Why the rag trade is a risky trade
Clothing retail offers high rewards when everything goes right but the odds are stacked against it in 2023, writes
Walking from one end of your local regional mall to the other, you’ll be enveloped by clothing shops. People care deeply about what they wear, regardless of their spending power, and a plethora of businesses compete to satisfy their needs at different price points.
Fashion is arguably the riskiest retail format, combining expensive shop rentals and long workingcapital cycles with the whims of consumerism. For investors seduced by juicy gross margins at these retailers, understanding the risks is important.
As a start, the products are not homogenous, so there’s the risk of misreading the season’s fashion. Shoprite and Pick n Pay don’t take a risk when they decide to stock milk, bread or chicken. In contrast, clothing retailers make critical style decisions every season, and from time to time they get them horribly wrong. This is even true in basic clothing, as the latest poor results from Ackermans (part of Pepkor) demonstrate.
A bad season creates a flywheel effect that investors need to be wary of. It starts with disappointing sales and ends with an overstocked warehouse. The stock needs to be cleared, so end-ofseason markdowns will be more significant than usual, driving a lower proportion of full-price sales and decreased gross margin. When combined with a drop in sales, that’s an ugly outcome for gross profit.
Operating costs are the same regardless of how appealing the clothes are, so the double-whammy impact of falling sales and margins is severe. Of course, this downside risk is balanced by the upside reward of getting the fashion and pricing exactly right. The fixed costs work in your favour when times are good. This is known as operating leverage, or the flywheel effect mentioned above.
In some cases, a fashion business loses its way over time. This is what happened at Woolworths, and the management team is making a concerted effort to turn this around. In other cases, operating profit can swing violently. This is something you don’t often see at the likes of grocery and pharmaceutical retailers, which is why they tend to trade at higher (more defensive) multiples than fashion retailers.
In addition to operating leverage, financial leverage (debt) is fraught with danger. When retailers go bankrupt, it’s usually because the balance sheet fell apart based on high debt.
An interest burden that is too high makes it progressively harder to compete, as cash ends up servicing interest rather than being reinvested in the business. Other retailers smell blood and turn up the heat to
squeeze the vulnerable player out of the market.
When the flywheel starts to spin against you, it is difficult to get out of the hole. A loss of market share requires a great deal of investment to recover. As the financial position deteriorates, the capital for that investment dries up. Eventually, there’s a change of ownership or the stores disappear altogether. Edcon, anyone?
To add to this competitive bloodbath, there’s the threat of new entrants. Years ago, names such as H&M or Zara did not have dominant positions in South African shopping centres. But with a relatively simple supply chain compared with grocery retailers (there is no cold chain), international clothing groups can enter the South African market with ease.
A recent development is the arrival of SHEIN, a significant issue for value clothing retailers. We can’t be sure whether this is the reason for recent pressure at the likes of Mr Price and Ackermans, but it can’t be helping. Consumers are cash-strapped and in search of bargains, so SHEIN’s Chinese supply chain offers prices that almost seem too
Despite being in a bright red ocean teeming with sharks, management teams further complicate their lives by looking for acquisitions, often in faraway lands
good to be true.
You don’t have to do much searching online to find out why the prices are so low. Let’s just say that if supply chain ethics matter to you, you should probably shop elsewhere.
We also can’t discount the entry of new local brands, such as Pick n Pay Clothing. It was supported by existing infrastructure, incubated in grocery stores, and today it is a powerful standalone player that has taken a bite out of the value fashion market with strong growth in the most recent trading period.
Specialist stores also emerge from time to time, though it takes a long time to build a meaningful footprint. Kingsley Heath and Freedom of Movement are perfect examples.
Despite being in a bright red ocean teeming with sharks, management teams further complicate their lives by looking for acquisitions, often in faraway lands. It’s all about the pursuit of growth, particularly for market leaders struggling to move the needle. Successful new entrants are often built with an entrepreneurial flair that is missing in corporates, with the result that corporates buy them.
Offshore markets are no easier, even if they have electricity. Woolworths is finally about to unscramble the David Jones egg, letting that disaster in Australia go and hanging on to Country Road as a consolation prize. The UK market has also claimed a few scalps, including Brait’s spectacular destruction of value with New Look. If retail executives struggle to succeed abroad, desktop balance-sheet jockeys should absolutely avoid that strategy.
A patchy peer-group track record in offshore deals hasn’t scared Pepkor away, and its recent acquisition of Brazilian retailer Avenida has brought a South American flavour to the JSE. It’s not a showstopper for the group, contributing low single digits to group revenue. That’s a good thing, showing Pepkor has learnt from the mistakes of others and chosen to dip its toes in the water instead of diving straight into the high street.
Speaking of the high street (or lack thereof), the best thing about this deal is that South America is a lot more like SA than London or Sydney. Brazil is the the biggest economy in Latin America, with a higher GDP per capita than SA, a population that is around three-and-a-half times larger and much lower unemployment. Avenida’s positioning in the market will be familiar to Pepkor, aimed squarely at clothing, accessories and cellphones for the average Brazilian family.
Other retailers have gone with a “local is lekker” approach, especially The Foschini Group (TFG) with its strategy to bring the supply chain closer to home after the horror stories of the pandemic. The 2022 acquisition of Tapestry Home Brands brought Coricraft, Dial-a-Bed and Volpes into the group and was an interesting sidestep from the acquisition of discount retailer Jet at the height of the pandemic. TFG took advantage of the business rescue process at Edcon and acquired a financially sustainable store footprint, leaving behind much of the mess that had hurt Jet.
In further deal activity, TFG’s latest quarterly update announced the acquisition of 114 Street Fever stores, with 90 of them to be rebranded Sneaker Factory. This is a small deal, so shareholders won’t be given full details of the underlying numbers.
While mentioning acquisitions of furniture and curtain businesses, it’ sa useful time to recognise that “clothing retail” is a misnomer. These are often clothing and homeware businesses, with a healthy contribution from cellphones as well. For example, clothing accounts for only 74.5% of
TFG sales.
Mr Price has also been on the acquisition trail, with Yuppiechef a good example of a nonclothing deal. There have been far more important clothing deals, though, such as Power Fashion and Studio 88. Those formats are growing strongly, unlike Mr Price’s core business, which has been plagued by insufficient power backup and an enterprise resource planning systems change.
The risk of management distraction due to corporate activity can’t be ignored, especially when operating conditions in SA are so difficult. Truworths is keeping it simple and doing a decent job of focusing on its core business. Its share price is up 12.5% in the past 12 months, while most of its peer group are down by more than 20%. Much of this was due to a rerating of the multiple, as value investors climbed in.
At the time of writing, TFG and Truworths are trading on nearly identical ebitda multiples (mid-7) vs Mr Price at 8.3 and Pepkor at 9. The multiple rerating story at Truworths has played out, so share price performance from now on is likely to be driven by underlying earnings growth.
The risks in this sector mean it’s probably sensible to leave it alone this year. Rising interest rates, load-shedding and consumer pressures make it difficult to justify the short-term upside vs downside case.