Retail is tough, can anyone really predict what the future has in store?
Not right now. You’re probably better off playing the Lottery as the range of different scenarios for the sector over the next 6-12 months could not be more extreme. High levels of domestic political uncertainty and the questions around Brexit are, at present, corrosive. Consumer spending has been resilient to date (not hugely surprising to us given the levels of employment and wage inflation), but appears to be a lonely and increasingly vulnerable prop for economic growth. Blink, and we could be back in recession. Maybe we already are?
The Bear Case
The bear case for the sector in H2 2019 is worse than H2 2016. On top of rising inflation and weakening spending power (due to higher import prices via £/€ and especially £/$) and another wave of margin pressure (via COGS inflation), this negative scenario could also include a reversal of the positive employment/unemployment trends, potential wage pressures and, to top it off, trade disruption as a result of tariffs and border issues. In the event of a Corbyn/McDonnell government, this could also potentially drive other adverse policies for businesses and/or tax payers.
With structural pressures on traditional operators not going away, namely the channel shift, over-capacity in several sub-sectors, and relentless cost headwinds (rents, wages etc), the bear case is for significant underperformance in many of the traditional names driven by more downgrades and another wave of selling. The effect on rates and bond yields would create yet more trouble for businesses with pension deficits too, where the retail sector is more exposed than most.
Near term, traditional domestic names therefore still look too risky. Only a few names are potential beneficiaries (translation/overseas mix/channel shift etc) including: Photo-Me, Gear4music, Boohoo and Walker Greenbank, although in our broader coverage universe, other names should be unaffected including: Ten Lifestyle, IG Design, Focusrite and Franchise Brands.
The Bull Case
In the event the Brexit question were resolved, and a majority government got back to the day job of uniting the country and driving the economy, the bull case would be the mirror image of the bear case. What is the probability of this, though?
£ would recover, imported inflation seen over the last 3 years should reverse, economic growth would quickly return, and spending power would be released. This would be very bullish for sector earnings, even for those still exposed to the structural headwinds. Given depressed valuation multiples and a change in the risk profile, this would trigger a wave of buying by international and domestic investors. Interest rates might even have half a chance of starting to normalise.
This could be a catalyst for the sector as a whole to outperform, led first by liquid large/mid caps. But greater upside could be available in some of the smaller names like the motor retailers (Lookers, Cambria, Marshall), Studio Retail (fka Findel), Halfords, N Brown, Safestyle UK, and Swallowfield (soon to become Brand Architekts). If the government were to stimulate housebuilding/housing transactions then home-related names could also offer substantial upside e.g. Carpetright, DFS, Dunelm, Howden Joinery, Topps Tiles.
With predictions for the future of retail having two very different outcomes, the key question to ask yourself is, which side do you reside with the most – the bull case or the bear case?
Whichever the outcome, companies with strong growth and/or self-help characteristics will be better placed to deliver, particularly companies such as Boohoo and Ten Lifestyle. Other companies such as Superdry, Gear4Music and Safestyle UK are also interesting ones to watch, given their well documented setbacks and clear strategic plans being implemented in response.
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