Sector analysis: Non-food retail

Consider the non-food sector as life's extras. It’s a rather big umbrella and covers retailers providing most of our luxuries in clothing and footwear; homeware; furniture & flooring; DIY and gardening; electrical and health & beauty.

As a consumer you’ll understand that buying products in these areas are not often life’s ‘must-haves’ but ‘would like to haves’ and as such we use our discretionary spending to buy the latest fashion clothing or to have a particular type of flooring in your home.

This is a crucial difference for the non-food sector as items in this category are considered luxuries rather than absolute necessities.

Retail companies that produce and deliver these products are categorised as part of the consumer cyclical industry.

If you are considering investing in this area then it’s important to understand the characteristics of the industry and the companies.

What is consumer cyclical?

Retail companies like other companies that fall under the consumer cyclical category will find performance is closely tied to the business and economic cycle.

When the economy is rolling and consumer confidence is high, these companies do well but when times are lean and consumers are less confident about the economy, they are vulnerable to consumers tightening their belts.

Retail companies are broken down further by sectors (Clothing and footwear; homewares; furniture and flooring; DIY and gardening; electricals and health and beauty) with some cross over between them. For example, Marks & Spencer and Primark can be found in both clothing and footwear and homewares. Argos, John Lewis and Ikea deliver products in both homeware and furniture and flooring. You can find a list of the top 10 retailers in each category by market share here www.retaileconomics.co.uk/top-10-retailers-furniture-and-flooring.

Who are the players?

It’s a diverse arena and many names are found on the high street such as: John Lewis Partnership, Walgreens Boots Alliance, Dixons Carphone, Home Retail Group (comprising Homebase and Argos), Amazon, Primark, Sports Direct, Debenhams, Inditex (including Zara, Zara Home, Massimo Duti, Pull and Bear and Stradivarius), Laura Ashley, ASOS and French Connection.

Other general retailers include Dunelm, Carpetright, Halfords, Kingfisher and Mothercare. Health & Beauty in the UK is dominated grocery retailers Tesco, Asda, Sainsbury, Morrisons and Boots and Superdrug.

Among the FTSE 100 companies, which are companies with the largest market cap, as of June 2017 there are three retailers: luxury brand Burberry, Marks and Spencer and Next.

Amazon Delivery Source: Shutterstock.com

What is shaping the non-food sector? The Amazon effect

When it comes to sales growth in the retail sector there is a complex interplay of economic factors such as consumer spending and the economic backdrop.

The current environment is described as challenging by many retailers and undoubtedly the non-food sector is one shaped by the twin threats of intense competition (particularly, the hulk that is Amazon) and the revolutionary change in the our shopping habits (think of the sheer range of things we now happily purchase online).

Certainly, a big headache for older companies are the new business models altering a fractious landscape and how to adapt.

There's the usual balancing act to make more cost efficiencies while delivering profits and value for shareholders. PwC puts it succinctly in describing  that "retailers are being confronted with challenges to their very existence".

Department stores are having a hard time to be relevant as more specialty stores crop up customers no longer have the same amount of time to browse and one-stop shopping no longer satisfies needs as specialty stores can provide more selection, quality as well as reasonable prices.

Then there is Amazon such is the breadth and scale of the online giant that analysts have taken to calling its catalytic presence on the retail map as the “Amazon effect”. The online retailer accounts for almost a third of the S&P 500 retail index and its market cap is $477bn.

In June, Amazon snapping up US grocery retailer, Whole Foods, had reverberations not just in grocery retail but also across the entire retail sector, as investors sent shares tumbling seemingly unconvinced of an able response by competitors.

Bricks and mortar retailers are suffering not only from the threat of Amazon but the way consumers are willing to shop is sending the sector in to spasms.

Consumers’ willingness to spend more of their time conducting their shopping experience online will have an impact on the level of footfall in shopping centres. Retailers may open more physical stores but they will do it in tandem with an increased online presence and expand in to other markets. 

PwC in its Total Retail 2017 report outlines six areas that retailers now have to focus on in response to changing consumer behaviour: pricing, loyalty, delivery, in-store knowledge of products and interaction, mobile and innovation (such as virtual reality and wearable technology). 

It is a difficult sector to invest in because of the many variables that can beset retailers and therefore involves greater risk. As with any other investment researching the stock is a must. 

Distinguishing which companies will outperform requires undertaking analysis to fully understand the metrics that underpin the industry, company, profit and return potential and ultimately, share price.

However, when the retail sector falls out of favour there may be room for improvement if interest rates remain low and consumer confidence rises. Naturally, if share prices fall enough bargains could be had but here are a few other things to consider:

What can make one company buck the trend?

Companies that are able to differentiate themselves from the competition are usually the ones at the forefront. But as set out previously, the sector’s intense competition means it’s only harder to stand out but also more difficult to do it over a long period.

Companies with scale and brand differentiation and strategies to stay ahead will be at the top of the class. Staying new and developing technologies to keep customers coming back. Remeber, the sector is a low-return business and has very few barriers to entry making it a competitive market place.  

Perhaps you were drawn to investigate a company because you’ve used it and spotted something unique as well. In retail, a standout company may have one or more of the following: unique products, brand loyalty, ability to be a low-cost producer and strong franchises.

ASOS web site Source: Shutterstock.com

ASOS future perfect?

ASOS niche online fashion retailer for the twenty-something set differentiates itself from the competition. It is a hot stock and brand.  

According to the Financial Times' market data, as of 21 Jul, the consensus forecast amongst 29 polled investment analysts advised that the company will outperform the market.

This has been the consensus forecast since the sentiment of investment analysts improved on  1 Sept 2015.

Andrew Wade of Numis Securities said in October last year about ASOS: "[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."

ASOS says it has a unique but constantly evolving understanding of its customers. The company uses new technologies and sets ambitious goals focused entirely on its target market in the UK, US and continental Europe.

Brian McBride, chairman of ASOS puts it plainly: “If we’re to become the world’s no.1 fashion destination for 20-somethings, as we fully intend to, our products need to be at the forefront of fashion, the price needs to be right for the market and we have to make it as convenient as possible for people to shop with us.”

The company sells over 85,000 branded and own-label products online and carries clothing for men and women, accessories and footwear, jewelry and beauty and has a market cap of £4.8 bn.

The stock price is up 28% for the year and has revenue of £1.6 bn and net income of £41.4 mn.  Its strategy for FY17 is expanding to sportswear, putting a focus on mobile and adding new brands to support growth.

Interactive Investor noted in April this year when shares tumbled and that investors are quick to punish: “Clearly, owning shares in a stock trading on a forward earnings multiple of around 76 times, dropping to a still-eye-watering 57 times in 2018, can be nerve-racking…ASOS has got to keep doing the numbers to justify investor faith and keep that multiple in the stratosphere.”

What can make a company's share price fall?

Lots of things influence the share price of a company but ultimately as the London Stock Exchange outlines there are only two principal factors:  either the company's performance or the wider environment. 

In retail, one of the latter can be weather. The Office of National Statistics in its latest retail sales data showed in the 3 months to June 2017, the quantity bought (volume) in the retail industry is estimated to have increased by 1.5%, with increases seen across all store types. 

According to the ONS, feedback from retailers suggests that warmer weather in addition to the introduction of summer clothing helped boost clothing sales.

The ONS report stated that clothing is one of the main sectors affected by weather, where unseasonal weather effects sales more than seasonal weather.

However, the relatively recent poor performance in this industry has meant that the warmer summer weather in June 2017 has had a positive effect."

In additon, slower employment growth may have an impact on retail sales. A lot of products are made outside of the UK and for retailers the cost of imports will rise with a falling pound.  A falling pound also drives costs of goods inflation. 

What should I look out for in company accounts?

As with any investment you'll check for a healthy balance sheet, regularity of earnings and revenues over a long time period which can provide an idea of the company's stability.

Also retail being a cyclical industry check whether there is debt and if serviceable in good times and bad.

For the retail sector particularly, an important metric is same store or comparable sales measuring sales growth and revenue from existing stores. It is typically expressed as a percentage.

Investors can see over time how well established stores (open for at least a year) are performing and can compare it sequentially and year on year.   Increases are what investors are usually looking for to determine the health of a retailer. 

Look at both gross profit and gross margin trends to gauge whether the company's story is backed up by the numbers. Gross profit is sales less cost of goods sold. This is money before taking any expenses are taken out. 

You can also look at gross margin which is the gross profit divided by sales.

You can ascertain with this metric if you look at it over a period of time whether a company is managing to increase its sales consistently without sacrificing gross margin and investigate where there are significant changes.

Review how stores perform on a period-to-period basis, for example, year over year. If sales are increasing that's great but any decreases in gross margin would be worrying because it could point to a decline in product competitiveness. 

Make sure to compare inventory and payables turnovers to sort the retailers that are superior operators. 

Also for context, another metric is retail sector trends to provide an outlook about the wider environment in terms of the economy, inflation and consumer spending. 

What else is there to watch out for?

Look out for future trends that may be grasped by retailers such as in areas of subscription and membership; data science and machine learning  and even checkout free stores. 

Also Brexit and its very real implications on consumers and businesses. We haven't yet exited the European Union and we are already dealing with a weakened pound, pushing up the cost of imports which has made shopping in Britain all the more pricier.

As the Financial Times notes in the absence of wage growth and increased taxes household disposable income (what people earn after taxes and benefits and taking into account inflation) has declined and in the first quarter of 2017 it was 2.7% lower than in the second quarter in 2016.

Stockpicking is hard enough. Choices are made according to your portfolio requirements, but the retail sector is not for the faint hearted and you should choose carefully.

Those companies already outperforming the broader index may have pricey valuations. There is much to choose from among the retail sector there will be a range of groups able to achieve superior growth and those that may undergo contractions.

Ideally, you would be seeking those with highest growth and decent valuations.

Although beware those with high growth expectations already priced in, only if you are able to get in early can you make money. Conversely, if the stock falls rapidly you could lose your shirt.

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