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We look at the outlook for the retail sector as several companies start to issue negative trading updates
Thursday 06 Jul 2017 Author: James Crux

A variety of negative factors caused by last year’s Brexit vote are starting to take a bite out of retailers.

Sterling weakness is driving up the cost of goods which means consumers have less money in their pocket after paying for essential items.

Some retailers now say they won’t hit earnings forecasts and share prices are taking a tumble in many parts of the quoted retail sector. Adding to these pressures are higher labour costs and higher business rates.

Ultimately, we’re at a major turning point for retail stocks from an investment perspective.

WHAT SHOULD INVESTORS DO?

Many retail stocks have rewarded investors handsomely for substantial parts of the last decade.

Given the change in market backdrop, should you now sell out or buy more at lower prices with a view that current market pains are only temporary?

Let’s take a closer look at the evidence and attempt to spot the likely winners and losers in retail.

WHAT’S HAPPENED SO FAR?

DFS Furniture (DFS), Next (NXT), Debenhams (DEB), Game Digital (GAME) and JD Sports Fashion (JD.) are among the quoted retailers to have recently spooked investors with news of trading weakness or pressure on profit margins.

In contrast, Dixons Carphone (DC.), Ted Baker (TED) and SuperGroup (SGP) are among the companies which have bucked the trend with decent trading updates.

Sitting in the ‘good and bad’ camp are BooHoo.com (BOO:AIM), which has been enjoying strong revenue growth but gross margins are falling; and N Brown (BWNG) which is also driving up revenue, albeit having to close some loss-making stores.

DATA POINTS TO TROUBLE AHEAD

UK economic news flow may have defied the doomsday predictions of ‘Project Fear’ since the EU referendum, yet heading into the second half of calendar 2017, ‘volatile’ is the word that best characterises the UK retail environment.

The latest Office for National Statistics (ONS) inflation reading of 2.9%, a four-year high, shows the household squeeze is intensifying.

Britons in the first three months of 2017 saved a smaller proportion of their income than at any time since records began in 1963, according to ONS.

 

Screen Shot 2017-07-05 at 16.59.06

The volume of retail sales fell 1.2% month-on-month in May, according to the latest ONS data (15 Jun), following strong growth seen in April.

‘There’s no getting away from the fact that life is getting tougher, with retailers clearly cautious over the near-term outlook,’ says Anna Leach, CBI’s head of economic intelligence.

cover story - BEST PERFORMING RETAIL STOCKS IN JUNE 2017

Pollster YouGov has reported a steep fall in consumer confidence following the indecisive result of the general election.

Consumer spending has fallen on an annual basis for the first time in almost four years, as higher prices tighten their squeeze on British households, according to a report by Visa.

Adjusting for inflation, real consumer spending by British consumers on Visa debit, credit and prepaid cards in May 2017 was 0.8% lower than in the same month last year. Visa said that seasonally adjusted spending was 1.8% lower in May compared to April.

cover story - WORST PERFORMING RETAIL STOCKS IN JUNE 2017

The data are based on a survey of money spent on Visa debit, credit or prepayment cards in Britain, which are used in almost 10bn transactions every year.

CLUES IN THE PROPERTY SECTOR

Investors should look at the property sector for further evidence of pain among retailers.

Significantly, the number of empty stores is rising as retailers focus on prime sites. And it seems demand for non-prime sites is weakening, as reflected by a negative shift in rental pricing.

Property group Colliers’ latest report on the state of the retail sector found the number of shops with falling rent more than doubled from 5% to 12% in the year to 30 April 2017.

‘The latest jump to 12% echoes the accelerating amount of stubbornly vacant property and suggests we are seeing another step change in the market,’ says Dan Simms, head of retail agency (south) at Colliers.

The report also found the proportion of all shops that have been empty for more than two years had risen from 3% to 3.6%. Colliers implies these locations might never be used as retail outlets again.

bright and fashionable window of modern european store

Alternative occupiers could be hard to find – interestingly, Colliers said that only about one third of BHS stores outside London had found a new tenant in the 15 months since 160+ large BHS sites were put on the market.

Meanwhile, warehouses used by retailers to ship online orders now pay higher rental yields ‘than all but the best trophy retail assets’, according to the report.

CHANGING MARKET DYNAMICS

Investment bank Berenberg says retail stores are closing as some adapt to the shift to online sales; and others are forced out of the market.

‘Combined with increased product and price transparency, incremental cost of delivery and returns, technology and marketing, we believe the outlook for over-spaced UK retailers remains negative, while retailers with low fixed costs and fewer stores that offer a better, differentiated experience, together with a strong online proposition, will continue to be the winners in the space,’ says Berenberg.

BIG TICKET FIRST TO BE HIT

Political uncertainty is undeniably hurting non-food retailers, notably those that sell big ticket items. If you’re feeling the pinch from rising inflation, cutting back on expensive purchases like a
sofa would be the first thing you’d do to manage your finances.

Indeed, we weren’t surprised by DFS Furniture’s profit warning on 15 June given the current landscape.

The Doncaster-headquartered firm warned recent trading had ‘weakened beyond our expectation’ since it previously updated the market on 30 March.

DFS Store, Mahon, Cork Copyright Fennell Photography 2012

Chief executive Ian Filby believes the drop-off in demand is market-wide rather than DFS-specific and ‘linked to customer uncertainty regarding the general election and the uncertain macroeconomic environment’.

A SHIFT IN SPENDING HABITS

Apparel and footwear retailers are now also starting to feel the pain with UK shoppers choosing to prioritise spending on leisure and entertainment rather than clothing.

Bearing the brunt of the high street’s challenges among the traditional apparel players is one-time retail sector darling Next.

Shares in the Leicester-headquartered clothing-to-homewares giant languish at £39.80, half the level at which they traded two years ago.

cover story - Next with annotations

The latest round of earnings downgrades followed news (4 May) of a worse-than-expected 8.1% slump in first quarter retail sales.

Chief executive Simon Wolfson spooked investors with the revelation that even the downbeat outlook issued in March, when Next reported a first profit decline in eight years,
had been overly optimistic.

Cover story - Next 10 years

‘The UK consumer environment remains challenging, particularly in the clothing and homeware markets, and real wage growth is
now close to zero,’ lamented Wolfson.

Shore Capital analyst George Mensah recently downgraded his pre-tax profit and earnings per share estimates for the current year from £716.7m to £705.9m and from 413.1p to 382.5p respectively.

That means Next’s shares are trading on a budget price-to-earnings ratio of 10.4 – a rare chance to buy a top-notch company on a low rating.

Next store

Next has a best-in-class management team led by retail grandee Wolfson, possibly the ideal executive to navigate Next through the current choppy waters. Cash flow remains strong and Next has impeccable capital returns pedigree.

Cheap rating, run by a retail expert, a highly cash generative business… surely Next is a takeover target at these levels? It would certainly be a target if the shares experience another downwards leg, in our opinion.

Mensah believes there is more downside than upside risk to full year revenue and profit expectations given the current state of trading and has reiterated his ‘sell’ rating on the shares.

cover story - Next bubble

We’re big fans of the company and believe the market has already priced in a weak trading environment. Buy now, but only if you can stomach share price volatility as we wouldn’t rule out further gloomy trading updates near-term.

EXPERIENCES VERSUS MATERIAL GOODS

Another issue to consider is the concept of ‘peak stuff’. More and more people, particularly millennials, are buying fewer material goods as they have no storage space or money to fund lots of purchases, preferring to save their cash to spend on experiences instead.

‘Peak stuff’ has negative implications for cash-generative homewares retailer Dunelm (DNLM), whose shares are currently in the doldrums too.

As an aside, the likes of Next, Dunelm and over-spaced babywear purveyor Mothercare (MTC), not forgetting Primark (owned by Associated British Foods (ABF)), would all welcome a rebound in the value of sterling, which would ease sourcing costs and enable them to maintain keen prices.

STRUGGLING FOR A LONG TIME

Marks & Spencer (MKS) continues to find life hard on the clothing side, although that might be self-inflicted due to its unimaginative choice of stock.

Halfords’ (HFD) chief executive Jill McDonald has been hired to revive Marks & Spencer’s fashion and homeware arm and she clearly has her work cut out when she starts the new job later this year.

Perennially struggling department store Debenhams warned (27 Jun) full year profit before tax could be towards the lower end of the forecast range ‘should current market volatility continue’.

Elsewhere on the UK high street, subdued first half results and a downbeat outlook statement (7 Jun) from cut-price shoes, boots and handbags seller Shoe Zone (SHOE:AIM) prompted analysts to downgrade their earnings forecasts for the company.

The good news is the cash-generative business continues to haggle down its rent bill, expand its larger store format and grow online sales at pace.

Many investors have made lots of money owning shares in JD Sports Fashion over the past few years. The company has been on a long winning streak of like-for-like sales growth and earnings upgrades, riding a boom in athletic inspired footwear and clothing.

cover story - JD sports bubble

Sadly that makes it vulnerable to large share price declines upon the slightest bit of disappointing news. We saw that exact situation last week when it flagged margin pressure, causing the shares to fall circa 12% over two days.

WHICH RETAILERS ARE STILL TRADING WELL?

Bucking the gloomy trend is a merry band of fashion and lifestyle brands with growing traction internationally.

They include the likes of quirky global lifestyle brand Ted Baker, whose retail sales rose an impressive 14.3% in the 19 weeks to 10 June.

Superdry brand owner SuperGroup’s retail, wholesale and e-commerce channels are all in growth.

Joules (JOUL:AIM), the premium British lifestyle brand whose wares span clothing, bedding and wellington boots, said on 6 June that its full year pre-tax profit for the year to 28 May 2017 would be ‘comfortably ahead’ of previous expectations.

BRAVE TIME TO HOLD A RETAIL IPO

We’re intrigued by womenswear retailer Quiz’s decision to join the stock market at a time when retail stocks are losing favour. It plans to list on AIM in July and has appointed seasoned retailer Peter Cowgill as chairman, best known for his leadership of JD Sports Fashion.

cover story - love hate

Online and international are the fastest- growing channels for Quiz, whose standalone stores and concessions are helping to drive sales and market the Quiz brand.

The one area that really looks interesting from an investment perspective is Quiz’s claim to have one of the fastest supply chains in the UK fashion industry.

It has a test and repeat model, similar to the one used by BooHoo with great success.

One of the biggest problems for retailers is having the appropriate stock for the latest weather and fashion trends – which means planning far in advance to get the items made and in the shops.

If trends change quickly (or the weather isn’t as predicted) then retailers can be left holding unwanted stock which they must then flog at discounted prices to make way for new items, hurting profit margins.

A test and repeat model avoids this situation as it involves a very short manufacturing run in order to see if customers like new products. The retailer will only make a larger order if the first lot sold well. In essence, it avoids having unwanted stock.

TAKE COMFORT IN COMPANIES WITH OVERSEAS EXPOSURE

If you’re worried about the state of the UK retail sector, look for companies which benefit from having international operations. For
example, fashion and beauty behemoth ASOS (ASC:AIM) generates nearly two thirds of its sales outside the UK.

Boohoo.com’s meteoric rise reflects similar trends, its upgrade cycle continuing to spin with stellar growth being delivered at home and overseas, including in the notoriously tough-to-crack US market.

Lost in summer girls

Also hitting the right notes is online musical instruments retailer Gear4music (G4M:AIM) thanks to international markets driving group sales.

WHO ELSE IS WORTH A LOOK?

We think plus-size fashion purveyor N Brown is a good investment, despite news it is closing some loss-making stores.

N Brown is predominantly an online retailer with healthy prospects in the plus-size and over-50s female fashion niches. Its transformation plan under chief executive Angela Spindler is evidently working and overseas prospects are rosy too.

N Brown’s first quarter update (20 Jun) highlighted a fifth consecutive quarterly improvement in performance. It delivered forecast-busting 10.2% growth in product revenue over the 13 weeks to 3 June.

WHAT ABOUT DIXONS?

We like Dixons Carphone’s market leadership position and highlighted the deep value attractions of the specialist electrical-to-telecommunications retailer in May.

Chief executive Seb James argues the business is ‘well positioned to flourish in the years ahead’, having improved its cost base, invested in its digital business and with a stronger recurring revenue base than in the last downturn.

It is also worth noting Dixons Carphone is an international play, benefiting as sales in the Nordics, Greece and Spain are translated back into weaker sterling.

Dixons Carphone’s Connected World services arm, which includes tablet-based sales platform Honeybee, is also on a growth tear.

dixons greece

 

One of Dixons’ shops in Greece

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