As with most contrarian, value sectors it is easy to make the bear case for the UK general retail sector today. The shift to online shopping, rising overheads and high debt burdens have (among other things) all contributed to a raft of recent bankruptcies and profit warnings, with the FTSE 350 General Retailers index underperforming the broad market (FTSE 350) by 47% over the last five years (source: Bloomberg 1 July 2019, total return). Nevertheless, investors may not want to dismiss the sector entirely. If you look hard enough, some potentially attractive opportunities can be found.
Focus on the positives
The UK consumer environment has actually been a touch better than feared this year. Employment and real wage growth figures remain strong, while the delay to Brexit can also be seen as something of a positive, given it has helped to delay interest rate rises (and therefore allowed consumers to avoid higher mortgage costs for now at least). Without getting too carried away, our bottom-up analysis of the retail sector suggests there might actually now be one or two interesting investment ideas to consider.
Pets at Home, the leading pet specialist retailer, is one such example. The company is differentiated from other retailers (and somewhat insulated from many of the headwinds affecting the sector) by its veterinary business. The stock also trades on an attractive free cash flow yield of around 7% and is inexpensive on earnings-based multiples. The retail business enjoys a high market share in many key categories, giving scale advantages over competitors. And recent results surprised positively at the sales, profit and cash flow levels. A major restructuring of the veterinary business, announced last year, is also encouraging, and the company is making good progress to date on this front. Another stock that our research suggests could be attractive is DFS Furniture, the UK’s largest upholstery retailer. The stock offers an attractive free cash flow yield of around 8%, a dividend yield in excess of 4.5% and is reasonably valued on alternative metrics. The company’s market-leading position (with more than 30% market share) gives it advantages over peers, while synergies from the recent acquisition of Sofology should drive future growth. (Source: Factset / IBES consensus as at 1 July 2019)
Backing the winners
It’s perhaps no surprise that these two companies for example share many things in common: market-leading positions, strong free cash flow generation and improving omnichannel offerings. In a sector that still faces many headwinds, these are the characteristics that give retail stocks the best chance to be in the winners’ rather than the losers’ camp in the years to come.
Ian Butler is portfolio manager of the JPM UK Strategic Equity Income Fund within J.P. Morgan Asset Management's UK Equity team.