It's Morningstar's report on the ASX retail sector in 2023 and the winners are... Kogan and Domino's?

Morningstar forecasts non-essential goods demand to weaken throughout 2033
Rising services spending a headwind to goods, but some opportunities in discretionary retail
Demand for some categories, such as recreational goods, remain above pre-COVID-19 norms

Ratings house Morningstar expects non-essential goods demand to weaken through 2023 as still-elevated goods consumption structurally reverts to pre-COVID-19 norms.

According to Morningstar’s Australian Retailing: First Quarter 2023 report, rising living costs are also expected to eat into non-essential spending along with forecast higher unemployment.

Australia’s unemployment rate fell to a near 50-year low of 3.5% in February seasonally-adjusted, compared with January’s reported 3.7%, according to the Australian Bureau of Statistics.

The figures show Aussie unemployment is holding up despite consecutive rate hikes since May 2022 to bring the cash rate to 3.6% as the Reserve Bank of Australia (RBA) works to bring inflation back to its 2-3% target.

Australia’s annual inflation rate in January eased with the consumer price index for the month to 7.4%, compared with 8.4% for December alone with the interest rates hikes seemingly having some effect.

However, the RBA forecasts unemployment to reach 4.5% by June quarter 2025.

Morningstar equity analyst Johannes Faul wrote in the report while the cash target rate is up 350 basis points in just 10 months, the maximum effect on economic activity and inflation can take one to two years.

“The implemented hikes won’t fully affect the economy until 2024 at the earliest,” he said.

Faul said “Australian consumer sentiment is recession-like” and expects consumers to shift more of their spending to services as interest payments on mortgage mount.

“The pandemic shifted the spending mix toward goods, but we anticipate a reversion to the pre-COVID-19 split of 61% services and 39% goods,” he said.

Faul said the shift is estimated to reduce current annual goods consumption by $30 billion. He said since March quarter 2021, consumers have already reallocated over $10 billion toward services.

“Discretionary retailers’ sales momentum slowed in the first few weeks of calendar 2023,” he said.

“Trading updates show sales growth materially weakened for omnichannel retailers after a booming six months to Christmas.

“Conversely, sales growth for many online players has improved.”

A pizza and a funeral

In discretionary retailing Morningstar sees upside for some service-exposed businesses, such as undervalued Domino’s Pizza Enterprises (ASX:DMP) and funeral provider InvoCare (ASX:IVC).

Morningstar views Domino’s as a high-quality company with a long growth runway.

“We forecast a near 20% earnings CAGR for the next five years, underpinned by a global store rollout,” Faul said.

DMP’s sales growth has been volatile and the share price tends to reflect near-term trading conditions rather than longer-term potential.

Faul said the near-term outlook is uncertain and hinges on a moderation in elevated inflation.

“However, we believe the market is overly discounting Domino’s impact and significant long-term growth potential,” he said.

“We forecast the network to grow to 6,200 stores by fiscal 2032, from some 3,700 as of December 2022, below management’s target of 7,250.”

Faul said the non-binding offer for IVC from private equity firm TPG underscores the services spending upside we see.

Growth for online players improves

Faul said online sales fell materially across the board in H2 CY22 and expects only negligible e-commerce growth near-term.

However, he said from fiscal 2024 e-commerce is predicted to again meaningfully outperform brick-and-mortar retailing with high-single-digit annual growth rates.

Online pure play Kogan (ASX:KGN) is one of Morningstar’s top picks to benefit from a structural shift away from physical stores.

Faul said it’s still trading at a discount to its intrinsic valuation.

“We ascribe share price weakness to a material decline in sales and earnings from boom time levels,” Faul said.

“We expect revenue growth to reignite as consumer spending growth moves back to online.

“We also anticipate margin expansion in the second half of fiscal 2023, as marketing and warehouse expenses are scaled back and discounting to clear excess inventory stops.”

Faul said there are early signs of improvement with a return to EBITDA profit in January 2023.

“We also expect Kogan First to underpin customer loyalty and generate a recurring revenue stream,” he said.

Demand above pre-Covid-19 levels

Faul said demand for some categories, such as apparel and recreational goods, remain above pre-Covid-19 norms.

He said cyclical retailers Super Retail Group (ASX:SUL), Myer (ASX:MYR), and Premier Investments (ASX:PMV) all screen as overvalued.

The KGN, SUL, MYR, PMV share price today:

Good and bad news for supermarkets

Unusually high food price inflation has helped the two supermarket majors Coles (ASX: COL) and Woolworths (ASX:WOW) expand gross profit margins, but at the cost of market share.

Faul said dining out sales volumes recovered strongly in 2022 after retreating in the early stages of the pandemic. However, he said WOW management sees initial signs of a shift back to at-home consumption.

“We see a risk that discounters and independents grab more market share and reverse recent margin gains,” Faul said.

“However, we don’t anticipate minor market share losses to affect Woolworths’ narrow economic moat.”

Morningstar sees fairly valued parent company to brands such as IGA, Cellarbrations, and Mitre 10 Metcash (ASX:MTS) and WOW spin-off and liquor play Endeavour Group (ASX:EDV) as the most attractive consumer staples.

The COL, WOW, MTS & EDV share price today:

The views, information, or opinions expressed in the interviews in this article are solely those of the interviewees and do not represent the views of Stockhead. Stockhead does not provide, endorse or otherwise assume responsibility for any financial product advice contained in this article.