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Retail is not a pretty sight at the moment, battered as it is by the downturn and by the longer-standing competition of the internet. Will the tills ring again or should investors take a tip from consumers, check out and stay away?

by John Marshall

Soaring inflation and a slowing economy have combined to erode consumers’ disposable income, which has fallen for the first time in over a decade, and confidence, which stands at the lowest level since 1974, according to a recent Gfk/NOP survey. The internet continues to batter traditional retail operating models.

As a result, the non-food, non-clothing portion of the retail sector has this year seen a torrent of profit warnings and – even worse – slashed dividend payments. That retail has historically been a cash generative sector could have lured in the unwary, who believed juicy dividend yields were secure. Instead, names such as Land of Leather (LAN), DSG International (DSGI), Woolworths (WLW), Topps Tiles (TPT), Pendragon (PDG), Kingfisher (KGF) and Jessops (JSP) have turned into value traps, where dividend cuts and earnings forecast downgrades have resulted in further heavy falls from stocks which were in theory cheap.

The general retail sector overall ranks 40th and last of the sectors which constitute the FTSE indices and investors would be well advised to adopt a cautious approach towards the sector. Stocks such as Halfords (HFD) and WH Smith (SMWH) will revel in their defensive strengths. Yet some companies will follow ScS Upholstery into oblivion and others will remain in the ranks of the walking wounded. Those contrarian investors who are tempted to ‘bottom fish’ need to be patient. Better opportunities should appear later this year, especially as Christmas is unlikely to be a bonanza for retailers.

Names such as DSG International and Carpetright (CPR) should still be avoided, even if their yields look attractive. If something looks too good to be true, it normally is, and investors should be ready to apply the old market maxim of never trusting a stock whose yield is more than 1.5 times the ten-year risk-free rate available on government bonds. Ten-year gilts currently yield 4.6%, so any stock yielding more than 6.9% has to be treated with some suspicion.

Hard times

This year has been the most challenging facing retailers for some time. Consumers’ real disposable income has been squeezed by a painful combination of rapidly rising prices and relatively static nominal wages.

Although the official measure of inflation claims prices have risen by 4.4% this understates the real impact on many families. Food prices have risen by some 25% as a result of the universal increase in soft commodities. Unleaded petrol is some 30% dearer than a year ago. Utility bills have risen inexorably. Uswitch, the price comparison website has suggested gas and electricity bills will have risen by 61% by the end of December. Mortgages, when available, are more expensive and require higher deposits than a year ago, again pressuring consumers’ wallets.

But this is only the beginning of the consumer’s woes. Incomes are only rising by some 3.4%, slower than even the official measure of inflation. Many will receive no increase at all this year and others face the awful prospect of redundancy – June saw the biggest monthly jump in UK unemployment for 16 years. Meanwhile higher taxes and national insurance contributions are eroding disposable incomes still further.

A weak housing market is exacerbating these woes, as for many years home owners have been used to the value of their property rising. At the beginning of the year Nationwide forecast house prices would rise or fall by no more than 5%, yet Nationwide’s data now show the value of the average house fell by 6.2% in the six months to 31 July. This fall gives credence to the Halifax forecast that house prices will fall by 9% this year. PricewaterhouseCoopers has estimated falling house prices have so far knocked £400 billion from individuals’ wealth this year.

Research by Capita Registrars has indicated the total value of private shareholdings has fallen from £209 billion at the end of May 2007 to £161 billion by the end of August. No wonder there has been an upsurge of interest in alternative investments such as stamps and old coins.

No quick recovery

Bad as this background is, the prospects are equally discouraging. The UK economy showed zero growth in the second quarter and is widely expected to go into reverse in the current one. The question policy makers and commentators are having to grapple with is the probable length of the downturn. With many a professional Jeremiah forecasting the downturn could last into 2010 it is not surprising consumer confidence has waned, at first gradually and then hastily.

What worries many retailers is the fact that there is no likelihood of an early recovery. If too many commentators talk of recovery in 2010 this could easily become a self-fulfilling prophecy. Last week’s Confederation of British Industry (CBI) reported a second straight month of falling high street sales volumes in August and a balance of 38% of firms expects the retail business situation to worsen over the next three months. The resulting climate has seriously dampened investment intentions.

A further complication has been the disruption caused to the housing market by the credit crunch.

A dramatic decline in the availability of mortgages has hit certain sectors hard. August’s trading update by Carpetright confirmed the firm’s market share is rising, but underlying sales still fell by 15.4% in the first quarter. Similarly Topps Tiles and Kingfisher, both of whom serve the home improvement market, have had to report lower underlying sales. There seems to be no early conclusion to these problems.

All of these groups should survive the downturn unlike some of their smaller competitors and they should therefore emerge all the stronger as competition will be less severe in future. But in the short term both Topps and Kingfisher have had to cut their dividends. Further cuts are probable, with Topps tipped to pass its final completely.

The decline in consumer confidence has affected different companies to differing degrees. Those retailing ‘big ticket’ items such as furniture, electricals and cars have been especially badly affected.

Furniture retailing has always been a ‘feast or famine’ sector. In the good times, the sector has negative working capital because customers pay a substantial deposit on any order. When the orders start to disappear this bonus quickly evaporates and in 2008 the sub-sector has suffered its most severe downturn for many years. As a result, ScS, the sofa retailer, has collapsed and rival Land of Leather needed a rights issue to survive.

Demand for cars has mirrored the decline in consumer confidence during the year. Sales were satisfactory in the first four months of the year and then started to decline. A fall of 3.5% in May was followed by further year-on-year drops of 6.1% in June and 13% in July – and that is only part of the industry’s problems.

The fall in used car sales has been accompanied by a substantial fall in the value of used cars, which has hit all the distributors who take cars in part exchange. Residual values have also fallen.

These problems have been powerfully underlined by the difficulties of Pendragon, which has suffered under the twin burdens of falling profits and heavy borrowings.

Life has also become more difficult for companies such as DSG International, which specialises in expensive electricals and computers. Both of these markets have become even more competitive with the result that profits are evaporating.

However, the corollary of the decline in sales of ‘big ticket’ items has been relatively resilient sales of ‘low ticket’ items. This has been of particular benefit to WH Smith, whose shares have outperformed the FTSE All-Share by 13% over the past six months. Chief executive Kate Swann has followed a two-pronged strategy. She has bolstered performance at the high street stores by cutting costs and eliminating low margin lines while at the same time the role of the travel shops, which remain the group’s hidden gems, has been increased and their performance improved.

Online onslaught

While the high street has been dismal for many retailers, online retailers continue to flourish. The internet provides many advantages over the high street. Amazon.com, for example, will provide a much wider choice than the average bookshop and do so at a more competitive price. Many consumers consider it more comfortable to shop online at home than to buy a television at Currys, for example. Online retailers have also made their delivery systems more effective.

Despite the rapid growth in online sales over the past five years, this revolution has much further to go. Sales are forecast to grow by a further 130% by 2012 when the web will account for some 13.8% of consumer spending.

Certain sectors such as books, music and electricals have already been badly affected by the net. Another of the chief victims is photographic specialist Jessops. Consumers will visit its stores to get advice and only to then buy their camera online from another (and less expensive) retailer. Last year Jessops decided to close a large number of its high street stores and it is only a question of time before others follow.

HMV (HMV) has so far weathered the impact of the web by acquiring Ottakar’s. This deal created significant synergies but the longer-term outlook is more uncertain.

What the web will do is to impoverish those retailers such as Woolworths who concentrate almost solely upon the high street. They will have to fight each other for an ever smaller proportion of consumer spending. Some may seek to ride both the high street and the web, but this merely helps the adverse impact of the switch to the web. For example, DSG International has a large web presence, but it only survives by undercutting the group’s high street stores.

The one consolation high street retailers have is their problems could force property companies to change strategy too. Property companies may have to recognise rental levels have to be reduced as a means of maintaining a viable high street.

John Lewis’ weekly figures helpfully break down the contribution by individual stores. The retail chain has emphasised the problems of stores at shopping malls such as Bluewater and Brent Cross. Higher petrol prices have persuaded customers to reduce their visits to these stores and also to out-of-town centres. It is debatable whether this is part of a long-term trend or whether the consumer will return to past habits if and when petrol prices recede.

Historically some of the UK’s larger retailers have sought to expand internationally but this policy has not succeeded in offering a bolt-hole, as the impact of the credit crunch is worldwide. Kesa Electricals (KESA) gave up on BUT and sold the French furniture and electricals arm to a private equity-backed consortium in April for ?550 million. Kingfisher withdrew from Italy but still has problems in the rapidly growing Chinese market, while DSG’s operations in Italy and Spain continue to struggle.

CONCLUSIONS: Non apparel/food retailers

Risk to earnings forecasts: 1 (5=upside risk, 1=downside risk)

Earnings predictability: 2 (5=very high, 1=very low)

Valuation: 2 (5=cheap, 1=expensive)

Balance sheet strength: 3 (5=cash rich, 1=heavily indebted)

Cashflow: 3 (5=very strong, 1=very weak)

Over-owned? 3 (5=all brokers negative, 1=all positive)

TOTAL 14 / 30

Stocks to buy: Dunelm, WH Smith, Nationwide Accident Repairs

Stocks to avoid: DSG International, Carpetright, Pendragon

Total Broker Buy Ratings on Stocks: 99

Total Broker Hold Ratings on Stocks: 61

Total Broker Sell Ratings on Stocks: 30

SHARES RATING: NEUTRAL

TRADES TO MAKE

Cushioned landing

Dunelm (DNLM) 148.3p BUY

Like-for-like sales growth, a sensible expansion programme and a lowly valuation all mean the specialist homeware retailer should continue to outperform many of its retail peers.

Results due next Thursday (11 September) should again highlight how the group has not suffered in the same way as the carpet and furniture retailers. The figures will demonstrate underlying sales growth, since the group has already indicated sales for the fiscal year, which ended in June, were ahead by 10.5%, with like-for-like growth of 2.5%.

Dunelm has significantly outperformed companies such as John Lewis. This success is due to the group’s simple ‘value for money’ philosophy and its concentration upon lower priced items such as cushions.

Last year gross margins improved by 60 basis points. Joint house broker Landsbanki believes margins should improve by some 40 basis points in each of the next three years as the group benefits from its stronger buying position.

In 2007/08 the company opened eight new superstores and it ended the period with 76 superstores and a dozen smaller high-street outlets. Dunelm hopes to take advantage of a weakening retail property market to open at least eight new stores in each of the next two to three years. Management also plans to spend between £3 million and £5 million refitting its older shops.

Following the July trading update Louise Richardson of brokers Arden Partners recommended the shares at 117p. She thinks in view of the group’s ‘very good new store programme and efficiency improvements the long-term prospects are very good’. Although she believes the shares ‘may struggle in the short term to get above 160p’, a prospective price/earnings ratio of 8.8 is not demanding and the shares look good medium-term value.

Dead on its feet

DSG International (DSGI) 47.8p SELL

Tough trading at home and abroad, the threat posed by the internet and the risk of further dividend cuts make DSG an unattractive investment proposition, despite the efforts of chief executive John Browett, who took over last December.

Once seen as a growth stock, DSG became a yield stock but after a cut in the full-year dividend from 8.87p to 5.45p in its last fiscal year the £836 million cap has become a recovery stock.

Nick Bubb of brokers Pali International carries a price target of just 33p. Bubb accepts Browett has brought energy and ideas but has ‘an overwhelming sense the economy will swamp his efforts to transform the group’.

The group’s own internet service undercuts its stores. Freddie George of Seymour Pierce says PC World ‘is mature, cannibalises the Curry’s format and is facing increased competition’.

Overseas DSG group suffered heavy losses in Italy, significant losses in Spain and now Scandinavia is slowing. The shares rallied in the past month on hopes the group might ape Kingfisher (KGF) and sell its Italian venture, but analysts remain sceptical.

Best Buy from the US has announced plans to enter the UK market. Optimists hope it might do so by bidding for DSG but Bubb believes this is unlikely. Sites are freely available and remain more attractive than a bid for DSG.

The company has warned it is ‘very cautious about consumer confidence in many of its markets’ and Bubb fears the firm may have to cut its dividend again, weakening the support an apparent prospective yield of 8.8% would offer.

Laid out

Carpetright (CPR) 650p SELL

The shares have risen by 18% over the past month but volumes have been thin and an early August trading statement revealed a 9.2% drop in group sales in the first 13 weeks of the financial year, so this move may be too optimistic.

Although the £439 million cap has gained market share due to the difficulties of Allied Carpets and the independents, some of whom have given up the unequal struggle, the group suffered a fall in like-for-like sales of 15.4% in the UK. The continental European operation saw ‘flat’ underlying sales, although at least gross margins were better across the group as a whole.

The industry is unveiling a big marketing campaign this month but the housing market seems to be paralysed and consumer confidence is still falling. Matthew McEachran of brokers Kaupthing Singer & Friedlander believes the ‘newsflow will deteriorate further’. He argues there will be ‘another round of downgrades’ and believes the group will cut the dividend from 52p to 39p this year. This would reduce the yield to 6%.

Andy Wade of Numis maintains this is a ‘great stock for the medium term’ as the company will enjoy strong growth when sentiment improves. However, ‘in the short term macro economic factors will be dominant’.

Both Wade and McEachran are forecasting earnings per share of just over 50p, placing the shares on a prospective price/earnings ratio of 13.

The group might be one of the best managed in the sector, but this rating is too demanding in the short term given the tough market and the possibility of a cut in the dividend payout.