Interactive Investor

Retail shares to buy and avoid

6th October 2016 14:22

Lee Wild from interactive investor

Business has probably been better than many shopkeepers expected just after the Brexit vote in June. However, next year will be tough, warns one analyst who now thinks retail profits will fall in 2017 and argues that the current sector valuation multiple is up with events.

"We expect 2017 to mark a tougher, but not disastrous, year for the retailers," writes Andrew Wade at Numis Securities. However, in a weighty 72-page research note, the analyst warns that slower employment growth will probably hurt retail sales next year.

The national living wage (NLW) will dent profits, and a slump in the value of the pound will mean a big increase in the cost of goods sold (COGS), given most of the things we buy from them are made overseas.

"As a result of this, we see underlying retail profits being down, with a mid-point of our base scenarios of -5% even assuming retailers can successfully mitigate the COGS headwind and offset some of the impact of NLW inflation," says Wade.

He points out that a 10% devaluation in sterling versus any given overseas currency would mechanically result in an 11% increase in the COGS for products sourced in that currency by UK retailers. A weak pound will drive COGS inflation.

Against this backdrop, stocks are looking pricey, argues Wade. The sector price/earnings (PE) ratio almost doubled between January 2012 and July 2015, peaking at over 17 times before falling back to 12.5 times amid sector earnings downgrades.

"The general retail sector is currently trading on 12 times calendar year 2107 PE, consistent with the long-run average PE over the last 15 years of 12.3x," says Wade.

"However, given a challenging earnings outlook, political uncertainty, structural pressures (ostensibly the online shift), and returns metrics markedly worse than six years ago, this looks somewhat generous, in our view."

So, what should investors do? A cautious Numis is increasingly wary of the mature retailers, so downgrades M&S from 'hold' to 'reduce', Dixons Carphone and Next from 'add' to 'hold', and Halfords from 'hold' to 'reduce'. Also avoid Kingfisher and WH Smith.

Instead, the broker prefers proven growth plays, mainly those who benefit from the shift to online retailing, and those rolling-out profitable space growth of 5% or more. That's why its key picks are ASOS, B&M, AO World, and Lookers.

ASOS

High-flying internet fashion retailer ASOS can continue to differentiate itself from its competition, reckons Wade.

"[We] have found no compelling example of a scaled profitable online pureplay competitor offering a targeted demographic the combination of a curated selection of third-party edits and a substantial range of fast fashion own-name own-brand product, a leading delivery proposition, and ever increasing levels of content."

He rates the shares a 'buy' with price target of 5,250p.

B&M European Value Retail

B&M is one of those variety retailers. It basically sells everything, from curtains and wallpaper to toys and vacuum cleaners. Wade likes its disruptive sourcing model, strict stock-keeping discipline, ability to target sector seasonal peaks and trade profitably across a large chain at high cost effectiveness.

It also trades at a discount to other retailers with similar brand/pricing integrity and international expansion potential. There's an implied yield of 6%, too, including specials. 'Buy' up to 350p, says Wade.

AO World

AO World is worth 250p, according to Wade's calculations, almost 50% more than today's price. "Assuming growth to £1.2bn of revenue and a terminal 4.5% margin, we value AO's UK operation at c.£600 million," he says.

"This compares to a market cap of £730 million. On this basis, we see significant upside as AO replicates its outstanding proposition-led model across Europe."

Lookers

The trading outlook for car dealer Lookers seems "set fair for the next few years," according to Wade. "We think investors' concerns over the industry margin structure are overdone, given Lookers' strong and consistent [return on capital employed] (currently 27%, having dipped to 15% in FY 2008).

"Similarly, although the industry clearly has cyclical characteristics, Lookers has a history of bouncing back sharply from major recessions. Its earnings before interest and tax in FY 2015 was more than double the peak level achieved before the last recession, significantly ahead of its auto and broader retail industry peers." 'Buy' up to 170p, says Wade.

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.