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Is this retail's rock bottom?

As retail stocks start to feel the heat, what constitutes a bargain and what's a basket case?
June 14, 2018

Walking down a British high street in the middle of the week can be a fairly depressing exercise these days. Footfall data shows that fewer of us are heading out to our local shops – even less the local shopping centre – and are preferring to spend our money on 'experience' based leisure activities such as dining out and going to the cinema. But there’s little evidence to suggest that people aren’t interested in shopping at all. If anything, we’re a nation more addicted to shopping than ever before.

So, surely this can’t be the end of retail. But many of Britain’s retailers are trying to adapt to a market that is undergoing a fundamental, not to mention, structural shift. And it’s not just a structural shift to online and e-commerce. Instead, retailers are thinking about how to serve customers who increasingly demand the convenience of online shopping, but in a real-life environment where service is still a top priority. In fact, many believe the internet acts as a shop window, and if the convenience of picking up goods in-store is guaranteed, then customers still want to visit stores to look at products. Despite the number of company voluntary agreements (CVA) sweeping the sector this year as companies try to rationalise store numbers and costs, it remains a broadly held view that physical retail will continue to play a role in the industry’s future.

Of course, Britain’s retailers are not just having to adapt to changing customer behaviour, but also a harmful mix of price inflation, wage stagnation and political uncertainty – all of which weigh on consumers’ confidence to splash the cash. It’s a complicated issue but, from an investor’s perspective, this changing climate has given rise to several rock-bottom share price ratings across the sector. The skill is identifying which of these valuations offers a true bargain poised for re-rating and which spell a possible end for these companies as we know them.

 

The life and times of the sector stalwart

Marks and Spencer's (MKS) shares are down by a fifth in the last 12 months, which has given rise to a forward earnings price tag of just 11 times consensus EPS according to Bloomberg. Couple that with a dividend yield above 6 per cent and some investment experts would say this is a classic sign of trouble.

In one sense, they’re not wrong. There’s enough to fill a book on what’s wrong with the high-street behemoth. But the arrival of industry veteran Archie Norman as the group’s new chairman suggests the retailer is getting tough when it comes to its own recovery. The board is accelerating the number of the store closures – originally 60 were slated, but the group now expects to shut up shop across 100 locations before 2022. In fact, work has already started on this front, with closure costs accounting for nearly two-thirds of the £514m in exceptional charges booked at the March year-end. 

It’s an ugly truth – annual pre-tax profits fell by more than 60 per cent – but Marks and Spencer needs to change its business model. Like many of its traditional peers – Debenhams (DEB), House of Fraser and Next (NXT) – it needs to focus on digital innovation and make its bloated property estate leaner. But don’t be overly afraid of that dividend yield. The group’s cash generation is solid, which helped not only to maintain last year’s 18.7p dividend, but also keep debt levels down.

 

The days are numbered

House of Fraser has announced plans to shutter 31 of its 59 UK locations before the start of next year by entering into a company voluntary agreement (CVA) with its creditors. Prime locations such as London’s Oxford Street, Edinburgh and Birmingham are all on the chopping block, putting thousands of jobs at risk. It’s not alone: beleaguered chains such as Carpetright (CPR), Mothercare (MTC) and fashion group New Look have all used similar schemes to exit punitive property leases and slimline their estates. In fact, the use of CVAs has become so prolific this year that the British Property Federation has called for a governmental review, claiming the process is being “abused” by troubled companies.

But so far, using such schemes hasn’t done much for stock valuations. In fact, Carpetright's shares offer up no traditional price/earnings valuation on which to base an argument for a recovery, because analysts at Peel Hunt expect losses of £4.3m this year. By contrast, Peel Hunt expects Mothercare to squeak a £500,000 pre-tax profit for the year ending March 2018, which hands the shares a valuation of 141 times earnings (based on an EPS forecast of 0.2p). Suffice to say, any recovery potential appears to be priced in.

 

Does quality still cost you?

In recent years, investing in a good retail company has come at a price. But even some of these valuations have slipped in recent months in light of the market jitters. They include the likes of Ted Baker (TED), which this week released a good trading update, only to see its shares fall on its release. True, the retail side of the business was a tad slower than usual, but e-commerce, wholesale and licensing revenues all performed well against a challenging backdrop. Furthermore, analysts at Liberum insist that a two-year compound growth rate of 15 per cent across the group’s retail division is, in fact, very strong, while management remains confident it will meet full-year guidance figures.

Similarly, shares in clothing group Superdry (SDRY) are down by close to a fifth in the last 12 months – exacerbated by a slower-than-expected fourth quarter. The group blamed lower sales across its stores, while a growing wholesale operation is causing wider margin dilution. Overall, gross margins have contracted by around 200 basis points following planned inventory reduction and clearance activities. Disruption from the recent snow and a cooler start to the spring/summer season has also delayed shoppers' purchases.

Even JD Sports (JD.) finds its shares flat year on year, despite consistently reporting figures ahead of expectations. Total sales rose by a third for the year ended 3 February 2018, which helped lift annual profits by a quarter. Breaking that down further, like-for-like sales across stores rose by a solid 3 per cent, marking a good performance in the UK and Europe, while online sales accelerated by 30 per cent over the same period. In fact, to put it in even better perspective, the sports retailer has taken annual profits from approximately £100m to £300m in the last three years.

But it can’t just be as simple as moving online. Digital pure-plays such as Boohoo.com (BOO) and Asos (ASC) have also seen their share prices under pressure as investment in sophisticated warehousing and distribution puts pressure on margins and thus, profits. In fact, a first-quarter trading update from boohoo recently prompted a fall in the shares, despite reporting sales growth in excess of 50 per cent during the opening period alone. Analysts are growing increasingly concerned about the level of competition, with reference to Amazon and Zalando, which seem only to go from strength to strength. Furthermore, brokerage Liberum this week argued that toppy valuations often demanded from the likes of boohoo and Asos no longer stack up in such a crowded market.