Toxic mix for retail sector

You only have to switch on the news to see what a mess Britain is in. With the country divided over Brexit, and with both main parties lacking leadership, neither voters nor investors have a clue what lies in store. That's incredibly dangerous, certainly for a consumer-driven economy like ours. Woolies, MFI and thousands of small retailers bit the dust during the Credit Crunch and another crisis could be looming.

It's already quiet on the high street. Admittedly, Austin Reed and BHS were dead men walking, but plenty more are struggling. Even big boys like Next and M&S have issued warnings this year.

The FTSE 350 General Retailers sector fell by as much as 3.3% early doors Tuesday, and a partial recovery following comments from Carney and Co. has unwound rather quickly. Bank of England governor Carney said in a conference that rules about how much capital banks must keep on their books will be relaxed, potentially freeing up £150 billion for lending in the domestic economy.

Now, both Jefferies and JP Morgan have raised major concerns about the general retail sector. In reaction to a plunge in the pound to below $1.32, the former has cut UK like-for-like sales forecasts for clothing retailers by 100-200 basis points for 2017 and 2018, and by up to 500 basis points for firms selling big ticket items.

"A post-Brexit world looks tough for UK retailers due to the combination of US$ strength and weakening consumers' willingness to spend," writes Jefferies which believes the combination of a weak pound and decline in consumer demand is "potentially toxic".

The broker has made only small cuts to earnings per share (EPS) estimates at Primark-owner AB Foods. But B&Q-owner Kingfisher, which is heavily exposed to UK housing, homewares favourite Dunelm, Next and Ted Baker are downgraded by 6-15%. It's even more at DFS, N Brown, Sports Direct, Debenhams and Poundland.

Among the worst-hit stocks, where goods are mostly sourced from Asia, is Marks and Spencer. Jefferies is particularly bearish and has just cut its price target from 300p to 250p. Look for a 4% drop in like-for-like first-quarter General Merchandise sales when the firm reports on Thursday.

"We believe Steve Rowe’s strategy to focus on stylish, wearable wardrobe essentials could work to improve customer satisfaction with the product. The only problem is this strategy is going to cost margin and with low margins to start with and Brexit induced headwinds the cumulative impact could be severe."

However, DFS, N Brown and Ted Baker are still rated 'buy', while Burberry, with 90% of sales outside the UK, has earnings upgraded by 10% and its target to 1,290p.

Over at JP Morgan, analyst Georgina Johanan has cut like-for-like sales forecasts for the UK retailers by an average of one percentage point, and pre-tax profit forecasts for 2017 and 2018 are cut by 9% on average.

"We stress that it is early days, and whilst we are confident in the direction of our move to LFL and gross margin forecasts, it is difficult to have confidence in the magnitude, and we see further downside risk to estimates," says Johanan.

"The UK retailers all buy a portion of COGS [cost of goods sold] directly in dollars, ranging from c.15% (Kingfisher) to c.70% (Next). We update our forecasts to take account of these headwinds although, for now, assume material mitigation is achieved."

JP Morgan remains either 'underweight' or 'neutral' on all six retailers except Dunelm ('overweight'), although its knocks the price target from 1,000p to 890p. Next is cut from an optimistic 6,370p to 5,500p, while M&S sticks at 285p.

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