Brian Gaynor: Retail firms prove a bargain for investors

Photo / Glassons

The retail sector's fantastic performance has been one of the more notable features of the New Zealand sharemarket.

Since September 30, 2008, which coincided with the collapse of Lehman Brothers and the height of the global financial crisis, most of the main domestic listed retail stocks have had amazing investment returns.

Over this two-year period Restaurant Brands has produced total market returns, including capital and dividends, of 332 per cent, Hallenstein Glasson has been up 98 per cent, Briscoe 71 per cent, Pumpkin Patch 66 per cent, The Warehouse 52 per cent and Michael Hill 15 per cent.

Over the same 24 month period the benchmark NZX-50 Gross Index appreciated by just 3 per cent.

Why have the listed retail companies outperformed in a difficult environment while the listed agriculture stocks, which were covered in last week's column, performed poorly even though commodity prices have soared?

This analysis covers four companies, Hallenstein Glasson, Kathmandu, Michael Hill International and Pumpkin Patch, the NZX's international retailers.

The accompanying table shows that these four retail companies had worldwide sales of $1.2 billion in the 2010 financial year with 34.3 per cent in New Zealand, 54.6 per cent in Australia and the remaining 11.1 per cent in the rest of the world, mainly United States, United Kingdom and Canada.

The four companies had a combined ebit (earnings before interest and tax) from direct retailing operations of $178.5 million with $79.1 million in New Zealand, $114.9 million in Australia and a negative $15.5 million in the rest of the world.

Hallenstein Glasson, which reported net earnings after tax of $19.6 million for the year ended August 1, 2010 compared with $12.8 million in the previous year, has 116 stores.

The company has 47 Hallensteins stores, 37 Glassons stores and six Storm outlets in New Zealand. It has 26 Glassons stores in Australia, evenly divided between New South Wales and Victoria.

Hallenstein Glasson is a successful retailer but is also extremely cautious. This is partly because of the failure of both its Hallensteins store experiment in Australia and its Hallensteins Kids concept in this country.

However Glassons is now profitable in Australia and the company is in an ideal situation to expand across the Tasman particularly as it has a new chief executive and has $34.9 million of cash and no debt.

The Glassons brand should have good potential in Australia as it has been operating there for over a decade and has sales of just $35.5 million in that country compared with $93.7 million in New Zealand.

By comparison Kathmandu, Michael Hill and Pumpkin Patch all have far more sales across the Tasman than in their home country.

Kathmandu has been the worst performing NZX retail stock since it listed in November 2009.

This is because of a number of factors including the company's failure to achieve its prospectus profit forecast and the lack of support from New Zealand investors.

The company's head office is in Christchurch yet its post-IPO shareholder base was 88 per cent Australian and 12 per cent New Zealand.

This has changed to about 75 per cent Australian, 20 per cent New Zealand and 5 per cent the rest of the world but the problem with a high Australian base is that they are quick to sell out if a company fails to meet its prospectus forecast.

Nevertheless the company has much higher ebit margins than the other three companies, particularly in New Zealand.

Kathmandu has 97 stores, comprising 36 in New Zealand, 55 in Australia and six in the United Kingdom. In contrast to Hallenstein Glasson it has an aggressive growth strategy with 15 new stores planned for the year to July 31, 2011, 12 in Australia and three in New Zealand.

Australia offers the greatest growth potential in terms of store and product range.

The United Kingdom has been a disappointment, albeit the losses were reduced in the July 2010 year, and it wouldn't be a surprise to see this operation closed down.

Australasian-based retailers are far less risky as demonstrated by Michael Hill and Pumpkin Patch.

Michael Hill has developed a successful business model, namely organic growth in the company's traditional jewellery area.

This organic growth model has been much more successful for New Zealand retailers than the disastrous acquisition growth model adopted by Restaurant Brands and The Warehouse in Australia. Both these companies have now abandoned Australia.

Michael Hill has deviated from its successful business model twice, when it diversified into shoes in the 1990s and acquired 17 stores in Illinois and Missouri in September 2008 from Whitehall Jewellers. The latter was in Chapter 11 bankruptcy.

Chairman Michael Hill wrote in the June 2009 year annual report that "the decision to enter the US market was a long-term strategy to ensure the group's long-term growth strategy".

The 2010 annual reported noted that the company had decided "to close eight of the 17 stores in the United States and focus on a smaller platform of stores to prove up our model in the US".

Investor confidence in the company was also eroded by a complicated tax deal whereby the intellectual property comprising Michael Hill Jeweller was transferred from New Zealand to Australia.

Michael Hill now has 232 stores - 53 in New Zealand, 141 in Australia, 29 in Canada and nine in the United States.

Losses increased in both Canada and the United States in the June 2010 year and the company's share price performance will continue to lag until these losses are turned into profits.

Pumpkin Patch is a truly global company with 49 stores in New Zealand, 119 in Australia, 39 in the United Kingdom and 20 in the United States. It also has a wholesale operation that distributes to a large number of additional countries and will have two new stores in Ireland by year end.

Pumpkin Patch is highly profitable in Australia and New Zealand, with excellent ebit margins, but the United Kingdom and United States have been a big problem although losses were reduced in the year ended July 31, 2010.

The company still sees plenty of growth potential and is planning to open 22 stores in the July 2011 year. This will comprise 14 Australian stores, three in New Zealand, three in the UK and two in Ireland.

Six of these stores in Australia - and one in New Zealand - will be the new Charlie & Me casual children's brand.

The problem facing Pumpkin Patch, the other retailers and the agriculture companies covered last week is where to expand offshore, the pace of expansion and whether to adopt an organic or acquisition growth strategy.

In general our retailers have got it right - with the notable exception of Restaurant Brands and The Warehouse in Australia and Michael Hill and Pumpkin Patch in the United States - whereas NZ Farming Systems Uruguay was trying to run before it could walk.

However it can be argued that Hallenstein Glasson has been too cautious in Australia and Michael Hill and Pumpkin Patch have yet to develop successful business models in the Northern Hemisphere, particularly in the United States.

By contrast Kathmandu seems to be one of the best positioned international-orientated retailers at present.

* Disclosure of interest: Brian Gaynor is an executive director of Milford Asset Management which holds shares in all the companies mentioned in this column.