Retailers face up to the twin threats of a weak pound and ‘peak stuff’

The first fall in non-food retail sales for six years in the three months to February, according to data from the BRC-KPMG monthly survey (7 March), helps to explain why the UK’s General Retail stocks continue to perform so dismally, even as investors remain generally upbeat on the prospects for future growth and equities in general.

The FTSE All-Share General Retailers sector has fallen 4.9% in the year-to-date*, compared to a 3.2% rise in the FTSE All-Share index, a showing which leaves it ranked 37 out of the 39 industrial groupings which make up the benchmark:

The 10 best and worst performing sectors within the FTSE All-Share in 2017

Source: Thomson Reuters Datastream. *Data to 7 March 2017.

This follows an equally poor effort in 2016, when it also ranked 37th.

The heady-days of the top-10 placings of 2012 and 2014 seem far away and this leaves investors with a decision to make.

Do they start to research the sector in the view that value may be appearing in the sector and its troubles are cyclical? Or do they simply file it away as too dangerous to touch, in the view that there are deep structural issues at work which could continue to eat away at profits, cash flow and ultimately dividends?

General Retailers have underperformed since 2014

Source: Thomson Reuters Datastream

Three problems

The weak BRC/KPMG data do flag possible timing issues related to Mother’s Day but it seems there are three more deep-rooted issues at work:

• The first is the ongoing war between bricks and clicks. In-store sales of non-food items fell 2.4% on a total basis (and 2.6% like-for-like) while online sales rose 7.7%. The price-crushing powers of the internet remain a key challenge for all retailers. This will favour some retailers – ASOS and Boohoo.com for example – but challenge those with a hefty High Street presence whose online platform still needs work (such as Marks & Spencer, for one).
• The second is the pound. This has boosted headline inflation, potentially crimping consumers’ spending power and although the price discovery provided by the internet may help buyers it is a further complication for sellers, who may also face higher input and raw materials costs. Many retailers face the difficult decision of whether to increase prices or take a margin hit and the long-term relationship between the pound and the FTSE All-Share General Retailers sector is an interesting one. Note how the sector looks to do better when sterling is strong (and inflation is potentially subdued, to the benefits of consumer spending and margins) and less well when sterling is weak (as it has been in the wake of the referendum vote).

The General Retailers sector has historically preferred a strong pound

Source: Thomson Reuters Datastream

• More fundamental still is the issue of whether consumers have reached ‘peak stuff’. This could be either because personal borrowing levels in the UK stand at a new all-time high of £1.9 trillion or millennials – used to the gig economy and sharing accommodation (since they are struggling to get on to the housing ladder) – are going to simply spend less on tangible assets and more on experiences. ‘Peak stuff’ does no favours to vendors of homeware like Dunelm, for starters.

If General Retailers’ woes are the result of the pound and concerns over Brexit then their fall from grace since 2014 could eventually tempt value-hunters, who will take the view the problems are cyclical.

If their problems are the result of the internet, consumer debt and demographics and look more structural than cyclical then even two to three years of underperformance relative to the broader UK market may not be enough.

Food, glorious food

Another notable feature of the BRC/KMPG report was the relative strength in food sales, which rose 2% in total and 0.6% for like-for-like.

This trend was confirmed by the Kantar Worldpanel sales figures for the 12 weeks to the end of February released the following day (8 Feb).

This report showed supermarket sales growth of 2.3% compared to the same period in 2016, the best growth rate since summer 2014.

Morrisons did best of the Big Four with a 2.6% gain, its best in four years. Tesco and Sainsbury’s made smaller gains and Asda fell, although Lidl and Aldi showed all of their rivals a clean pair of heels with increases of 13% and 12.9%.

Yet as the first table makes clear, the Food & Drug Retailers sector is also in the doldrums this year, ranking within the bottom ten within the FTSE All Share.

This is largely due to an 8%-plus drop in Tesco shares.

Bringing a deal to book

The market’s initial enthusiasm for the planned £3.7 billion cash-and-stock acquisition of FTSE 250 wholesaler Booker appears to be waning and the deal will shape sentiment towards Tesco for some time to come.

Investors must subject any merger and acquisition (M&A) deal to four checks and then take a view:

• The reasons for the deal: is to boost growth or create it?
• How does the acquirer plan to achieve the deal’s financial targets? Bear in mind at this point that some 70% of all acquisitions fail to generate the planned benefits, with cost savings proving easier to achieve than revenue synergies.
• How many new variables are being introduced to the business? One is usually enough. Deals that bring both a new line of business and new country of operation at the same time usually cause grief.
• Is the price being paid a fair one? ​The price paid is the ultimate arbiter of return on any investment and although the stock element reduces the risks, Tesco is paying a forward earnings multiple of 25 times for Booker, which has a 3.2% interim operating margin and operates in a competitive, mature market.

Only one new variable is being introduced (new operation but same country) and Tesco says the deal will be earnings accretive after two years, but this excludes implementation costs and assumes all synergies are met.

We shall see, especially as the multiple paid leave little margin for error, especially as the FTSE 100 firm has its hands full dealing with competition from its own competitors.

Russ Mould, AJ Bell Investment Director