Consumer health check

But there are some bright spots. Global retail stocks enjoyed a brief rally last week as footfall numbers came in ahead of expectations, while food retailers – even once ‘squeezed middle’ operators such as Tesco (TSCO) and Sainsbury’s (SBRY) – appear to be holding up well. But to what extent is this the result of general action taken by these companies post-2008 to defend against an ever-changing retail landscape? Or does it reflect a new set of trends emerging among consumers?

The data is dense and confusing, often conflicting, too. But in this feature we’re aiming to understand current British consumer. How resilient are they, and what does this mean for the British retail sector this year?

When the price is right

Inflation has been a direct consequence of last year’s referendum, which triggered a subsequent devaluation in sterling against global currencies and, notably, the US dollar. This last point is significant because many retailers source their goods in greenback, but sell domestically for the most part, which has led to an inevitable rise in costs but no such corresponding improvement in sales. Given the operationally geared nature of many British retailers, this has led to downward pressure on margins, and thus profitability.

The best way to offset this pressure is to raise prices but this isn’t as easy as it sounds. If British consumers aren’t as confident about their finances as they once were, paying more for everyday items might start to grate. This hasn’t been particularly evident in the food retail sector – which has enjoyed a return to price inflation after years of price wars post-referendum – but for ‘mass market’ or ‘middle market’ general retailers, this has been difficult. Many have been left without a choice, while others, such as clothing chain Next (NXT), took the initiative and announced price rises even pre-referendum.

But this strategy has had varying degrees of success. Some more 'premium' retailers such as Ted Baker (TED) or SuperGroup (SGP) have found little change in trading patterns as a result of price changes, whereas companies such as JD Wetherspoon (JDW) have been wary to push prices too far for fear of alienating traditionally price-sensitive customers. All of this suggests retailers aren’t sure how the British consumer is really going to react to higher prices and limits on discretionary spending. During the last recession, ‘experience-based’ spending became increasingly popular – dining out, cinema trips, day trips – while more discretionary items such as home goods, electricals and fashion suffered. There’s clearly trepidation that the same trends might emerge in this inflationary environment.

One particular trend retailers are wary of is the tendency of consumers to ‘trade down’ when the purse strings start to tighten. During the last recession this was a particular problem for the grocery sector – more on that later – but it could start to creep into general retail too. If recent numbers from discount chain B&M European Value Retail (BME) are anything to go by, this might be happening already. Group revenue growth in the first quarter of 18.3 per cent included UK like-for-like growth of 7.3 per cent, buoyed by – wait for it – strong grocery sales. 

The weather also played a helping hand as it encouraged sales of garden furniture. There are sometimes concerns about discounters’ margins in an inflationary environment, as it’s thought they have less ability to manoeuvre on price. But investors should take heart that B&M management say they’ve successfully renegotiated with suppliers, meaning gross margins should remain flat this year.

But there’s also confusion as to where inflation is truly headed. Having steadily increased since October 2016, inflation rates actually fell in June 2017 to 2.6 per cent from 2.9 per cent in May. Similar falls in the retail prices index (RPI) and consumer prices (which include housing costs) were also recorded. Economists say this was a direct result of a fourth month of falling oil prices, and could ease pressure on the Bank of England to raise interest rates.

This could be good news for spenders and borrowers, too, as credit card spending and mortgage payments could be spared a rate rise. Some believe the dip is an anomaly and, more importantly, inflation is still running ahead of average wage growth, which stands at 2 per cent excluding bonuses. This means pressure still exists on household incomes, and gives retailers reason to worry that people will be forced to cut down on how much they spend.

Crunching the numbers

Of course, inflation isn’t the only measure being used to gauge the health of the British consumer. The GfK Consumer Confidence Index actually started to show some improvement as recently as May. The index rose by two points to -5 just two months ago, which Joe Staton, head of market dynamics, labelled “an unexpected uptick”. It came after consumers reported feeling more confident in their personal financial situation, the wider economy, and future plans for shopping and saving despite the wider inflationary backdrop. This also corresponded with a 0.9 per cent increase in the quantity bought across the retail industry compared with May 2016.

But this surge in optimism didn’t last long. Why? Cue another destabilising political event in the UK, this time in the form of the recent general election which threw up unexpected results. Three weeks post-vote, the GfK Consumer Confidence Index fell by five points to -10, with the Overall Index Score just two points away from last year’s post-referendum low of -12. Mr Staton said the performance was especially concerning for UK retailers, with the plunge in the Major Purchase Index (down eight points) reflecting “increased caution over non-food spending and [a] softening appetite for debt”.

None of that sounds good at face value. It certainly suggests consumer confidence is waning, but is it the weakest it’s been in recent history? Looking at the data over a 10-year period to include the last recession, the short answer is no. The Consumer Confidence Barometer hit a trough around July 2008, when it plummeted to a staggering low of -40, while the 10-year high was actually recorded as recently as July 2015. Depending how pessimistic one feels, it’s possible to argue conditions are much better than in the last recession, while bears might argue this leaves room for deterioration.

There’s a possible read-across from US data too. Last week global retail stocks were given a moment of relief when it was revealed that US footfall data wasn’t as bad as analysts had predicted. More specifically, some of the data related to customer traffic numbers across clothing stores – which is usually seen as one of the most vulnerable product categories in this kind of climate. Total US retail traffic dipped 9.7 per cent year on year for the week ending July 15 2017, and is down 8.3 per cent year-to-date compared with the same period in 2016. Dig a little deeper, however, and the numbers worsen significantly. Apparel traffic declined 5.3 per cent year on year, but this compared with a decline of 26.2 per cent for electronics product retailers.

Similar trends are emerging on this side of the pond. Clive Black, an analyst at Shore Capital, says June’s surprising UK footfall numbers across retail parks and the high street suggest British shoppers are hardening to the consistent political shocks seen over the last year. According to the British Retail Consortium’s footfall and vacancies monitor, overall footfall rose by 0.8 per cent in June 2017 versus the prior year, with a 0.9 per cent improvement on the high street compared with a decline of -3.7 per cent a year ago. But Mr Black says there are still reasons to be cautious: although unemployment rates are low, it’s his belief we’re in a period of contracting living standards as wage growth lags the consumer price index.

As household incomes shrink, companies might resist investing in growth and adopt a more ‘heads down’ approach, which could actually lead to job cuts as a means of cost control. If this spirals into widening unemployment rates, we could see similar conditions to 2008 emerge, and thus a full consumer downturn.

At face value, the June retail sales figures from the Office for National Statistics (ONS) paint a similarly rosy picture to the footfall figures. Richard Lim, chief executive at Retail Economics, said that June’s retail sales “bounced back” as “warmer weather drove shoppers onto the high street”. As temperatures soared, “consumers decided to refresh their summer wardrobes” with clothing and footwear retailers performing particularly well. But Mr Lim goes on to say that while anxiety over recent political events and the ongoing Brexit negotiations seems to have been “put aside” momentarily, pressure is still expected to intensify on households over the coming months. Real earnings are expected to remain “in negative territory for the remainder of the year”, and “retailers will be hoping shoppers remain resilient in the face of further uncertainty”.

What are the companies telling us?

Statistics are all well and good, but it’s difficult to find truly consistent patterns this year. Month to month the numbers jump around and are often driven by unpredictable variables such as weather. The volume of retail sales has been quite volatile over the first half of this year. Andrew Sentence, a senior economic adviser at PwC, said that while there was a recovery in June sales data relative to a disappointing May, over the past three months the level of retail spending adjusted for inflation is “no higher than it was in the final quarter of last year”. Plus, there are some companies that seem to defy the odds.

Luxury retailers have performed particularly well this year for a number of reasons. First, their higher level of US dollar earnings provides them with a natural hedge against weaker sterling, but the pound is also driving a number of high-net worth individuals to the UK capital to shop. But that’s only going to happen if the brand name and discounted price makes it worth the trip. Second, their regular clientele is far less fickle than the average high street shopper, and companies can rely more on brand loyalty, macroeconomic trends aside.

This kind of resilience is even showing up at the upper end of the high street for what are typically dubbed ‘premium lifestyle retailers’. They include the likes of Ted Baker and SuperGroup as well as market newcomers  Joules (JOUL) and Hotel Chocolat (HOTC). The latter just released a full-year trading update which revealed a 12 per cent improvement in like-for-like revenues to £104m, although it should be said that total top-line improvements have been driven by a consistent stream of new openings as well.

But what of the ‘middle-market’? Two of the largest stalwarts set to be hurt by a potential downturn are Next and Marks and Spencer (MKS). The former has had a spectacular fall from grace. A weak set of 2015 Christmas numbers prompted what has turned out to be a prolonged share price de-rating, compounded by a contraction in full-price sales, currency-related margin issues and difficulty in understanding the Next customer. Marks and Spencer hasn’t had the easiest ride, either. A high-profile management change has led to a significant overhaul of the business. New boss Steve Rowe has taken dramatic action on store closures, curtailing the international business and minimising the number of promotional days across an annual trading period. Sadly for him, this isn’t quite showing up in the company’s numbers just yet. A 1.2 per cent contraction in first quarter like-for-like clothing and home sales was towards the lower end of analysts’ expectations, and more worrying still was a 0.1 per cent contraction in underlying food sales. Food has typically been Marks and Spencer’s strong suit, with Steve Rowe himself overseeing the division during the last recession. External conditions for food retailers have largely been positive, according to analysts at Peel Hunt, so a move into the red on that side was a shock.

Food, glorious food

The negative sentiment from investors towards UK retail is reflected by its current position as the most shorted sector on the London Stock Exchange – aside from supermarkets. Food retail didn’t have an easy ride during the last recession, so why are the major stocks in this part of the retail sector – namely Tesco, Sainsbury’s, Morrisons (MRW) and Booker (BOK) – enjoying better fortunes this time around? And what does this tell us about consumers?

Many of the supermarkets are working through a very different structural phase compared with 2008. Last time, the biggest challenge arrived in the form of German discounters Aldi and Lidl, both of whom were determined to drive down prices in the name of competition. It worked and Britain’s four largest supermarkets suffered as a consequence. But since then, the landscape has changed dramatically. The price war is largely over thanks to inflation, while the arrival of Amazon and its fresh food service has prompted many of Britain’s supermarkets to rethink how they serve their customers. 

For some, this has prompted some pretty large M&A transactions. Tesco is currently in the process of merging with wholesale giant Booker (for years the top dog of the grocery market), while Sainsbury’s acquired the Argos brand from Home Retail Group at the start of 2016. Although not an active participant in this M&A flurry, Morrisons was quick off the mark to team up with Amazon, signing a supply agreement with the online behemoth to sell its goods via its website and Prime delivery service.

The question is, then, to what extent does the supermarkets’ good fortune reflect resilience in shopping trends? Or should we give credit to companies making sure they remain competitive in an ever-changing retail environment? The answer is, inevitably, a bit of both. People will always have to buy food, but where they choose to do so is variable. Supermarkets have to offer convenient, price competitive options which promote ‘value for money’. If they don’t, they risk falling behind.

For many retailers, the end of the price war and a growing appetite for online orders has led to a clear top-line recovery. To a large extent, this is true for online grocer Ocado (OCDO)  as well. At the half-year stage, group revenues rose by more than a fifth with order volumes up more than 15 per cent following a 12.7 per cent rise in active customer numbers. But the group is still struggling to turn a profit due to high levels of investment in technology and distribution operations. Investors have also been left disappointed with its inability to sign a major contract similar to those it already has with Morrisons and Waitrose. It did announce a new European partnership post-period end, although the client’s identity remains a mystery as do the exact terms of the deal. Suffice to say, Ocado doesn’t expect the contract to be earnings or cash accretive either this year or next.

This all said, it could be that the good run seen with other food retail stocks will tail off. Looking at the retail sales data for May 2017 from the ONS, the value of food sales rose 1 per cent year on year, but volumes actually fell flat. That suggests that much of the growth has been price driven due to inflation, rather than rooted in customer acquisition or a rise in the average spend per basket (a typical metric used by supermarkets to measure how much customers are buying per visit).

It also helps explain why M&S food might be struggling. If everyday groceries are getting more expensive, shoppers may be less inclined to visit premium food retailers for one-off ‘treats’ let alone conduct the bulk of a weekly shop at these pricier locations. Finally, recent research by Kantar Worldpanel showed that supermarkets’ own-label sales rose 6 per cent year on year, but branded products only edged up only 0.6 per cent. That reflects a predominant recessionary trend which saw customers trade down to less expensive options – one which could become more prevalent once again.  

Motoring towards disaster 

Another measure for consumer spending is the credit market – something we’ve started to take a serious look at this year and which spans several sectors. It’s an interesting indicator of where consumer confidence lies, with cracks starting to show in the motor finance market both in the US and at home.

Possible defaults on this kind of lending in the US motor market could have global consequences. In recent years there has been a rapid expansion in the use of dealership car finance to fund new and used car purchases in the UK, which has raised concerns over its sustainability in the long term. Data from the Finance and Leasing Association (FLA) says its members provided £31.7bn of finance to consumers to buy cars in 2016 (up from £13bn in 2011) with finance on new cars contributing £18.1bn and used cars contributing £13.6bn.

The Bank of England believes the growth in new car finance has been entirely driven by the expansion of personal contract purchase (PCP) deals, whereby customers pay an initial deposit, then make monthly payments to cover interest and depreciation costs, and at the end of the deal they can either make a larger, final payment to own the vehicle, trade it in for a new car or simply hand the keys back. In 2016, PCPs accounted for around 85 per cent of total new car finance plans written through dealers.

While retailers stand to suffer if the appetite for these sorts of loans shrinks, there’s danger for lenders as well, and we’ve already seen some UK stocks hurt by growing fears over this possibility. S&U’s (SUS) shares have been relatively weak performers following the Bank of England’s comments around the rapid growth in consumer finance. And while analysts at Shore Capital argue that S&U operates in the subprime space, where loans are typically hire purchase in nature and are held against second-hand cars, they concede it remains exposed to residual value risk “should second-hand car prices fall sharply” (because of a glut of new cars rolling off PCP deals and hitting the market) and this risk needs to be “borne in mind” by investors.

Of course, the wider concern here is a rapid expansion in the pool of sub-prime customers. Shore Capital argues that after a period of relatively strong growth, “low-income households are starting to see disposable income squeezed by inflation” while a slower UK economy “could also see unemployment rise”. Any deterioration could see the number of potential sub-prime customers increase dramatically, creating some of the same conditions seen in the run up to the last recession.

Favourites

Depending on your appetite for risk, there are a number of ways to build buy cases around retail stocks this year. In terms of ‘old reliables’ where the risks are limited in our view, Tip of the Year Ted Baker and luxury conglomerate LVMH (Fr:MC.) rise to the top of the pile. The latter doesn’t depend on one particular geography or brand for the bulk of its sales and that share price has gone from strength to strength this year. But we’ve also put skin in the game with contrarian calls on Marks and Spencer and Next to come through this tough spell. There’s more downside risk here, but if the numbers beat expectations there could be some serious re-ratings on the cards. In terms of food retail, our top pick is still Sainsbury’s. The stock is cheaper than Morrisons and doesn’t carry the M&A risk now associated with Tesco and Booker. Its acquisition of Argos appears to have been well-timed and although a degree of integration risk persists, we see it as the most attractive of the bunch.

Outsiders

For all our bullish calls, we’ve got a strong bear position too. Not only are companies vulnerable to wider trends, there are – in some cases – inherent problems to the business model. One such victim is Halfords (HFD), which is suffering from escalating losses, a management vacuum and stagnant profits. Another is N Brown (BWNG), whose ‘over-50s’ and ‘plus size’ target customer we see as increasingly out-dated. Provisions made against its financial services division also have us worried. Other groups we see as growing at a price. White goods retailer AO World (AO.) is keen to expand its online model across Europe but the amount it’s spending both on internal investment and marketing by which to do this is eye-watering.