Edmond Jackson's Stockwatch: Will we keep shopping at JD Sports?

Does this retailer exemplify the kind of share exposed to rising interest rates and sticky wages? The chart for Mid 250-listed, JD Sports Fasion shows a strong rise from 170p to 375p last year and is currently near the higher end of a volatile-sideways range of 340p to 455p this year.

Management is doing well from selling sports shoes but losses have increased in fashion and a genuine turnaround - i.e. profitability - at the acquired Blacks and Millets stores is yet to be proven. This stock has been a good read-across from the success of Sports Direct, reflecting demand for sportswear amid high-profile sporting events such as the Olympics and World Cup.

I drew attention to both stocks early in their re-ratings: as Sports Direct attained an average price/earnings (P/E) multiple of 24 times last year it became more interesting to consider JD on a single figure P/E. A simple P/E approach has worked well enough as Sports Direct soared from 7 to 27 times over five years, but its stock has drifted by one third this year to 620p on a forward P/E of 15; whereas at 435p currently, JD trades on 13 times 12-month forward earnings.

Sports Direct is the more substantial and sportswear-focused operation and, while it does not pay a dividend, the prospective yield at JD is only about 1.7% and net tangible assets so low that the valuation emphasis is similarly earnings.

Consumer discretionary spending

In this context it's worth being aware how macro risks are tightening around shares affected by consumer discretionary spending. Economists focus on "marginal" change i.e. what it takes to drive incrementally higher revenues; yet a recovery in UK wages for example is proving sticky, a latest warning is many British workers being trapped in a "lost decade" of real wage growth set to last beyond 2017.

Growth in consumer spending is therefore expected to be weak. Furthermore, the Governor of the Bank of England is making it plain, interest rates will have to start rising in order to contain risks building up in the financial system.

How many people are over-extended?

While JD's latest interims show a 27% rise in revenue and doubling of normalised pre-tax profit, it's worth remembering that the average cost of UK consumer borrowing has edged down near 5% - a historic low - compared with just over 6% a year ago. The cost of unsecured loans has halved since the height of the credit crunch, implying quite a shock for some people when interest rates rise.

How many people are over-extended? The Office for Budget Responsibility projects UK household debt as a percentage of disposable income will regain peak levels of 170% (just before the financial crisis) within five years. How sustainable is this scenario and what kind of headwind might retailers face? Presently, this is speculative but no less relevant.

It doesn't imply the likes of JD are an outright 'sell', as sports events and the message for a healthier lifestyle should support earnings. But it may get hard to grind them much higher which is significant also for ratings; some caution is wise hence a lack of conviction buyers for the shares.

Certainly it is hard to define any "margin of safety" in buying prices; JD shareholders are taking the view management can substantially cut losses with its fashion and Blacks/Millets, outdoors' retailing fascias. It's easy to give management the benefit of doubt with strong overall results being reported; however, mind a possible cold front approaching.

Results at the top end of expectations

Last week's profit warning and 36% share price plunge at banknote printer De La Rue reflects investors' complacency and is a cautionary flag for firms with a lot to deliver in their second-half financial year. In fairness, banknotes have a specific industry overcapacity problem whereas JD has guided the market to expect annual results at the top end of expectations.

It made £75-77 million normalised pre-tax profit last year (according to different measures) and is substantially ahead at the interim stage. Much still depends on Christmas trading and £20 million interim normalised pre-tax profit compares with an £82.7 million consensus for the year to 1 February 2015. Again, where is any margin of safety?

With 17% of last year's revenue derived from continental Europe, there are initiatives for further store openings in France, Germany and Spain. However, deteriorating sentiment within and towards the Continent has helped weaken stockmarkets over the last week or so.

JD's executive chairman owns 1.64 million shares, the finance director 95.8 million, i.e. facing risk/reward in good partnership with outside investors. There has not been any director trading since end-2011 when the finance director and another director added small amounts; this may not be a share where the directors trade actively to be indicative. It would, however, be easier to trust expectations for the second half-year if they were buying.

While this piece may come across as negative, my message is more that stocks are fairly priced for the risks ahead - and mind how they assume plenty. The brokers' consensus rates JD a 'buy' targeting up to 500p; however, this appears to assume the turnaround has further scope and the effects of low wage growth and a rise in interest rates won't dent progress - like they could car sales, by comparison. I'd be turning more cautious, alert to potential for change in consumer behaviour. You need to be thinking about downside risk with consumer and cyclical shares if spending power is nearing constraints.

For more information see jdplc.om.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.