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Doubts on TFG and Truworths

Clothing retailers Truworths and The Foschini Group (TFG) have long been mainstays of the domestic fashion scene. For years, Truworths was a front runner in the sector, with strong operational performance and world-class metrics making it a standout performer. But things have shifted.
Doubts on TFG and TruworthsTFG has changed its business model and focused on diversifying itself in terms of product categories and expanding the number of geographies in which it operates. Where TFG used to be immersed in mass-appeal women's apparel and not operating as efficiently as its competitor, analysts now increasingly see it as the stock to back.

But apparel retail has its challenges. SA had its weakest growth in seven years last year and clothing retailers were hit hard. Single-digit growth is forecast for the sector.

Evan Walker, fund manager at 36One Asset Management, says the outlook for the SA consumer is still deteriorating and he finds the TFG strategy a bit confusing.

"I certainly wouldn't be exposed to Truworths yet and I'm not sure about the TFG strategy. It's still a little perplexing for me. It is moving to the UK where the retail landscape is weakening by the hour. It is not moving to geographies that are shooting the lights out. It seems to be a bit of a land grab."

But many see TFG as the preferred "buy" at the moment.

Atiyyah Vawda, retail analyst at Avior Capital Markets, says it prefers TFG for a number of reasons. Its growth profile is more resilient as it is less exposed to womenswear (a segment of the market that is highly saturated) and more exposed to high-growth areas like sportswear. "Overall TFG's strategy is the one that is supported," even though it includes a jewellery offering which is struggling due to the weak economic environment.

"A number of its brands operate in underpenetrated or niche segments which also allows for more resilient growth," says Vawda, adding that it seems to be gaining market share from Truworths.

Vawda points to its cost structure and room for improvement. It has a wide array of brands, and duplication of roles and costs so there is the potential for improvement by focusing on cost management.

Operating cost growth used to be faster than revenue growth at TFG but this is changing. And inventory levels are high because it has slow- moving stock like jewellery, but this can be improved "and we're already seeing evidence of this in the most recent results".

Vawda says Truworths has a premium product offering but its product tends to lack innovation. "It is a very strong operator but the top-line growth is weak, hence sustainability of margins is a concern."

TFG has gone for mass diversification overseas, and its overall strategy is to have 50% of revenue from offshore with possibly a listing overseas at some point.

As one analyst points out, the difficulty with diversification is that you can buy stocks as a portfolio manager directly overseas; there is no need to buy it through a local company with an offshore portfolio. TFG's response is that it has the ability to pick speciality brands and, through that, facilitate ownership of these brands.

"It has definitely improved its operating leverage, cost centres, management of working capital and allocation of capital," says Kaeleen Brown, SBG Securities equity analyst.

Truworths is on the opposite end. It is sticking to its original nature. It has the best operating retail metrics, operating profit, margins, return on equity and return on investor capital.

"It is the best retailer in SA in terms of numbers," says Brown. The question is how sustainable that is. "Everyone has been predicting the demise of its gross margins and that hasn't materialised".

Alec Abraham of Sasfin Securities says TFG is doing better than Truworths. "The main concern in terms of Truworths is that, given its position in the market, it has upper-income customers looking for internationally inspired fashion. That puts it firmly in the firing line of Zara, for instance."

He says of all the SA retailers, Truworths is most in danger from Zara, yet it seems to have done the least in terms of trying to defend against that danger. "I don't think the loss of market share or wallet can be recovered."

Abraham says Truworths has simply doubled its bet in the space of high-income individuals, buying Earthchild and Naartjie.

"I don't think it has done enough to defend against the onslaught of Zara. Strategically it is weaker than it was." The purchase of Office in the UK has given it some diversification geographically, which was prudent, but it's not particularly big in the context of its business.

Abraham says TFG has done a far better job of diversifying risk geographically and in income groups. It is weighted slightly more to the middle market but also has upmarket brands like Fabiani and G-Star.

Geographically TFG is exposed to the UK, Australia and SA. It has been active in terms of the supply chain with the acquisition of Prestige. Due South covers the outdoor sports scene, which gives access to the younger market and diversification of merchandise categories.

"From a diversification of risk perspective they've done a far better job. It seems the management have been a little more on the ball in terms of managing the business in the sense of understanding the customer better."

From a fundamental point of view, Truworths seems to be stagnating in terms of strategic thinking, says Abraham.

Damon Buss, equity analyst at Electus Fund Managers, says strategically Truworths has the wrong model and hasn't adapted to the new age. "The price points of the product are set too high. The only way consumers can access the product is through credit. Its credit sales and cash sales growth are both negative, which shows the consumer can't afford the product and is choosing to shop where better value is offered.

"We like TFG. Strategically it is doing the right thing in terms of increasing local manufacturing capacity."

Buss talks of the new local manufacturing facility in Caledon that gives a huge advantage in terms of flexibility and quick turnaround, which increases the proportion of on-trend product and makes it more competitive with the fast-fashion multinational operators like Inditex (Zara) and H&M.

TFG orders a small percentage of what it wants for the start of the season, then it tracks what is selling well and sends orders to its factories. The factories turn the undyed fabric they hold into finished product on shelf in stores in under 56 days - which is quick turnaround, says Buss.

The other attractive aspect of TFG is that historically it has let each of its brands negotiate terms of trade on its own, on such matters as rental and security. Now, it is doing so as a group and with favourable economies of scale it is able to invest savings into prices and make product cheaper, and/or increase margins.

"Truworths has far less levers to pull in this tough environment," says Buss, adding that while its product has always been good quality, it is expensive. TFG is a buy."

Others take a different view. Jean Pierre Verster, portfolio manager at Fairtree Capital, says if you compare Truworths to TFG, Truworths has effectively flat-lined in the past few years. "Its latest sales are slightly down, both overall and like-for-like.

"It's quite commendable, though, that it is showing relatively flat earnings notwithstanding lower sales, assisted by higher gross margins, good expense management and sticking to its more fashionable offering, even though it is more exposed to fashion risk and credit risk than competitors. In the context of that business model it's not too bad.

"Because of its diversification strategy TFG has shown better growth than Truworths has indicated." TFG's same-store sales in Africa were up 2.8% compared with Truworths where sales were slightly down.

"Even on a like-for-like basis, adjusting for new store openings, TFG is outperforming Truworths.

"I find that on a valuation basis there's not much to choose between TFG and Truworths. TFG is performing better operationally but it's also trading on a higher p:e ratio than Truworths, and therefore from an investment perspective there's not much of a difference.

"If you ignore price you would say TFG is the better investment proposition but if you bring price into it, one could say the difference in operating performance has been discounted adequately in the valuation differential between the two."

Truworths issued an update this month, pointing to a sales drop as a result of the challenging trading environment. Sales for the first 17 weeks of the 2018 financial period fell by 3% to R5.5bn against the same period in the previous year when sales were R5.7bn. Sales at Truworths declined 2% to R4bn, though trading space grew 3%.

TFG in the same week posted interim results for the six months ending September in which revenue grew from R12.9bn to R14bn.

Operating profit before acquisition costs and finance costs rose from R1.7bn to R1.8bn, and headline earnings/share were higher at 504.9c/share from 496.8c/share.

Source: Financial Mail


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