Structural shifts in retail are accelerating as we change the way we shop. The sector’s constituents also find themselves at a crossroads at a time when consumer budgets are under pressure.

Weak consumer spending remains a headwind for retailers. The volume of retail sales grew 0.1% month-on-month in January 2018 according to the Office for National Statistics, below analysts’ forecasts, with cautious, cash-strapped shoppers keeping a
lid on spending.

For much of 2017, retail sales held up better than expected, but the squeeze on spending created by high inflation and a weakened pound eventually dribbled down to the high street.

Citing analysis from Deloitte, investment bank Liberum Capital says the number of retailers that entered into administration rose by 28% in 2017 to 118, up from 92 in 2016.

‘This rise marks the first increase in the number of retail insolvencies in five years, and was exacerbated by a 55% jump in the number of administrations by those with more than 10 stores, including Jager, Brantano, Jones Bootmaker and Multiyork,’ comments Liberum.

Supermarkets – Strong food sales

According to the latest BRC-KPMG Retail Sales Monitor, total retail sales in the UK rose 1.4% in January 2018 versus 0.1% growth in January 2017, with food sales outperforming non-food.

With shoppers ring-fencing spend on celebratory festive food and drink, WM Morrison Supermarkets (MRW) proved a Christmas winner, like-for-like sales surging 3.7% higher in the six weeks to 7 January 2018.

Tesco’s (TSCO) UK & Ireland like-for-likes grew 2.3% in the so-called ‘golden quarter’ while rival Sainsbury’s (SBRY) enjoyed a strong Christmas week too. Tesco will report its full year results on 11 April; followed by Sainsbury’s on 2 May.

BETTER OUTLOOK FOR RETAIL?

Consumer spending has been hampered by prices rising faster than wages, with the fall in the pound following the EU referendum leading to rising inflation.

Yet the good news for the nation’s hard-pressed shopkeepers is the Bank of England expects the consumer squeeze to ease in 2018 – imported price inflation should begin to fade as the effects of sterling’s devaluation annualise out – and wage growth ticks higher.

The Bank of England has also raised its UK growth forecast for 2018 from 1.5% to 1.7%. That is supportive for confidence in the wider economy.

Inflation remains stubbornly high for now though. The latest UK consumer price index (CPI) reading of 3%, ahead of forecasts for 2.9%, reinforced concerns that interest rates will rise sooner and higher, putting additional pressure on consumers, many of whose finances are already stretched.

WHICH RETAILERS ARE FLOURISHING?

January’s blizzard of retail Christmas updates highlighted weak footfall dynamics being offset by strong online sales, continuing the trend of recent years.

‘What we are seeing is that the disparity between the “new-world” retailers versus the more traditional, mid-market players, where the consumer proposition and service elements are not compelling or agile enough, is widening,’ says Liberum.

‘Online is not a silver bullet for everyone and while, in general, management teams may be strong, the foresight to invest in the right systems, sell fashionable brands and have a clear market presence is central to ongoing success, in our view.’

Stockbroker Numis Securities says fortunes were mixed through the Christmas period. ‘There was the biggest gap between winners and losers that we can remember in recent years, but with downgrades/profit warnings more frequent than upgrades.’

Overall we’d suggest that the retail sector continues to have attractive investment opportunities, but the gap between the winners and losers is getting much bigger.

You need to think about brand relevance, whether there has been any recent investment in stores or websites, customer service standards, quality of goods and leadership. You can’t simply say all online companies are good investments and all high street ones are bad. We see good and bad players in both of these channels.

Read on and we’ll explain who’s hot and who’s not in the retail sector.

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ASOS LEADS THE WAY

Christmas is one of the most important trading periods for retailers. We’ve now had updates from all of the major UK-quoted retailers and can get a sense for how the next set of financial results may play out.

Festive winners included the pure-play online retailers which have structural advantages (no costly stores) and global growth potential.

ASOS (ASC:AIM) achieved 30% increase in retail sales in the last four months of 2017 to £790.4m. Nearly two third (62%) of those sales were generated from outside of the UK.

Focused on the 20-something demographic, ASOS’s US sales shot up 24% to £102.4m, EU sales skipped 42% higher to £235.2m and rest of the world revenues rocketed 34% north to £151.9m in the four-month period.

The period’s strong performance was supported by an outstanding showing from the UK. ASOS highlighted an acceleration in sales ‘in a challenging market’, with retail sales shooting 23% higher to £300.9m.

Significantly, as it demonstrates a business happy to invest for the future, CEO Nick Beighton said the customer proposition was further enhanced in the UK following the launch of Try Before You Buy and ASOS Instant, its same day delivery proposition.

Retail winners with a high street/physical store presence include JD Sports Fashion (JD.), the sportswear-to-outdoor brands business riding the ‘athleisure’ boom. It positive sales momentum carried over into Christmas, triggering another upgrade to earnings guidance.

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BOOHOO IS GROWING FAST

Also strutting its stuff over the peak selling period was smaller online fashion peer Boohoo.com (BOO:AIM), sales doubling to £228.2m in the four months to 31 December as all brands – Boohoo, PrettyLittleThing, Nasty Gal – generated record revenues.

Drawing confidence from its festive showing, Boohoo also upgraded current year sales growth guidance yet again, from 80% to around 90%.

ASOS’s shares are currently trading at an all-time high of £75.68. In contrast, Boohoo.com’s shares have been struggling since September 2017 when its joint CEO Carol Kane sold £10.7m worth of stock and the company reported a slight fall in margins.

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WHICH SHOPKEEPERS ARE STRUGGLING?

BHS has gone (from the high street), House of Fraser is in dire straits and both Marks & Spencer and Debenhams (DEB) are shuttering stores, so few would deny the department store model is structurally challenged. Indeed, if no department stores existed today, would anyone feel the need to invent them?

Ailing Debenhams issued a profit warning in January after a terrible Christmas for the business. We think the fact the hard-pressed British brand is locked into very long-term leases will hinder CEO Sergio Bucher’s attempts to turn round Debenhams.

Liberum downgraded its full year pre-tax profit estimate by a whopping 35% to £52.1m following the sobering festive showing.

Post-Christmas profit warnings were also issued by children’s goods retailer Mothercare (MTC) and flooring chain Carpetright (CPR).

Meanwhile, high street doyen Marks & Spencer’s clothing, home and food like-for-like sales weakened in its third quarter period to 30 December 2017. The British retail institution also reported a significant year-on-year slowing of sales via M&S.com.

Suffice to say; the success of its turnaround strategy under veteran chief executive Steve Rowe and backed by chairman Archie Norman remains quite uncertain. Marks & Spencer’s full year results will be published on 23 May.

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MAKING A COMEBACK?

TVs-to-mobile phones purveyor Dixons Carphone (DC.) said like-for-like sales grew 6% in the 10 weeks to 6 January 2018, buoyed by strong performances in the Nordics and Greece, while UK & Ireland like-for-likes were up by 3%.

One disappointment was the top end of the full year pre-tax profit guidance being downgraded to a £365m-to-£385m range from £360m-to-£400m previously. However, the appointment of Shop Direct boss and digital expert Alex Baldock as Dixons Carphone’s new CEO is very welcome.

Mobile phones are the weak part of Dixons, so Baldock needs to look at that part of the business quickly. He also needs to assess the size of the company’s physical store estate. There are growing expectations he will close many stores.

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THE VALUE END OF THE MARKET

Investors have been hungry for exposure to the growth story on offer at B&M European Value Retail (BME), the multi-price discounter and beneficiary of the cash-strapped shopper’s quest for value.

B&M is among those shopkeepers targeting the value end of the market, appealing to hard-pressed consumers. It is a self-funded growth story and a cash generative business offering scope for higher dividends in time.

New customers are driving strong growth at B&M. It is opening new stores in the UK and Germany and the acquisition of Heron Foods provides a new growth channel in the attractive convenience sector.

Other quoted plays on value, one of the sector’s structural growth themes, include Associated British Foods’ (ABF) Primark fashion chain, which achieved record sales in the weeks before Christmas.

Womenswear purveyor Bonmarche (BON) and budget footwear retailer Shoe Zone (SHOE:AIM) are also among the value-orientated retailers on the stock market.

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WHO COULD THRIVE IN 2018?

In our view, those retailers with strong, differentiated brands, distinct market positions and the well-invested infrastructure to power online sales, are those best placed in this challenged retail environment.

Over-spaced retailers with weaker brands facing tougher competition in crowded markets are best avoided.

Online transactions are here to stay, but investors shouldn’t underestimate the staying power of shops.

Shopping is a major leisure activity for a great number of people – not just a necessity, but a social activity, even a hobby and the convenience of clicks can’t always compete with that.

Meanwhile, many bricks-and-mortar retailers are meeting the e-commerce challenge head on, by creating multi-channel offerings with mobile apps and ‘click and collect’.

There are some very exciting growth stories in the wider retail space although investors will have to pay up in order to gain access to their soaring sales and growing cash flows.

For instance, e-commerce and international expansion are powering sales and profit growth at quirky British lifestyle brand Ted Baker (TED) and at Cheltenham-based Superdry (SDRY).

Fast fashion womenswear brand Quiz (QUIZ:AIM) has positive momentum at its heels and awareness of the brand is growing, supporting omni-channel growth that includes opening new physical stores.

And last but not least, Joules (JOUL:AIM) has the kind of brand differentiation that provides insulation from the headwinds facing the sector and is firmly in an earnings upgrades cycle.

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OUR TOP FIVE STOCKS TO PLAY THE RETAIL SECTOR

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BEST-IN-CLASS RETAILER

NEXT 

Investors should buy cash-generative clothing-to-homewares retailer Next (NXT) at £49.66.

It has best-in-class management and strong cash returns pedigree. Despite recently being cautious on the outlook, Simon Wolfson-led Next has committed to spend another £300m on earnings enhancing share buybacks in the current financial year to January 2019.

Any further strengthening of the pound will provide a boon for Next’s margins, while the Bank of England’s upgrade to UK economic forecasts and bullish view on wages implies a more positive backdrop for the retailer.

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GREAT WAY TO PLAY THE VALUE SECTOR 

B&M

Liverpool-headquartered B&M was founded in 1978 and floated on the stock market in 2014. It now has more than 540 stores and has considerable buying power, enabling it to sell goods at low prices. It also owns JA Woll, a chain of over 80 discount variety stores in Germany. Buy at 432.2p

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HIGH STREET WINNER

JD SPORTS FASHION

Established in 1981, JD Sports has proved to be one of the most successful retailers on the high street. It has more than 1,200 stores in the UK and Europe, using a range of brands including JD, Size?, Kooga and Nicholas Deakins.

Pre-tax profit before one-off items grew by 56% in 2017 to £244.8m. It ended the period with £213.6m net cash. Buy at 385.9p.

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GLOBAL ONLINE CHAMPION

ASOS

This stock is a great way to play growth in e-commerce. Asos sells more than 80,000 branded and own-brand products, delivering from fulfilment centres in the UK, US, Europe and China to almost every country in the world.

The shares always trade on a very high valuation, yet the business keeps delivering strong earnings. Buy at £75.66.

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CONTRARIAN PICK

DIXONS CARPHONE

This is the highest risk of our five retail selections. We’re confident management have the right skills to revive the business following issues around mobile phone sales, scrapped EU roaming charges and a change to its Honeybee sales software.

At 199.35p, the shares are trading on a mere 8 times current year forecast earnings – implying that the bad news is fully priced in to its equity valuation. We have a ‘buy’ rating at the current price.

However, we must stress that Dixons’ turnaround could incur some bumps along the way and therefore investors should not expect the share price recovery to go up in a straight line.

The contrarian’s view – why one fund manager believes the retail sector offers good investment opportunities

Alasdair McKinnon, fund manager of The Scottish Investment Trust (SCIN), believes the UK high street presents a happy hunting ground for contrarian investors.

‘The issues facing the sector are well known but there is a lot to love about some of these unfashionable stocks. People often get caught up in the latest trend and that makes it hard to see that world domination is not the only possible outcome.

‘The so-called “Amazonification” of the world is an excellent example and investors are prematurely foretelling the demise of physical shops. Ultimately, physical shops are here to stay. Shoppers like to see and feel products, they like to socialise while they shop and they enjoy the experience of shopping. Retailers need to adapt to changing habits and we believe those with strong brands are best placed to do so.’

McKinnon says physical stores can be a competitive advantage because they allow for convenient collections and returns.

He believes there is a lot of pessimism surrounding the retail sector and that creates potential to defy gloomy expectations. McKinnon says Marks & Spencer (MKS) is a great example of an ‘ugly duckling’ on the high street.

‘It has a strong brand and a compelling turnaround plan that is backed by excellent leadership. Traditional retailers have one thing that online competitors often don’t and that is profits. That allows for attractive dividends to be paid to shareholders.

‘The depressed valuations on offer conceal compelling opportunities. It is not always possible to say when sentiment will improve but a strong dividend yield rewards you for your patience. That is the case with M&S which has a sustainable dividend yield of over 6%,’ he adds.

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