Shop 'til you Drop

Thursday, 25th January 2018 09:12 - by David Harbage

Three weeks into January, and trading updates from the UK’s retailers have almost run their course. Seasonal spending on gifts, food and drink is critical for shops – be they offering a high street front or an online face – and investors in stock market listed businesses will have hoped that domestic consumers adopted a ‘heart over head’ (or generosity prevails) attitude.

That spendable income is increasingly being squeezed – as wage growth lagged inflation yet again in 2017 - is not in doubt and the prime question facing the prospective investor is where the consumer would spend (which product area) and just who the beneficiaries and ‘losers’ within the retail sector would be. Perhaps spending on gifts, something the clothing stores particularly depend on, would continue but the ‘Black Friday’ sale and online competition might have destroyed profit margins for the traditional ‘bricks & mortar’ retailers.

Food retailers performed reasonably well, as Tesco, Sainsbury, Morrison, Asda, Waitrose and Iceland all managed to increase sales in the three months to December – albeit not market share, as Aldi and Lidl continue to deliver 15% and 14.5% revenue growth respectively in the last quarter of the year. Alcohol sales were a strong feature, up 5.1% compared to last Christmas, led by gin +26%, whisky +10% and sparkling wine +7% – with leading spirits manufacturer Diageo and carbonated mixer drink newcomer Fevertree (who issued another strong trading update today) likely to have benefited. Morrison exceeded analysts’ forecasts by announcing a better than expected 3.7% rise in sales for the 6 weeks to 7 January 2018, and beating its UK peers. This week Tesco and Sainsbury have announced further headcount initiatives, aimed at reducing management costs at store level (not dissimilar to that effected in banking branches), to cut costs and compete with the German retailers.

The so-called Big 4 food retailers have also seen more of their customers adopt internet ordered home delivery - essentially cannibalising their own businesses. In that regard, it is interesting to note the online operator Ocado’s UK sales growth of just over 5%; hardly impressive and helping explain why the company, best known for serving Waitrose, is looking overseas (announcing plans to link up with Canada’s second largest grocer, Sobeys, this week). The shares have very much been a ‘jam tomorrow’ story and one of the most ‘shorted’ stocks in the UK equity market over the past five years, as general opinion amongst fund managers has been dominated by sceptics. For a £3.3bn market capitalised business to only make profits of £5.9m (the current forecast for the year to 30 November 2017) – itself a 50% fall on the previous year -– and to only regain that lost ground over the next two years does not inspire. Nevertheless, Ocado retains a loyal following amongst overseas hedge fund managers, notwithstanding the heady rating – EPS of 1.9p in the year to November 2019 equates to a PE ratio of 220+ - and the absence of a dividend.  

While food is an essential, no one company has a divine right to expect sustained success – as market leader Tesco has found over the past five years or so. In terms of stock market valuation, the market seems to be anticipating that a pick-up in inflation can lead to widening profit margins and an improvement in profitability for the major stock exchange listed food retailers. Earnings at Tesco (which has a 28.2% share of the domestic market) are expected to recover strongly (EPS forecast to rise 55%) in the current year to 28 February 2018, and by 25% & 20% in the next two years to 29 February 2020 aided by the acquisition of cash ‘n carry wholesaler Booker. The consensus of 17 research analysts suggests earnings per share (EPS) then of 15.9p, which equates to a price-to-earnings multiple (or PE ratio) of 13.1 times. Taken in conjunction with an estimated 7.1 pence dividend (a 3.4% yield on the current price), this would be very close to the wider UK equity market’s average rating. Prospective investors have to ask themselves, “Is the UK’s largest retailer and biggest private sector employer likely to deliver inferior or superior earnings growth – or perhaps just match the average returns – beyond 2020? Time alone will tell.

Sainsbury is Britain’s second largest food retailer and, while its business and shares have also struggled over the past few years, it has a better record of managing to maintain market share (currently 16.3%) than the other members of the ‘Big Four’ supermarkets. In its trading update earlier this month, management reported that 20% of group sales originated online (aided by Argos’ contribution) in the 15 weeks to 6 January 2018. Complicated by the inclusion of recent acquisition Argos, the company’s current accounting year, to 31 March 2018, is likely to show a 13% fall in underlying profitability before recovering ground to deliver an estimated EPS of 22.3p in the year to March 2020. Based on the share price at the time of writing, this would put Sainsbury shares on a PE of 11.5x and an income yield of 4.5% (based on brokers’ forecasts of an 11.6p dividend).

William Morrison is the third largest of the UK listed food retailers, with a 10.6% market share, and has also experienced a roller coaster ride in both trading and equity performance terms. Looking forward, the City expect profits to rise by 11%, 7% and 9% over the next three years to 31 January 2020 – culminating in EPS of 14.2p, which would put the stock onto an earnings multiple of 16 times and a prospective dividend yield of 3.1%. Perceived by many as a recovery stock, the premium valuation implies high expectations and analysts are currently ‘sitting on their hands’ with an underwhelming neutral view: 3 say Buy, 10 Hold and 5 are Sellers. By contrast, while analysts are a little more positive about Sainsbury (7 Buys, 10 Holds and 5 Sells) and Tesco (7 Buys, 5 Holds and 5 Sells) there is a high level of scepticism surrounding these ‘brick & mortar’ businesses being able to deliver sustainable growth in their profits or asset worth.      

Moving onto non-food retailers, there has been a long list of Christmas trading disappointment – with the subsequent falls in equity worth typically reflecting the magnitude of the adverse surprise, relative to the City’s expectations - from the traditional shops, typically contrasted by robust trading from online retailers. Some companies will have both avenues to sales, and well-known ones like Marks & Spencer offer clear evidence that having a website is not necessarily a guarantee of achieving incremental revenue. By contrast, the online Directory part of fashion chain Next performed better than most brokers’ forecasts. Notable losers range from Carpetright (shares fell 40% last Thursday on ‘a sharp deterioration in UK trade’) to department store Debenhams (where like-for-like sales fell 2.6% in the 13 weeks to 30 December), from Mothercare (whose online sales fell 6.9% and profits were likely to be just £1m) through to plus-size online clothing group N Brown (whose shares fell 20% yesterday on disappointing +2.7% product growth, compared to 5.9% in the previous year).

Considering which areas of discretionary (non-essential) consumer spend are most likely to hold up or increase in the UK’s current austere period, most would opine that young people in the 18-24 age range will continue to purchase fashionable clothing and that most of us would want to purchase new technology products, like mobile phones. Most recent evidence from the first segment - the online youth fashion retailers ASOS (as seen on screen) and Boohoo.com (owner of websites PrettyLittleThing and NastyGal) – is that the ‘call’ is correct, with both beating market expectations. This blog has featured these high growth (sales, margin, profits), high valuation retailers before; prospective investors have to calculate what the present worth of these companies’ future earnings will be in endeavouring to set a fair price for the stock today.

Boohoo.com is less mature than its larger AIM listed peer ASOS, but its latest trading update saw a doubling in turnover, at a profit margin of 52.5%, for the four months to 31 December 2017 and net cash of £127m to progress its expansion into menswear and children’s wear. The historic growth of both businesses is impressive, and the outlook for the next year or two encourages, but these highly valued stocks remain susceptible to any disappointment. Looking at the market’s current assessment of their worth, the £5.8bn market capitalised ASOS anticipates annual EPS growth of 25% in each of the next two years, putting the consensual forecast EPS of 122p in the year to 31 August 2019 on a PE of 56x. Analysts of the smaller £2.2bn market capitalised Boohoo.com anticipates annual EPS growth of between 23% - 29% over the next three years, putting the forecast EPS of 4.4p in the year to 29 February 2020 on a similarly heady PE multiple of 44x.                  

Ultimately, profits drive prices and if these internet-driven retailers – which aim at the under 30 age customer – continue to exceed broker forecasts then either the PE ratio falls (if the share price does not move, because it doesn’t believe that the pace of growth is sustainable) or the premium earnings-based rating is maintained (and the share price rises, in the expectation of further ‘beats’). Incidentally, the earnings mentioned above represent an average taken from at least 13 brokers’ research; none of the research anticipates payment of a dividend, as both companies are wholly reinvesting the cash they generate into their businesses. For your interest, of the 25 broking houses covering ASOS, 16 say Buy, 6 suggest a Hold and 3 Sell. In Boohoo.com’s case, 10 analysts recommend Buy, 1 is neutral and 2 suggest Sell.

It might be that their premium valuations put the prospective investor off the idea of buying those businesses, and he or she might look for another area of perceived above average spend for UK consumers. Technology is an obvious segment – with perhaps mobile phones or gaming products (think X box or PlayStation) in mind – so we will take a brief look at Dixons Carphone and GAME Digital. First, on Monday the leading well-known electronic goods (incorporating PC World) retailer announced a trading update for the ten weeks to 6 January: overall sales were up 4%, boosted by contributions from new operations in the Nordic region and Greece. In-line with market expectations, the group claims to be growing market share in the UK - although like-for-like sales (comparing store performance with those open a year ago) were flat, and profit margins continue to come under pressure.

Clearly, Dixons Carphone is ‘having to run hard to stand still’ against its wholly online competitors and uncertain pricing power (relative to product manufacturers). By contrast solely online electrical retailer of white and brown goods, Bolton-based AO World, achieved 11.2% sales growth in the last quarter of 2017. GAME Digital managed to increase its like-for-like turnover in the same period by 5.2%, as its Spanish business performed well, but the UK part delivered a less impressive +2.9%. The company has had a mixed track record of trading, as a shortage of games consoles (notably from Nintendo) has disrupted earnings, the industry has changed dramatically over the past decade, with management strategy and board changes. Yesterday the chief financial officer (CFO) unexpectedly resigned to cause further unease amongst investors.   

Looking at the stock market’s valuation of these electronic retailers, they are dramatically different: £2.3bn market capitalised Dixons Carphone is expected to witness a 26% drop in profits in the current year to 30 April 2018 and then to see no earnings growth over the next two years. This consensual forecast would put EPS at 25.5p for the year to April 2020, which equates to a submarket PE ratio of 7.4x, and small dividend increases would result in an income yield of 6% in that year (based on a forecast 11.3p, well covered, pay-out). On the face of it, the shares - which have fallen from 480p to 205p over the past two years - appear undervalued, but only if the UK’s biggest electrical retailer can grow its profits. Currently, 7 ‘Sell-side’ brokers rate the shares a Buy, 5 are Holders and 1 says Sell, while a number of notable fund managers – including Aberdeen, Standard Life, Legal & General, AXA, Newton, Capital, Odey and M&G – own stakes of between 3% and 12%. By contrast, the less mature AO World is currently loss making and first profits are expected in the year to £1 March 2020; then, EPS of 2p would put the shares on an earnings multiple of 72x.     

GAME Digital is a £66m market cap minnow, by comparison (and mustn’t be confused with the much larger Games Workshop, a profitable maker of war-gaming model soldiers). The former is unlikely to be profitable in the current year which ends on 31 July 2018, but positive earnings (EPS of 0.4p, equating to a PE of 117x) are forecast for the following year. Three years ago, the shares traded at 348p and a significant reversal in its fortunes would be required to persuade shareholders that a genuine recovery is possible. One notable name on the shareholder register is Sports Direct, who own 27% of the business and whose intentions towards this group (akin to their stakes in other retailers) is unknown.     

Bottom line, retail remains one of the hardest businesses in which to make good returns – with only a small minority managing to sustain growth – and the current outlook for the domestic economy and marked change in shopping habits (not only internet- driven) makes stock selection especially hazardous. Big companies like Marks & Spencer appear undervalued (EPS of 27.5p is forecast in the current year to 31 March 2018, a 10% fall on the previous year, putting the shares on a PE of 11 with a 1.5 times covered dividend equating to an income yield of 6%), but are only for the bravest investor - given the outlook for static-at-best profits over the next two years, and the significant headwinds that they face.