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The retail sector faces challenging times, but astute investors who sniff out opportunities can still make money. The sector is up against higher interest rates, fuel prices and cost of living expenses, so stock selection among the retailers is critical.

Woolworths and Wesfarmers (the owner of Coles) offer widespread appeal, not only as supermarket giants, but diversified industrial conglomerates, where top results in one division can offset disappointing ones in others. Discretionary companies selling apparel, fashion accessories, furniture and auto parts are feeling the pinch in anticipation of higher interest rates slowing spending and lifting unemployment. Investors have taken a knife to the share prices of Noni B, Specialty Fashion Group, Fantastic Furniture, Nick Scali, Oroton and Super Cheap Autos, and will use it again on signs of a cooling economy.

While the share prices of the The Reject Shop, JB Hi-Fi and David Jones are trading well below their highs, their products still sell relatively well in tougher times and even more so on rising consumer confidence. More on these later.

Back to the big two retailers whose supermarket outlets are somewhat cushioned from any economic slowdown because they sell food and liquor.

The consensus is that Coles can only improve after disappointing years lagging its rival amid management upheaval, profit downgrades, an inferior supply chain, inadequate computer systems and uncertainty over ownership. Wesfarmers owns the highly successful Bunnings hardware chain and is certain to impose a similar culture on the Coles Group that comes with fabulous assets in prime locations across Australia. Coles will not become an overnight success, but no one is expecting it to. A more efficient and profitable Coles in future will enhance the bottom line for Wesfarmers already benefiting from a soaring coal price and boosted by earnings from insurance, industrial and safety, gas, chemicals and fertilisers. It posted a half-year net profit after tax of $601 million. Buying Coles Group brings Kmart, Target and Officeworks under the Wesfarmers umbrella.

The Perth-based Wesfarmers is raising $2.5 billion from shareholders rather than credit markets to help fund debt obligations flowing from its $18 billion takeover of the Coles Group last November. Its rights issue of one new share for every eight ordinary Wesfarmers shares is enjoying market support for a company with a long history of rewarding shareholders. Analysts consider Wesfarmers a mid-to-long-term buy while bedding down Coles and preparing it for a market-share assault on Woolworths. The market is informed about Wesfarmers’ debt schedule, and its diversity positions it well to adequately deal with any slowdown in the Australian economy. And, the company is trading well below its 12-month high of $45.90 a share in June last year.

Analysts say Coles offers earnings upside under new management because its past performance compared to Woolworths has been simply poor. David Spry, of F W Holst, says Woolworths has beaten Coles’ supermarkets in almost every department and this has been reflected in a growing number of shoppers switching to “The Fresh Food People”. “One of the major problems Coles had was actually getting goods to their stores – they were continually running out of stock,” Spry says. “The Coles supply chain and computer systems were second rate and they just couldn’t compete with Woolworths. I live near both stores and I have constantly compared them on product quality and price.”

Spry says Woolworths was able to absorb increasing transport, labour and input costs, making it far more competitive than Coles in groceries and liquor. Woolworths will continue to dominate its major rival until the Wesfarmers restructuring of Coles makes it more competitive. “Wesfarmers has the management capability to set Coles right,” Spry says. “It knows what has to be done.” Spry considers Woolworths a mid-to-long term buy for a company that also owns Dan Murphy’s, Dick Smith Electronics, Tandy and a major stake in the Australian Leisure and Hospitality Group.

Woolworths remains a core stock of any balanced portfolio after delivering a net profit after tax of $891.3 million for the six months to December 30 – an increase of 28 per cent on the previous corresponding period. Last month, Woolworths reported third quarter sales of $11.6 billion, an increase of 10.2 per cent.

Today’s much softer share price, compared to its 12-month high of $35.05 in December, is what excites Tolhurst investment adviser Mark Goulopoulos. “Woolworths is cheap,” he says. “It has never disappointed the market on earnings per share growth. For the past five years, it has reported earnings per share growth of 15-to-20 per cent year-on-year. It has an impeccable record and I don’t expect that to change.”

Goulopoulos also considers Metcash a buying opportunity because it offers a defensive earnings stream. It’s effectively a grocery wholesaler, supplying its own IGA supermarket chain and other independent grocers, liquor stores and wholesale confectionery outlets.

Importers benefit from a strong Australian dollar because overseas goods are cheaper to buy. That brings us to the The Reject Shop, which is somewhat shielded from an economic downturn by selling large volumes of discounted variety product to eager bargain hunters. Constant new store openings across Australia are contributing to impressive profit growth for a company offering a proven business model, strong balance sheet and little-to-no debt. Investors could find value as the share price is trading at $10 levels, a solid discount to its 12-month high of $14.81 in July last year.

Australia’s love affair with the latest technology and gadgets should sustain JB Hi-Fi’s revenue. Strong sales of flat panel TVs, laptops and digital cameras contributed to a record first-half profit of almost $42 million for the six months to December 31 last year. The company reported strong sales momentum for January and February and forecast a full-year profit between $57 and $60 million. The technology sector attracts more than its fair share of young customers without a mortgage. JB Hi-Fi’s 12-month high was $17 a share in December last year. It can be given serious consideration as a buy trading below $10 levels.

Department store David Jones attracts a loyal following, particularly among the well-heeled business set with plenty to spend regardless of how the economy is travelling. This has been reflected in impressive results, which should continue in line with forecasts. The company is opening new stores, cutting costs and releasing a new general purpose credit card later this year.

Raimond Aide, of Shadforths, says David Jones is trading on a favourable price/earnings ratio of 14 times and offers a dividend yield that is about 20 per cent higher than the average of listed retail stocks. “There is no reason why David Jones can’t deliver on earnings per share growth forecasts,” he says. “At today’s price levels, I do rate them very highly.”