Worth it?

Was this simply a function of the referendum-induced sterling slump? Or is it representative of something more endemic happening across the retail sector? 

References to retail’s ‘squeezed middle’ aren’t new, but the idea that the sector has become polarised into budget or premium brands is perhaps oversimplistic, and could be a dangerous strategy in stockpicking. Traditional thinking might be that retailers sitting firmly at one end of the market or the other offer more defensive positions in an industry undergoing structural change. But is this really true? After all, defensive investing is just one strategy, and one that ignores the possible returns to be made from betting on potential recovery plays or new, disruptive market entrants.

In defence of luxury

The destabilisation in the value of the pound gave rise to widespread price inflation across the sector as retailers scrambled to offset the damaging effect of exchange rates on margins. By raising prices, many mass-market and value-based retailers – already operating on delicate margins – passed the problem on to customers. 

But this only works if your customers are loyal to the brand – something chains like Next (NXT) and Marks and Spencer (MKS) have struggled to engender with their customers. In fact, it’s today’s post-referendum inflationary environment that has forced customers to ask whether prices are truly reflective of product quality. And by forcing such a spotlight onto quality, middle-market discounting has proved a less successful strategy to drive volume. 

By contrast, luxury retail is more immune to price inflation. Product quality is superior to high-street wares and, in any case, people are mostly splashing out on a brand name for its associated status. Whether it be an Hermes Birkin bag costing £10,000 or a Rolex watch at £30,000, an incremental price change won’t be felt as strongly. It’s also less likely that high-net-worth individuals pinch the pennies when times get tough. Add to this the fact that margins at this end of the sector tend to be much richer to begin with, and any inflection in the cost base is easier to absorb. 

So perhaps the only thing luxury retailers worry about then, is keeping demand high. And there’s evidence to suggest that this is indeed the case. Interestingly, when the pound de-rated, London registered a significant influx of tourists seeking out luxury sold at better value relative to what their own, domestic currency could afford them. In August 2016, just a couple of months after the referendum sent the pound plummeting, data from Global Blue, a tourism shopping tax refund company headquartered in Switzerland, revealed tourist spending was down only 5.2 per cent year on year – the slowest decline for six months – with the biggest improvements in the UK and Korea, two very important markets for luxury retail. So, even though demand has the potential to move shoppers overseas, perhaps this speaks to the fact that there are bargain-hunters at this end of the market after all.

Still an uphill battle

But to assume that luxury stocks are defensive investments simply because of their global reach, the relative wealth of their customers or the fatter margins underestimates the challenge these companies still face to stay on top. A recent report from Deloitte entitled ‘Global Powers of Luxury Goods 2018’ revealed that composite year-over-year luxury sales growth across 100 ‘top’ brands (companies with minimum sales of $211m) only amounted to 1 per cent. Equally, a compound annual growth rate (CAGR) in luxury goods sales between 2014 and 2016 didn’t even crack 4 per cent, with a composite average net profit margin of only 8.8 per cent. 

Varying economic trends, changing consumer tastes and the digital revolution have also wreaked havoc at this end of the sector, just as they have for more value-conscious retailers. So, while the potential for continued growth in luxury sales is good, companies must still face up to these challenges to remain competitive. Deloitte analysts have been particularly impressed with Kering (KER)-owned Gucci, after sales rose by a whopping 86 per cent in 2017 following the appointment of new creative chief Alessandro Michele. Millennials now account for roughly half of sales, with total brand sales up 42 per cent to €62bn. It’s thought Mr Michele’s influence – which was more youth-orientated and focused on online experiences – allowed for this sudden return to form. Indeed, in 2017 Gucci launched new online stores in key markets including China and the Middle East, and started to offer more personalised online customer service including webchats. Special attention was also paid to the product range itself, so that a broader range of prices could encourage more shoppers into the brand. At the time of writing, online luxury retail site Net-a-Porter’s cheapest Gucci product is a pair of £90 socks, while its most expensive is a £16,200 evening gown.  

But such operational success has been assisted by what Deloitte describes as “favourable conditions” in luxury retail. The entire luxury market edged closer to annual sales of $1 trillion at the end of 2017, even though UK consumers are suffering from diminished spending power. It’s for that reason luxury retailers such as Somerset-based handbag specialist Mulberry (MUL) have turned their attention overseas. But is it too little too late?  There doesn’t seem to be chance of a near-term share price rerating here given the company’s poor domestic outlook – exacerbated by the collapse of trading partner House of Fraser – as well as the fact that the shares continue to be very tightly held. And although Mulberry’s push into Asia helped lift international sales by 13 per cent during the first half, the strategy feels at least 10 years behind schedule. 

It wouldn’t be the first time the group has misjudged its strategy. After developing a devoted customer base in the early 2000s the group appointed ex-Hermes employee Bruno Guillon as its chief executive in 2012. His appointment only lasted two years after Mr Guillon chose to upgrade the quality of Mulberry’s leather, thus inflating prices significantly, and pricing out a large swathe of once-loyal customers. The consensus now is that Mr Guillon tried to fix something that wasn’t broken, and neglected pushing the brand into regions that could have fuelled future growth. Now, the group is left playing catch-up, on far weaker operating margins than nearest rival Burberry. Such a case study suggests that while a conducive market is helpful, it’s still possible to get it very wrong indeed.  

In for a pound… or a penny 

At the other end of the spectrum, low-price retailers have also enjoyed renewed attention, with the grocery sector serving as a particularly interesting example. That market has undergone a radical shift since German discounters Aldi and Lidl entered the UK market in the early 1990s. But the stronghold that brands such as Waitrose and Whole Foods have at the other end of the market has been equally influential. Indeed, it’s led to a long period of discounting for ‘middle market’ retailers such as Sainsbury’s (SBRY), Wm Morrison (MRW) and Tesco (TSCO), while Amazon’s eventual foray into the UK food retail market prompted another wave of change, specifically large-scale mergers and acquisitions (M&A). 

Now, it seems Britain’s appetite for cheap food is proliferating the discount end of the general retail sector. B&M reported strong demand for its grocery products, enhanced by its acquisition of Heron Foods, which added chilled and frozen goods to the range. Of course, what this foray into grocery provides is certainty of repeat custom. The move online has been much slower for this category, and discount food retailers can still count on a certain level of footfall into stores – something other mass-market retailers have struggled to maintain. 

But are all discount retailers immune to the march of the digital revolution? While the shopping experience at retailers like B&M isn’t necessarily enhanced or made any more convenient by being web-based, and shoppers on the hunt for a bargain often aren’t deterred by the thought of having to leave the house, the argument that discounters needn’t worry about turning digital falls short in excluding the rise of groups such as Asos (ASC) and boohoo.com (BOO). By offering fast-fashion at competitively low prices, online pure-plays have loosened the grip of Philip Green’s Arcadia brands and stalwarts such as Next and M&S. In fact, it’s arguable that companies like Asos didn’t just capitalise on the digital revolution, but were the digital revolution – one that forced retailers up and down the value chain to re-evaluate their operating models. And as customer demands become ever-more complex and convenience-driven, the share of these newer market entrants only looks set to grow, while investments made by legacy businesses to keep up looks highly probable. 

Taking the middle road

But is there still value to be found in the middle of the market? Perhaps so, but investors should limit themselves to the “aspirational” part of the high street, including the likes of Ted Baker (TED), Hotel Chocolat (HOTC) and Fevertree Drinks (FEVR). 

Ted Baker shares have had a difficult run this year, down roughly a third over the past 12 months, as exposure to the recent House of Fraser collapse and persistently tough conditions on the high street have succeeded in putting investors on edge. After releasing interim results in early October, analysts at Liberum warned that recent gross margin gains could reverse in the second half. Although chief executive Ray Kelvin agreed, saying the second half would indeed be “challenging”, the strategy remains developing Ted’s ‘multi-channel’ style of retailing, which spans shops, online sites, wholesale and licensing. This comes at an inevitable cost, but appears to be paying off. In the first half, e-commerce sales rose by nearly a quarter to £53m, helping to pep up total retail sales by 1.1 per cent, while wholesale revenues climbed by 10 per cent to £86m. In turn, Ted is doing what most retailers intent on survival should: minimising dependence on traditional modes of selling and discovering alternate channels to grow revenues.

By comparison, Hotel Chocolat and Fevertree offer different plays on the premiumisation of the food and beverage market. While mass-market restaurant chains such as Prezzo and Jamie Oliver’s Jamie’s Italian brand are falling on hard times, these two companies appeal to millennials’ acquired tastes. The former just opened a new store in Japan via a new joint venture, and the first day’s trading is said to have exceeded management’s expectations. For the latter, some have grown sceptical of the group’s growing trade receivables balance – particularly as a percentage of sales – as more cash heads out of the business. More generous credit terms could be partly to blame, something which has been part of our analysis of other high-profile collapses this year. Despite being a function of fast-growing companies, if discipline isn’t maintained, a sudden cash shortfall could cause chaos. 

Final thoughts

As the millennial generation becomes a more shaping force in retail and political events suppress otherwise ‘ordinary’ spending patterns, investors’ desire to split retail holdings into premium and budget groups isn’t unsurprising. But that doesn’t make investments at either end of the scale a ‘sure bet’, and individual company strategies are still an important criterion of any investment decision. 

Steve Clayton, manager of Hargreaves Lansdown Select UK Growth Shares fund, recently reduced his stake in Burberry in favour of LVMH. Having originally invested in the trench coat maker at the start of the fund’s life, the decision of former creative chief and eventual co-chief executive Christopher Bailey to leave the business unsettled Mr Clayton and his colleagues. But now that the shares have moderated in value he thinks the share price could re-rate if Burberry manages to demonstrate improved sales and profitability over the next couple of seasons. 

In the meantime, Mr Clayton is still adamant that “conventional mass-market retailing” is not where he wants to be. For this reason, the fund has started to build a position in the owner of Louis Vuitton, Paris-listed LVMH. The valuation, he says, is about average and “doesn’t demand anything extra” from the company or its managers. In his view, it also has “the most attractive portfolio of brands” of any luxury group in the world. There’s no turnaround needed (unlike Burberry) and the company operates from a “position of strength”. Compared with closest rival Kering, the group isn’t overly dependent on a single brand either. At the last count, roughly 73 per cent of Kering’s operating income was derived from Gucci alone. 

Luxury retail, for Mr Clayton, offers the high-margin, cash generative model all retail-interested investors should seek. As for the value end of the market, he “can’t understand why [one] would invest in a physical store business on thin margins”, which will ultimately be more difficult to maintain in the long-run as high-street operation grows only more expensive. When it’s suggested that discount chains like B&M have turned their focus overseas to pursue growth, Mr Clayton agrees that it’s “probably their best chance”, but could create a bigger business “which will just have more problems down the line”. 

So, if the high-street bloodbath continues, perhaps developing a polarised retail holding isn’t in investors’ best interests. In our view, opportunities in the middle aren’t to be ignored altogether, especially when it comes to the upper echelon of high-street brands. Recent de-ratings in this part of the sector – an inevitable by-product of the general retail doom and gloom – could offer investors a decent chance of a recovery.