CONSUMER SECTOR

01CONSUMER & RETAIL

CONSUMER STAPLES

INTRODUCTION

The Consumer Staples industry is made up of three sub-industry groups:

Food, Beverage & Tobacco – packaged foods, agricultural products, brewers, distillers, soft drinks and tobacco companies

Household & Personal Products – companies producing products like toiletries, vitamins, supplements and other health and household products.

Food & Staples Retailing Industry – companies involved in food distribution and retail.

INDUSTRY DRIVERS

Companies in consumer staples provide necessities to customers. The demand for these necessities typically remains unchanged even during recessions. This means that the sector’s performance tends to be relatively stable regardless of the macroeconomy. As a result, drivers such as interest rate which would otherwise have substantial impacts on other industries have minimal effect across staples sector.

Instead, the main driver of consumer staples are emerging trends that shift consumer preference. Nearly all individuals consume staples in some form or other, and their decisions are based on preference between the different companies competing to provide a sustainable advantage. For example, a major recent shift has been the move away from traditional plastic and the use of bio-friendly production means due to public sentiment. This change would induce the staples industry to adopt a more efficient and eco-friendly means of packaging.

INDUSTRY RISKS

Structural

Changing consumer preferences – customers have shifted their purchasing habits to include e-commerce and specialty brands such as organic alternatives. The rise of e-commerce and other smaller staples could disrupt existing players in the industry, as it can damage traditional routes to markets and other retailers. This can potentially result in companies adopting excessive price promotions in pursuit of a price leadership strategy, which can harm the brand’s equity.

Cyclical

During periods of fundamental shifts in consumer preference, large companies often take a long period of time to remodel their operating structures to take advantage of emerging trends ahead of other participants. There is no guarantee that a consumer staple company will always remain on top of the predicted market trend.

RATIOS

Dividend Payout ratio: Businesses in the consumer staples industry are generally mature and efficient with stable growth opportunities. As a result, they generate a surplus of free cash flows, much of which is returned to shareholders through dividends and stock repurchases. Comparable-store sales: Also called same-store sales, this ratio is used specifically by retailers to express year-overyear growth after adjusting for the opening or closing of store locations. That is, it describes the fundamental operating momentum of the business. Companies who are looking to expand their retail footprints would enjoy increases in same-store sales growth. Gross profit margin: The well-performing consumer staples businesses attribute their profitability to their brand power, large sales base and efficient operating structure. Gross margin is what remains after the company covers the direct costs from manufacturing distributing the product (otherwise known as cost of goods sold or COGS). A strong gross margin figure translates to higher earnings and indicates that the stock enjoys pricing power.

CONSUMER DISCRETIONARY

INTRODUCTION

The consumer discretionary sector comprises of companies that sell non-essential goods and services. The sector is considered highly cyclical, meaning it will grow and contract in line with the overall economy. The consumer discretionary sector is divided into 2 segments. The first is the manufacturing segment. This includes companies that are involved in the manufacturing of goods, such as household durable goods, textiles and leisure equipment. An example of an ASX listed company in this segment is Breville Group Limited (BRG). The second is the services segment. This includes companies that are involved in the provision of services to consumers, such as hotels and other leisure facilities as well as media and retail services. ASX listed companies in this segment include Myer Holdings Limited (MYR) and Tabcorp Holdings Limited (TAH).

INDUSTRY DRIVERS

The economic cycle is the most important driver of the sector. The stages of the economic cycle are as follows: expansion, peak, contraction, and trough. When the economy is expanding, businesses have stronger earnings and as a result, consumers have more disposable income to spend on discretionary goods and services. During economic contraction, the sector suffers as well. Consumers forego discretionary purchases and are more likely to save their money for the tough times ahead.

Consumer confidence is another driver of the industry and gives an indication as to the performance of the consumer discretionary sector. When consumer confidence is high, companies in this sector benefit from increased sales. When confidence is low, it leads to weak sales as consumers postpone discretionary spending and save money. An example of a consumer confidence index is the ANZ Roy Morgan Consumer Confidence Index.

Theoretically, an expansionary monetary policy is meant to stimulate spending in the economy. As interest rates are low, consumers have less incentive to save money, and thus are forced to spend money on discretionary items. This is meant to increase activity after an economic contraction. However, numerous retail players in Australia have suffered from numerous closures due to poor sales, some dubbing it as the “Retail Recession”. This implies that expansionary monetary policy may not be effective as it once was.

Particularly in times of economic contraction, government stimulus packages (fiscal policy) may drive activity in this sector. Monetary benefits are given to consumers to spend funds on discretionary items to stimulate activity in the broader economy. An example of this was seen in 2009, when the Rudd government $950 to each family earning below $80,000. These funds were to be spent on discretionary items to stimulate the discretionary sector as well as the broader economy. However, it appears that the $750 economic stimulus given to social security recipients during 2020 to combat the economic slowdown due to Covid-19 has faded.

7

CONSUMER DISCRETIONARY

INDUSTRY RISKS

As explained above, one of the risks to the industry is the contraction of the economic and falling consumer confidence. When the economy is contracting, consumers will generally have less disposable income, and therefore, this will directly impact the profitability of companies that provide discretionary goods and services to consumers.

As is now apparent, global pandemics, such as Covid-19, are especially bad for companies operating in this sector, particularly those with brick and mortar operating models. Just in 2020 alone, 161 Australian brick and mortar retailers have closed due to poor sales prior to 2020, together with the pandemic. With the imposition of lockdowns, as well as a contracting economy, compared to the same time last year, clothing spending is 58% lower, personal care and beauty spending is 61% lower and spending on recreation is 37% lower.

The Australian consumer discretionary sector is also facing cheaper competition from overseas brands online. This trend is particularly affecting Australian fashion retailers. For example, overseas brands such as Zara and H&M are taking business away from the Australian retailers. In 2017 alone, Australian retailers lost over $700 million in revenue to overseas competitors. Also, every few weeks, overseas brands come up with new offerings and new fashion, compared to Australian brands, which operate on a 4-season offering. This is not attractive to consumers who want constant updates to fashion.

RATIOS

The ratios below are used when analyzing companies within the consumer discretionary sector:

Inventory Turnover Ratio: This ratio is calculated by dividing net sales revenue by the average inventory over a period. This ratio is especially important for retail business, such as fashion companies. It measures how fast a company can sell its inventory. A higher inventory turnover ratio indicates that a company has a strong sales record and has a lower chance of its stock going out of fashion or becoming obsolete. However, a high inventory turnover ratio could also indicate that the company does not hold enough inventory. On the other hand, a low inventory turnover ratio indicates that the company has weak sales or has too much inventory on hand.

Interest Coverage Ratio: The interest coverage ratio is calculated by dividing EBIT by the total interest expense on the company's outstanding debts. This ratio is used to indicate the longerterm financial health of a company. A lower interest coverage ratio indicates that a company has a higher chance of not being able to service its debt, meaning that a company has a higher prospect of becoming bankrupt. A high interest coverage ratio (usually around 3x or more) indicates that the company has more than enough funds to service its debt obligations and is able to grow without facing financial hardship. It also means that the company is in in better shape to take on more debt in order to fund future expansion projects.

EBIT Margin: This is calculated by dividing a company’s EBIT (Earnings before Interest Expense and Tax expense) by a company’s total sales revenue. This margin considers a company’s operating expenses and accounts for a company’s use of its capital assets to create sales. A company with a higher EBIT margin indicates that its costs are lower and more of its sales revenue is converted into profit.

GAMING INDUSTRY GAMING INDUSTRY

INTRODUCTION

Video game, DVD and music retailing makes up a portion of the consumer discretionary sector in Australia. Two types of video games are predominantly sold in the Australian market, being console-based games played on platforms such as Sony’s PlayStation and Microsoft’s Xbox consoles, and video games played on computers such as Minecraft. The most significant companies in the industry are JB Hi-Fi (ASX: JBH) and EB Games (subsidiary of America’s GameStop Corporation).

In recent years, brick-and-mortar retailing has faced an uphill battle with online retailing. Sony and Microsoft offer digital downloads for their consoles, while most computer games can be accessed online without physical retailers. The same is happening with DVD and music retail, as streaming services such as Netflix, Stan and Spotify have eaten into the market share of Australian retailers.

PROS OF GAMES BOUGHT:

ONLINE

Quick

Cheap

Accessible

IN STORE

Bonus features

Trade-in value

Do not take up console storage

GAMING INDUSTRY

INDUSTRY DRIVERS

Discretionary income and consumer preferences

As the industry makes up a component of discretionary consumption, an increase in discretionary income and consumer sentiment increases the likelihood of expenditure on video games, DVDs and music.Leisure time and hours workedVideo gaming, film and television and music are all leisurely activities. As such, the industry is driven by the amount of leisure time that households and consumers have to spare to engage in such activities. This is reliant on the average number of weekly hours worked.

Technological advancements

Although detrimental to brick-and-mortar stores, increasing internet broadband and technology has an effect in driving the transition of video game and other entertainment sales to online platforms. Streamlining online transactions and expanding ranges of games available have resulted in increased comfortability of consumers purchasing goods online.

Engagement with younger generations

The younger population is a key driver of engagement with the video game industry, albeit through the funding of their family’s household. Demand for the industry is hence driven by trends and preferences of children and young adults. Additionally, there has been rising popularity within younger consumers for vintage formats, such as vinyl records or old gaming consoles, which has seen a rise in demand for niche products.

INDUSTRY RISKS

Structural

Mobile gaming applications – not included in the industry, more accessible and cheap, declining life cycle, presence of international online retailers

Cyclical

Dependence on consumer sentiment and preferences

CASE STUDY WESFARMERS

Wesfarmers Limited (WES) is a diversified business operating in supermarkets, department stores, home improvement and office supplies, resources, chemicals, energy & fertilisers and industrials & safety products. Major businesses include full ownership of Bunnings, Kmart, Officeworks, Target, Australian Vinyls and have an ownership interest in Coles.

Over the last 6 months, Wesfarmers has actually benefited from an increase in sales revenue across its major brands. With the imposition of lockdowns and more and more aussies working from home, sales for Officeworks have grown by 27.8% over the last 6 months (Jan-June 2020). This is compared to an 11.5% growth in sales from July to Dec 2020. Bunnings has also increased sales by 19.2% this year, compared to 5.8% growth from July to Dec 2020, as many begin to do home projects themselves instead of getting tradespeople. Across all retail businesses, online sales growth has increased by 89% since the start of the year. This means that so far, during the pandemic, Wesfarmers business segments have increased in sales and profitability.

Wesfarmers has also taken various actions to strengthen the group’s balance sheet, including the sale of a 5.2% interest in Coles on 31 March 2020 and extending their debt facilities to $5.3 billion from $2.0 billion, which was priced well below the group’s current overall cost of debt. These actions would allow Wesfarmers to respond to a range of economic scenarios as the pandemic continues, and support their investment opportunities.

However, the Victorian strict stage 4 lockdown imposed since early August, and to last 6 weeks, may impact Wesfarmers. Approximately 17% of sales comes from stores in metro Melbourne. However, due to the strength of its online sales operations, it is not expected that this lockdown will affect its profitability too much. The retail businesses of the Wesfarmers Group will continue with online sales operations, including home delivery and click and collect options. However, only time will tell if the surge in their major business segments will continue during the lockdown, as some believe that consumers have already stocked up on home office equipment and other items. However, perishable items, sourced from Coles will continue to be of demand during this pandemic.

Currently, Westfarmers’ P/E ratio is 26.68x, which is significantly above the industry average of 17.7x in multiline retail.