revealing insight and the subsequent increase in earnings and share prices in the second half of 2020 and into 2021 was testament to the strength of the Consumer Discretionary sector.
Our store walks in late June 2022 highlighted conditions were more benign. While End of Financial Year promotional activity was significant, foot traffic is certainly down. We find this type of scuttlebutt useful. While our financial models are a critical part of our Investment Process, we know that there is more to investing than simply what lies in a spreadsheet. Some high- level discussions and observations included:
- A coffee shop owner in the only café in a homemaker centre on Sydney's North Shore: "Foot traffic has dropped a lot in the last couple of weeks. The customer has become a lot more price conscious."
- Adairs: seemingly had a lot of inventory and heavy promotions underway.
- Plush Furniture: an employee commented that business is "only OK". The wait time on a new sofa has reduced from the supply chain induced delays of six months ago. A couch ordered in late June, would be delivered in late October.
- Freedom: it seemed that almost everything was on sale. There were only two staff that we could see in the store. Perhaps that is a way to reduce costs.
- Good Guys: noted that they were still tight on a lot of items (notably Miele and Asko). Activity was expected to be strong with the promotions underway.
- Harvey Norman: conditions in the electrical department were strong. Like the Good Guys, HVN was expecting a big weekend given the EOFY promotions. There is a long lead time on BBQs. The furniture department seemed quiet.
- Nick Scali: activity had slowed with the employee stating that he believed that the reopening of international travel had meant that many consumers were prioritising travel over spending on household goods
- Total Tools: was a well-presented store. Activity remained strong (again EOFY a factor) yet very little was on sale.
onlyIn early July, we are starting to see many sell-side analysts aggressively cut their earnings estimates for a lot of Consumer Discretionary stocks. Many of these cuts seem reactionary and have followed material falls in share prices. The table below outlines the price movements of several Consumer Discretionary names. With several companies trading on single digit P/E multiples and compelling dividend yields, a lot of negativity is already priced in. Harvey Norman is the only company that BKI owns in the list below. Our investment case is tied to its Property Portfolio as much as the retail business. With Property assets conservatively valued at over $3 billion, we believe that the market is only valuing Harvey Norman's vast international retail business on a low single digit P/E multiple.
Table 3: Summary of share price declines and valuation metrics of Consumer Discretionary stocks
Current P/E | Current | ||||||||
52 week | Change | Multiple | Dividend | ||||||
Code | Company Name | Price | high | from High | (FY22e) | Yield (FY22e) | |||
use | AX1-AU | Accent Group Ltd | $1.33 | $2.85 | (53)% | 17.9x | 4.3% | ||
ADH-AU | Adairs Ltd. | $2.08 | $4.35 | (52)% | 7.2x | 9.1% | |||
UNI-AU | Universal Store Holdings Ltd. | $4.16 | $8.56 | (51)% | 14.9x | 4.2% | |||
NCK-AU | Nick Scali Limited | $8.59 | $16.30 | (47)% | 8.9x | 7.9% | |||
BLX-AU | Beacon Lighting Group Ltd | $1.94 | $3.39 | (43)% | 11.0x | 4.8% | |||
PMV-AU | Premier Investments Limited | $20.15 | $32.62 | (38)% | 12.8x | 5.0% | |||
HVN-AU | Harvey Norman Holdings Ltd | $3.84 | $5.93 | (35)% | 7.5x | 9.5% | |||
SUL-AU | Super Retail Group Limited | $8.90 | $13.73 | (35)% | 8.9x | 7.4% | |||
LOV-AU | Lovisa Holdings Ltd. | $15.46 | $23.07 | (33)% | 32.2x | 3.1% | |||
JBH-AU | JB Hi-Fi Limited | $39.04 | $56.85 | (31)% | 9.1x | 7.2% | |||
XKO -ASX | S&P ASX 300 | 6575 .6 | 7628 .2 | (14)% | 13 .0x | 4 .9% | |||
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BKI Investment Company Limited published this content on 10 July 2022 and is solely responsible for the information contained therein. Distributed by Public, unedited and unaltered, on 10 July 2022 23:43:06 UTC.
