We upgrade our sector call to OVERWEIGHT, largely underpinned by our bullish view on mid market retailers as: (i) consumers rekindle shopping-in-person, (ii) their customer base is skewed towards the M40 group whose spending power is less impacted by the high inflation given a healthy household balance sheet, and (iii) they have been able to pass on higher costs and hence maintain their margins. On the other hand, while F&B producers are likely to sustain their sales, this will be achieved at the expense of margins. F&B producers have little room to hike prices as their customer base is skewed towards the B40 group that is harder hit by the high inflation. Our sector top picks are AEON (OP; TP: RM1.95) and PADINI (OP; TP: RM4.10).

Consumption softens but will sustain. MIER 2QCY22 consumer sentiments index (CSI) fell 23 points to the 86 mark, below the consumer optimism threshold. Citing rising prices and subdued expectations for employment and finances, sentiment appears to be softening. Year-to-date (YTD) growth of total distributive trade sales as of July is hovering around the 20% mark. Based on our in-house forecast of 15% for the full year, growth is expected to taper off going forward as interest rate hikes and inflationary pressure squeeze consumption. We project consumption to soften from August onwards due to tighter financial conditions following Bank Negara Malaysia’s back-to-back rate hike. On top of that, rising cost of living and impending global recessionary pressure due to China’s persistent zero-COVID-19 policy and Europe’s worsening energy crisis may also lead to a decline in consumer spending. We continue to expect growth in private consumption on the back of the reopening of the economy, but overall growth is expected to normalise significantly (estimated at +7.7% in 3QCY22 vs +18.3% in 2QCY22). However, Retail Group Malaysia (RGM) member associations, the Malaysian Retailers Association (MRA) and the Malaysian Retail Chain Association (MRCA) are positive on robustness ahead with the retail industry average growth rate expected at 62% for 3QCY22 (2QCY22: 62%). Department store-cum-operators are expecting sales to reach 99% YoY with the fashion and accessories sector at 165% YoY for 3QCY22. Owing to the firm recovery of the Malaysian retail industry since beginning of this year, RGM has revised its growth target for the retail industry to 32% YoY (from 13% previously).

Inflation mitigated by policies supportive of consumption. Despite the inflationary pressures we expect topline for the remainder of 2022 to be resilient supported by: (i) recovery in the labor market, (ii) end-of-year demand with supporting policies (e.g. higher minimum wages, wage subsidy program), and (iii) gradual pick-up in tourism activities. We believe the M40 group will continue to maintain spending underpinned by a healthy household balance sheet, but the B40 group will be struggling amidst depleting pandemic handouts and fund withdrawals. We expect the retail players to be able to defend their margins on a combination of better product mix and operational efficiency coupled with the absence of major supply disruptions especially from China. The same cannot be said for F&B producers that have not raised product prices steep enough to offset higher input costs, for the fear of demand destruction (as consumers down trade or switch to cheaper alternative) and loss of market share. F&B producers face renewed economic challenges - elevated input and logistics costs arising from inflationary pressure. On-going geo political tensions are stoking further inflationary pressures as energy prices surged amid volatile supply. Although commodities prices have gradually softened in the last few months, global indicators showed a reversed trend well into 2023, posing risks to earnings, indicating that pre-pandemic level margins is still a long way off especially for the F&B producers.

Our top picks are AEON (OP; TP: RM1.95) and PADINI (OP; TP: RM4.10). We like AEON for: (i) it is a good proxy to consumers rekindling shopping-in-person (vs. online) which offers the sound-and-sight experience that online shopping is unable to match, (ii) its expansion plans on one full-fledged AEON store in IOI Putrajaya, as well as the rejuvenation of three existing AEON stores, and (iii) its digital transformation by introducing self-checkout terminals, which will reduce dependency on labour and improve productivity. We like PADINI for: (i) the strong spending power of its primary target customers, i.e. the M40 group, (ii) its strong net cash position enabling it to purchase inventory ahead of price hikes and potential supply disruptions, and (iii) innovative all-in-one (men, women and children) Brand Outlet, boosting the chances of garnering footfall from shoppers.

Source: Kenanga Research - 4 Oct 2022