Join our community of smart investors

Recession: is it all retailers have to worry about?

Fears of a full-blown recession are receding, but that doesn't mean Britain's retailers have nothing to fear after the Brexit vote
October 27, 2016

In light of the recent Brexit vote, the question on several investors' lips is whether the UK is headed for another recession. It's fair to say that fears over a full-blown recession have receded despite a predicted halving in third-quarter GDP data (due to be published this week). But consequences from the June referendum haven't left the London market unaffected, and there are particular consequences for the retail sector. Here we're summarising what these consequences are, what pre-vote challenges persist for the retailers and which companies are best positioned to tackle the current trading environment as Theresa May prepares to trigger Article 50.

The pound problem

The most significant change for British retailers in the aftermath of the vote has been the movement in global exchange rates, and specifically the devaluation of sterling against the US dollar. While this has benefited the FTSE 100 as a whole, the cumulative rise in that index is down to the fact that many of those companies earn a chunk of their revenues in US dollars, which neutralises the impact from any costs they incur in that currency. But constituents in the FTSE 250, for example, tend to buy more products or services in US dollars before selling them domestically in sterling. That leads to a considerable shortfall based on the exchange rate, sending costs higher than what's planned for what are, ultimately, lower-value sales.

The effect has been felt far and wide. Sports Direct (SPD) was forced to issue a profit warning in the wake of sterling's 'flash crash' in early October, admitting that events had crystallised an exchange rate of $1.19 - instead of the $1.30 accounted for - resulting in a £15m hit to FY2017 cash profits. Plenty of Britain's big brands - from Next (NXT) to DFS (DFS) to Laura Ashley (ALY) - source stock in US dollars and euros, only to earn the majority of their revenues in pounds. That means they pay more for goods, which aren't worth as much when it comes to selling them. This can be offset by increasing prices, thus passing the cost onto consumers, but a retailer's flexibility to do this in a deflationary environment is limited. Some companies which are best protected in this kind of currency environment are the online pure-plays, specifically fast-fashion e-tailers such as Boohoo (BOO) and Asos (ASC). Due to the online nature of their businesses, these companies find themselves 'naturally hedged' thanks to a more 'multi-territory' - and therefore multi-currency - business model.

 

Which price is right?

As a result, these companies have more flexibility to remain competitive than traditional high street retailers - particularly when it comes to price. Asos's shares are up by more than two-thirds over the past 12 months, making it one of the best performers on the London market since the referendum. During the last 12 months ended August, adjusted pre-tax profits rose 37 per cent to £63.7m. But, more importantly, retail sales grew 26 per cent, with strong performances across all major markets, including the UK (up 27 per cent), the US (up 50 per cent) and Europe (up 28 per cent). The group cited "price investment" - effectively lower prices - as a main driver of sales on the continent and across the Atlantic.

Back on the British high street, the future appears somewhat bleaker. The Office for National Statistics (ONS) reported a 1 per cent rise in UK inflation during September, which it put down to higher oil and clothing prices. The similar jump in consumer prices index (CPI) inflation from 0.6 per cent to 1.0 per cent in September was the biggest month-on-month increase since June 2014. That suggests British retailers are passing their higher dollar costs onto customers, although it's probably too early to tell what effect this might have on group sales.

 

 

However, it's important to remember that higher prices have been on the cards for most of the year, particularly in response to the New Living Wage, which has only been exacerbated by the pound's fall. For evidence about what effect higher prices are having on the sector, it's best to look at the ONS retail sales data. Analysts at Short Capital said the "main takeaway" was "a material weakness in apparel and clothing sales from both a value and volume perspective" during the month of September. The 6.4 per cent fall in clothing volumes has been clear from recent updates on the market from the likes of Bonmarché (BON) and Next. Shore Capital said that aside from unusually warm weather at the start of the new autumn/winter season, price was "a material factor" that impacted clothing trading, as retailers protected margins after a fall in sterling against all major trading currencies. However, the broker expects most retailers "are well hedged through the current autumn/winter season".

 

 

Food glorious food

By contrast, a volume-based recovery continues for Britain's supermarkets, with the quantity bought up 2.9 per cent ahead of the 1 per cent value growth achieved during September. The difference is the food price deflation recorded by the CPI, where eight of the nine food categories saw a continued downward trajectory in prices. Competitive pressures in the category have resulted in many food retailers keeping prices low, with recent market data indicating that Tesco (TSCO) is at the forefront of this trend. Quite how low Tesco will go, however, remains to be seen as the supermarket has promised a 3.5 per cent to 4 per cent operating profit margin come the 2020 financial year. That means clawing a significant amount of costs out of its business in order to remain competitive at the top line. Encouragingly, recent stand-offs with suppliers such as Unilever suggest Dave Lewis refuses to kowtow to pressure.

 

IC VIEW

Retailers don't have to worry about a full-scale recession - yet. But the challenge they are confronted with is not insignificant. If consumer sentiment does weaken into 2017, retailers risk alienating customers with price increases which are designed to offset higher costs as sterling remains depressed. However, in order to maintain top-line growth, the retailers will have to sacrifice margins. This is an age-old problem in retail, but in a deflationary environment where value keeps retailers competitive, the pressure is on. What's more, those retailers still firmly in recovery - and Tesco springs to mind here - have promised investors better margins. Their flexibility in terms of prices rises is therefore limited.

 

Favourites

Our favourites right now fall into two different categories. The online pure-plays have the most natural insulation from swings in global currencies, and their flexibility on prices also helps them remain competitive. Other favourites include quality plays such as Ted Baker (TED), SuperGroup (SGP) and wholesaler Booker (BOK), all of which have weathered previous storms well. Ted's focus on quality product and core customer also stands it in good stead, and fears over its exposure to a weakening Asian backdrop are lessening. Booker, meanwhile, is establishing a trend for special returns, as is cash-generative SuperGroup.

 

Outsiders

The outsiders for us have been made clear, even a few short months following the vote. Companies such as Sports Direct and N Brown (BWNG) have more than just insufficient hedging policies to deal with, while Bonmarché has a lot of work to do to identify its core customer again. In terms of food, Tesco and Morrison (MRW) are solid recovery stories, but the share price reflects much of that future margin recovery already. On the high street, we expect groups such as WH Smith (WHSM) to continue fighting hard, but it'll be glad it has its more resilient travel business to offset consistently depressed footfall numbers.