I remember a phrase a CEO of a well-known British retailer told me a few years ago, ahead of an uncertain Christmas trading period. “It may be late, but it always comes”. Fact. I don’t dispute facts, not for a second. But what kind of Christmas will we be having this year? From a consumer point of view of course… It certainly looks challenging to me. Why do Christmas matter so much? Some retailers make the bulk of their profits that period and for all it is an extremely important trading period that defines momentum into the beginning of the following year.
Uncertainty over Brexit will hit consumer confidence and hence spending
Britain will be invoking Article 50 to exit EU for all we know. Will it be a “soft” exit or a “hard” one? I certainly don’t claim to know more than you do but news headlines are already increasing and they will get fiercer with time. I know for a fact that uncertainty doesn’t help consumers’ psychology and when the mood is not great then spending probably takes a hit. Let’s try to quantify that towards the end of this article.
The sterling weakness will cause price inflation for the consumer and margin erosion for the retailers
The sterling has fallen off a cliff. Now other than boosting my adrenaline to the limits by me spread betting on the “cable” (no I certainly won’t be doing that again), it hasn’t really touched on people’s everyday lives. But it will! An economist would probably say this is a good thing for the economy (nominal growth!). Well I am an equities guy I don’t see it that way. Inflation will put strain in people’s purchasing power. I bet the retailers will seek to pass on some of the cost pressure they feel from the strengthening USD to the consumers otherwise margins will also fall off a cliff. In 2011 (when cotton prices skyrocketed and many apparel retailers raised prices by 5-10% to offset the cost) the price elasticity of demand worked in their favor. But in 2011 things were improving and the savings ratio was more than double what it is today (see later on in this post). Now things are uncertain at best. Uncertainty and higher retail prices. Not a great combination!
So what will retailers need to do? The £/$ is down c20% post Brexit and most apparel retailers source 2/3 of their product from the Far East paying in US$. If they keep their prices stable then they can suffer up to a 500bps margin erosion. Alternatively they can raise prices by 5% and maintain their level of absolute profitability (assuming that consumers don’t buy less product after the price increases which is very unlikely) or they need to raise prices by 13% to maintain the level of gross margin they had (check the example’s table below). Now of course we need to take into account negotiations with suppliers who could be supportive and get some of the hit but the point doesn’t change. The movements are very big and the retailers will need to mitigate the damage through both suppliers and consumers. Otherwise here is an exercise for you. Go put a reduction of 500bps of margin (or even half that) to any retailer’s revenue that you can find in their annual report and see what happens to profitability. It can be an Armageddon!
In the example I am using a potential retailer who makes a 60% gross margin (usually apparel retailers have a bought in margin as high), with 66% of their Cost of Goods Sold (COGS) sourced in USD assuming that sales grow only by the amount of price inflation with volume growth being zero (economic theory will tell you that rising prices will cause volume declines).
Consumers are not even aware (well most of them I reckon)
The other very important thing is that a really challenging Christmas period is kind of not widely expected, either by the retailers or the consumers. The UK is a nation of spenders, granted that, and “Brexit” has been voted by the majority of the British people so in the view of most consumers Brexit is not a disaster, hence the mood has not yet worsened. Also unemployment at 4.9% is close to historical lows. Consumer confidence is actually close to all-time highs. Only 19% of the Brits expect the situation to get a lot worse in the next 12 months (see http://www.gfk.com/en-gb/insights/infographic/uk-august-2016-consumer-confidence-landscape ). If I am right this is very likely about to change. I don’t want to sound too gloomy but emotions will gradually give the baton to the reality of price inflation and uncertainty. Take a look at the consumer confidence chart in this link (hit http://www.tradingeconomics.com/united-kingdom/consumer-confidence and click Max in the graph). From July’s blues post Brexit to September’s “it is all fine” it is too much emotion too soon. Even if the mood settles somewhere in the middle it is not great news.
What is very alarming is the close to historically low savings ratio (% of net disposable income the UK households save at a certain time). What does it mean? Consumers have very little leeway in retaining their spending level if their income gets squeezed. This could warrant abrupt behaviour on their spending patterns. Put simply, the consumer has not saved much for a rainy day. I don’t want to be too cliché but last time the savings ratio was so low was just before Lehman’s bankruptcy. Well sure but now we are not faced with such a radically negative event like a big investment bank’s collapse (dejavu?), are we? Anyhow I really can’t see where the positive news are coming from for the consumer. And before I get accused of thinking that 52% of the UK population made the wrong decision, I don’t claim that. I don’t know that. But I am certain we won’t find out whether Brexit was a good or a bad choice this Christmas or maybe even next Christmas.
Many UK consumer discretionary share prices can hit or cross their post Brexit lows
So what kind of sales declines should we expect to see? Well go back to a time when consumer confidence was falling rapidly with a combination of a savings ratio as low as it is today. You have to look at the 2008 era (I know Lehman’s collapse time. Darn so much coincidence making me so cliché). Back then, for a period of 5-6 quarters non Food LFLs (Like for Likes is a measure looking at sales coming from existing stores) were down 4%. DIYers like Homebase and B&Q were recording LFLs of down up to 10%. Well from experience I can say that every percent of sales decline can cause on average a negative swing of c3-4% on earnings all else equal. So we may be looking for earnings declines of more than 10% and for some retailers a lot more than that. Let’s look at the valuation.
The share prices of many UK consumer discretionary companies like Next, M&S, Kingfisher, Dixons Carphone, Sports Direct etc. have actually been weak for the last couple of weeks, if you check their price charts, and their forward Price/Earnings ratios hover around 11x, which many may see inexpensive. But before someone calls the UK retail space cheap and a “buying opportunity” we need to define where earnings estimates are heading. There is a high risk that earnings are heading south in a potentially big way as we established above (sure there will be particular names which could actually differ). The market is usually early to spot uncertain times, hence the 11x PE from c15x a year or so ago but there is still room for downside to the P/E levels if investors start factoring in a deteriorating consumers environment. There can be a multiple contraction of 1x, which can translate to another c10% downside to share prices.
If we add both together then for some retailers we can see share price declines of 20% or so. It has started already, as many companies have already lost 5-10% of their local highs. Whether there is some sort of recovery in the next few days, time will show, but my verdict is that shares of many UK retailers can touch their post Brexit lows before we start fishing for buying opportunities!
Conclusion: I would exert extreme caution with UK consumer stocks right now and for the next few quarters.
Let’s leave it there for the time being, this post is a lot bigger than I wanted it to be initially. The fun part about UK consumer discretionary stocks is that they are almost all unique cases. Self-help stories, restructuring cases, distressed plays or growth names. Every one of them is treated differently by investors who have diverging expectations. I will be touching on specific names at later posts. The overwhelming theme though is that sales declines, maybe major ones, will be very difficult to avoid and reliance on cost cutting will intensify. UK consumer names who are exporters, like ASOS and Boohoo, who benefit enormously from a weak sterling, will fare a lot better. They don’t come cheap (how expensive is expensive? Is a whole new topic) but they are severely less impacted by the UK consumer’s upcoming troubles. But I have told you that a lot later than you would have liked to if you look at their share price charts.
Of course there are names worth owning in the midterm because they can react to a potentially tough environment or they have a particular good story behind them. Also worth remembering that a good company does not necessarily make a good investment and a bad company does not necessarily make a bad investment.
But many retailers will find that they need to keep pedalling hard just to stay still.
It’s getting cold out there so some may want to play the short term benefit UK apparel names may experience. Don’t fall into that trap!
Author: Chris Chaviaras
Disclaimer: The author has no open positions on any UK consumer shares at the moment.