The retail sector has had a dire 2022, heavily sold off on fears earnings will disappoint as households curb spending due to rising UK inflation and the energy price crisis.

Earnings expectations have been cut and investors have priced in a recession already, which means bargain hunters may take the view retailers are now oversold, particularly as prime minister Liz Truss’ energy price guarantee will put some cash back in the pockets of hard-pressed consumers.

Given this challenging backdrop, investors need to be highly selective when it comes to retailers and focus solely on those with strong competitive positions and fortress balance sheets. Retailers that survive the crisis should emerge with enhanced market share opportunities as competitors will have fallen by the wayside, while the losers will be left with battered finances and diminished prospects, if they make it through the crisis at all.

CONSUMER CRUNCH

Though the consumer has held up well so far, supported by pandemic savings in many cases, soaring utility bills will leave less discretionary income for shoppers to spend on goods and services, a nightmare for retailers already struggling with cost inflation.

Consumer confidence has fallen to historically low levels, with GfK’s long-running Consumer Confidence index decreasing three points in August to -44, the lowest since records began in 1974.

According to the ASDA Income Tracker, UK discretionary income saw a 16.5% contraction in July. As measured by the BRC-KPMG Retail Sales Monitor, UK retail sales were marginally ahead year-on-year in August, up 1% versus a robust 3% comparative, but this performance was boosted by clement weather, notably around the Bank Holiday, and as Shore Capital suggests, was ‘perhaps a calm before an energy hit autumn storm’.

Consumers are having to fork out more for essentials such as energy, transport and food, with the under-30s age group impacted the most by rampant inflation, which means they are having to cut back on non-essential items such as clothing and DIY products.

LIKELY SURVIVORS

Little wonder then that shares in high street bellwether Marks & Spencer (MKS) have declined 50% year-to-date at the time of writing, with fashion seller Next (NXT) and home improvement giant Kingfisher (KGF) both down by around 30%; tellingly, Kingfisher is among London’s top five most shorted stocks along with online fast-fashion retailers Boohoo (BOO:AIM) and ASOS (ASC) according to Shorttracker.co.uk.

Led by experienced retailer Simon Wolson, Next looks better positioned than many other sector peers due to its strong balance sheet, robust cash flows and high margins, which shold provide a cushion in the tough times ahead.

The cost of living crisis is driving demand for great value products, which should play to the strength of discount retailer Primark, the hawker of cheap fashion that was one of the few retailers to maintain positive like-for-like sales during the financial crisis.

However, shares in parent Associated British Foods (ABF) plunged to multi-year lows on a profit warning (8 September) pinned on margin pressure at Primark, having to absorb rising costs caused by surging energy prices and a strengthening US dollar.

The retailer has also decided not to push prices too far to help maintain its value credentials for its customers. Short-term pressures notwithstanding, Primark should benefit as shoppers trade down from more expensive retailers, though we concede its core customer demographic is really feeling the pinch.

Primark’s survival looks assured given the strong balance sheet run by Associated British Foods and the company’s conglomerate structure which sees it derives revenue from food processing.

Other retailers targeting lower income consumers include B&M European Value Retail (BME), the variety discounter in a very favourable space given the squeeze on consumers’ finances.

The shares are down sharply year-to-date as B&M has found it difficult to fully pass through cost inflation and consumer behaviour has proved unpredictable, while analysts have expressed concerns over inventory levels and B&M’s loss of price food leadership.

Bucking the sector-wide de-rating is Shoe Zone (SHOE:AIM), the discount shoes, slippers and boots seller which recently (31 August) delivered its third earnings upgrade in as many months off the back of strong August trading driven by bumper demand for summer and ‘back to school’ products and ongoing margin improvements resulting from good supply chain and cost management.

As Zeus Capital points out, Shoe Zone’s attractive value proposition means it is ‘well placed to win market share as consumers seek more affordable alternatives against the current backdrop of high energy costs and food price inflation’.

Also famed for its value proposition is Sports Direct, the sportswear chain at the heart of Mike Ashley’s retail conglomerate Frasers (FRAS). Sports Direct controls the value end of the UK sporting goods market and through Flannels, Frasers has a leading position in UK luxury – two areas that should prove robust.

Retailers under financial pressure

The finances of the retail sector already bear the scars of a period when they were effectively unable to trade normally due to Covid restrictions.

This means many retailers could find it harder to weather the current consumer storm caused by the cost-of-living crisis.

The table shows companies with an Altman Z-score of less than 1.8 according to data from Stockopedia. The Z-score was developed by Edward Altman, an assistant professor of finance at New York University, in the late 1960s. It looks to analyse a balance sheet to identify the risk of bankruptcy and a score below 1.8 indicates a high probability of financial distress within two years.

Eyebrows may be raised by the presence of WH Smith on the list. While it is carrying significant debt, both as a result of the pandemic and thanks to acquisitions aimed at growing its travel division, its scale and track record plus the fact a significant chunk of its liabilities relate to leases on its shops provide some comfort.

The presence of leaseholds on the balance sheet probably doesn’t help the scores of other names on the list, though there may be particular concern about sofa seller ScS (SCS) given it sells the kind of big-ticket items which hard-pressed consumers are likely to think twice about buying in the current climate. [TS]

JD A STEP AHEAD

Another name in negative share price territory this year is athleisure leader JD Sports Fashion (JD). Given its focus on the youthful demographic, the market evidently thinks the ‘King of Trainers’ could struggle as consumer incomes are squeezed. Yet JD Sports is an international business with strong relationships with Nike and Adidas, while its net cash balance sheet leaves it well-placed to survive the crisis. As Shore Capital argues, ‘JD’s differentiated offer allows the retailer to distance itself from the highly promotional environment’.

Books, stationery and snacks seller WH Smith (SMWH) continues to exhibit resilience, generating cash by running its legacy high street stores business as efficiently as possible while investing in its international travel business as the growth engine of the group. The fact travel sales are now above pre-pandemic levels is very encouraging.

Also proving its robustness is car parts-to-bicycles seller and autocentres operator Halfords (HFD), which reported (7 September) resilient trading over the 20 weeks to 19 August 2022 and maintained full year profit guidance in the £65 million to £75 million range. Over 70% of Halfords’ sales now come from motoring products and services, an area of spend that tends to be more needs-based rather than discretionary. Buying a new bike is unlikely to be a priority for cash-strapped households, but Halfords can afford to lean on the motoring business and wait for the next upswing in demand.

The needs-based nature of greetings cards, which people purchase for annual and everyday events, makes this a resilient space too. Step forwards Card Factory (CARD), the value cards and gifts retailer which has scope to raise prices while still leaving its products cheaper than rivals.

LIGHTS FLASHING RED

Retailers without a distinctive proposition or with fragile business models or weak balance sheets are in for trouble. Marks and Spencer’s clothing and home business lacks the value credentials of a Primark, while its margins are lower than those of Next, suggesting it might be less resilient in a downturn, though it has come through periods of pain in the past.

The outlook for digital fashion retailers ASOS and Boohoo is gloomy given their online-only businesses models generate skinny margins and they sell to a younger customer cohort being hammered by the cost-of-living squeeze.

The pandemic-inflated home improvement boom is also fading, bad news for B&Q-owner Kingfisher and Wickes (WIX), as well as other discretionary retailers including Topps Tiles (TPT) and even sector star turn Dunelm (DNLM), though the UK homewares leader’s keenly priced-yet-quality home furnishings will resonate with price sensitive shoppers and Dunelm has successfully navigated past periods of consumer uncertainty.

With consumers avoiding big-ticket purchases, expect furniture sellers DFS Furniture (DFS) and beleaguered Made.com (MADE) to find things tough. An emergency fundraising might be on the cards at online furniture purveyor and initial public offering (IPO) flop Made.com as rising essentials inflation squeezes household spending. Investors should also be mindful that consumers stocked up on laptops and new TVs during lockdowns, so Currys (CURY) and AO World (AO.) will struggle to grow sales in the months ahead.

One of the retail sector’s biggest casualties is ‘British lifestyle group’ Joules (JOUL:AIM), the wellies-to-outwear purveyor whose shares have plunged following a string of profit warnings that have pressured the balance sheet, though they did rally on news Next was poised to inject some cash by taking a strategic minority stake – ‘positive discussions’ continue.

Though CEO Julian Dunkerton has steered apparel retailer Superdry (SDRY) through the pandemic and it has comfortable financial headroom, we would be wary of the potential for near-term downgrades here, as hard-pressed shoppers can always defer the purchase of Superdry’s premium clothing, accessories and footwear.

KEY PICK – NEXT (NXT)

£57.66

Shares in Next have plunged from their September 2021 peak, but only the brave would bet against the best-in-class retailer’s equity reclaiming those highs on a medium-to-long term view.

Admittedly, the Simon Wolfson-led clothing and homewares chain isn’t immune to the headwinds facing UK retailers, but Next is better at managing them than most and is delivering robust sales in physical stores and a resilient showing online. Long-term growth prospects for the business look better than they have done for some time, as less durable rivals like Topshop and Debenhams have disappeared from the high street, enabling Next to gobble up market share.

There is also growing excitement over the potential of the ‘Total Platform’, which sees Next leveraging the expertise, infrastructure and software it has developed for its own online business to provide an e-commerce outsourcing service for third party brands.

This is allowing the retail giant to offer more products on its website which makes it more attractive to customers, and it also earns a fee from clients for handling their e-commerce needs. Cash generation remains a key plank of the investment case, with the retailer returning cash to shareholders through earnings enhancing share buybacks.

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