MINTER COURT

Morning all, here's some more news and insight on the Retailers.

The Retail Sector in 2003
By Richard Ratner, Head of Research, Seymour Pierce

27 December 2002

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We look towards the New Year somewhat in a state of uncertainty as to where the sector is going, with the relative to the FTSE All Share index falling back to a level in the low 80s having almost touched 92 at the beginning of November.

Why is this? Well, first the rate of increase in consumers' expenditure in the previous year was 4.1%, which in 2002 will have slowed to around 3.5% and in our view will fall further in 2003 to say around 2.8% to 3.0%.

Whilst a fall in consumers' expenditure is not in doubt, the difference between the "bulls" and the "bears" is a question of degree of slowdown. Moreover, the latter will argue that some companies failed to do well once spending was running at more than 4%, so why should the rest not suffer at sub 3%?

True, companies such as Mothercare, Woolies, Allders and William Baird have had a bad time - but we must remember that when things are good there are always companies that succeed in doing badly. The corollary of this is that in difficult times not everyone trades poorly. A good company can usually prosper in more difficult economic circumstances.

The "bear" argument has been helped by the weather, which during September and November clobbered clothing sales. It certainly was mainly the weather because October saw a very strong bounce back in this area, and anecdotal evidence is telling us that the "build" in the last week before Christmas is quite pronounced.

That apart, one should not pretend that all is plain sailing. Although the return of the cold dry weather may have boosted clothing sales, it has come rather late and thus after Christmas there is likely to be an above normal volume of discounting as operators struggle to reduce their inventory levels.

Moreover, whilst the major driver of retail sales is "feel good", it is fuelled by a number of different factors, the outlook here is somewhat mixed. Interest rates are likely to remain low, with at most a half percentage point rise over the next twelve months. In the past it has not mattered whether rates move fractionally, unless they reach the crunch level of 6.5%-7%. This time around, given the level of individual borrowings, a lower figure of say 5% might cause problems.

Equally there is the problem of house prices, and irrespective of some suggestions that prices will continue to go up, or at worst steady, we are convinced that we are in for a fall of say 20%-25% in London where much of the market has been boosted by the "buy to rent" speculators.

We also think that this will spill over into the South East and South West and to a lesser extent affect the rest of the country. One must remember that whilst one's equity in one's house continues going up, one may not be so concerned about the level of debt, credit card or otherwise. Were this not to continue then we feel this would have a negative impact on spending.

Finally, there is the question of pensions, together with personal investments, hitting sentiment and, with worries about both, we believe that this has already adversely affected spending, certainly amongst the older demographic groups.

However, what is equally clear is that whilst employment prospects remain somewhat benign - except in the City! - then the youngsters will continue to spend. Indeed, even with the lousy weather, "young fashion" did well, considerably outperforming the older "classic" brands.

Now the negative argument runs as such: Christmas won't be good - that is probably true with an OK outcome at best boosted by an extra trading day before Christmas. Even if it is OK it will fall off after Christmas, and if the "sales" are OK, then it will fall off once they are over!

A reasonable argument but the problem is that some commentators were saying the same thing last year; and one of our competitors over two years ago called the top of the market in household goods!

The bear case

Of course the "bear" case was reinforced by the unexpected and genuinely surprising trading statement from Game Group. Is it not unreasonable that if one of the significantly more promising areas of the market goes "pear shaped", then one should draw a rather negative line from it towards the rest of the retail sector - QED collapse the sector!

Whilst one cannot say that the argument is illogical, we would be surprised if the rest of the sector followed suite in profit terms.

The bull case

May we now turn to the "bull" case. First, the economy is very fragile and indeed the retail recovery is also fragile, driven mainly by price.

Whilst price deflation will continue to be the order of the day, good retailers have managed their supply chains and improved their housekeeping skills, such as scheduling labour and purchasing utilities, so that not only have intake margins widened but so have net operating margins. We believe that there is still further to go in these areas.

Secondly, retail is just about the only area keeping the economy from going into recession. It would appear that the Government will do just about anything to ensure that it is not killed off, or else we are likely to end up in a full blown recession.

For once a Labour Chancellor has realised this and rather than revert to the old downward spiral of "tax" and spend policies, ie the higher the tax rise the lower the tax yield, Gordon Brown has chosen to make up the deficit by borrowing - thank goodness.

In our view, retail profits will encounter 2003 outstrip those of the market, perhaps a 7%-10% increase in profitability. Except for a few stocks the days of 15%-20% profit growth are long past. Moreover the ratings of some of the stocks - other than the big ones - is in mid to high single digits, not expensive.

We therefore take a somewhat controversial view and would recommend a slightly overweight position in the sector - but stock selection is all important.

We prefer the "young fashion" stocks such as Monsoon, New Look and French Connection, whilst avoiding on the whole the "classic brands", and of course the major players in the "classic brands" are the department stores.

Whilst Debenhams and Selfridges are differentiated "offers", the remainder of the sub-sector is deep in the mire and were it not for bids for Allders and House of Fraser share prices would have been blitzed out of existence, particularly for the latter two stocks.

We are also cautious of the bottom end of the discount market, because of low margins and intense competition from both quoted and unquoted players. Let us make it clear that by "bottom end" we mean Primark, Brown and Jackson and Peacocks and not the slightly better end "value" players such as Matalan.

More controversially, the household goods sector should be less cyclical this time around, and the better players in the sub-sector look attractive, particularly DFS and Carpetright.

In addition there are some very exciting niche players, like J D Sports, Ottakar's and Topps Tiles, which all look very interesting.

Amongst the major players, boring but M&S and GUS look the best two prospects.

So we remain, going into 2003, unashamed, albeit slightly battered, "bulls". We could be wrong, but if we are then what other sectors look more attractive and where else do you put your money, other than oils and golds?