Black Friday Bargains
Scott McKenzie and David Clark talk us through their black Friday bargains in the retail world…
As we write, it is Black Friday and every online retailer on the planet is going gangbusters trying to convince us to buy all manner of things that we did not know we needed. The narrative in the weeks ahead will be one of dismal Christmas trading and the death of the high street at the hands of the internet. Yet more long-established names are likely to go the way of Woolworths, Mothercare, House of Fraser and BHS. We are often told that there is no way the big high street names can compete against the online companies with their lower overheads and more nimble business models. Once the rot sets in, so the received wisdom goes, there is no way back.
But is it true? Actually, not always.
It is in the nature of the beast that retail businesses go through bad patches. Some suffer from self-inflicted wounds whilst others reflect larger, more fundamental economic forces. Change and the need for reinvention are constants. Marks and Spencer received a takeover approach from Philip Green in 2004 at 400p per share. It is fair to say that Mr Green’s empire is not what it once was and M&S shares can be bought for 199p today. Neither have moved with the times.
Older readers may well remember Next shares trading at 10p in the early 90’s as investors bet on it going under. Trading at £69 today, it is now the largest stock in the UK general retail sector with a market value of £9.2 billion, more than double the size of Kingfisher in second place. It is probably our most widely respected retailer now, with Lord Wolfson’s every word devoured by sector followers and property landlords alike.
And Next has not been alone in its reinvention. Under Kate Swann, WH Smith changed its retail strategy and moved heavily into travel locations. Since 2012, its shares have risen by over 500%, despite having received the Which magazine award for terrible customer service on an almost annual basis since. Similarly, JD Sports spotted the trend for expensive trainers and athleisure early and put poor results behind them. Investors have watched their shares rise from 100p to 773p over the past five years, aided and abetted by the failings of Sports Direct, which has more than halved in value during this time.
If you think that’s all a bit dim and distant, then consider Pets at Home and Dunelm more recently. Both companies issued profit warnings in 2018 and suffered serious setbacks in their market valuations. Following effective management action and a focus on the core retail proposition in each company Pets at Home has risen by over 125% and Dunelm by 70% during 2019.
The prevailing sentiment in today’s retail sector is that retailers are all doomed. We would agree that more disasters are likely. However, our examples above demonstrate that, in reality, some retailers can and do turn around and there are big rewards for investors who can spot the changes early.
This brings us on to a couple of our recent purchases for the Saracen UK portfolios – Halfords and Superdry. These are both names which fill investors’ hearts with revulsion. Superdry has fallen by over 75% since its peak at £20.75 in early 2018. Halfords has fared little better, falling 65% from a peak of over 500p in 2015. Both companies have had well publicised troubles in recent years. Boardroom coups, dire trading results, bad strategies poorly executed and frequent changes of management are but a few of the elements in their respective soap operas. Many bloodied towels have now been thrown into the ring and they are deemed as uninvestable by many.
Why are we catching these falling knives?
Both companies, over the last several months, have been communicating to the market their strategies not just to survive but to thrive. This has involved painful but necessary sacrifices including cut dividends, stock write offs and wholesale management changes. Expectations are now very low and valuations on the floor, reflecting the risk that the illnesses may well be terminal. We have stress tested their forecasts (and ours) and conservatively modelled our expectations. Our conclusion is that Superdry and Halfords both offer incredible long term value and the strategies adopted by the management teams are credible with a sporting chance of success. As history shows, when retail stocks do recover, they tend to recover big. Patient investors can be very well rewarded indeed.
Our philosophy at Saracen is to buy stocks on a 5-year view, with valuation being crucial to our initial decision. This means we may often be premature and buying when risks are at their greatest.
Looking forward over five years at Superdry, our estimates suggest that the company trades on about a 7x PE ratio and, even if we factor in our worst-case expectations, that multiple still lies at around 13x. The chart below demonstrates how far the PER has fallen over five years which, allied with a collapse in profits, has led to a perfect storm for shareholders. At its peak, Superdry traded at over 20x much higher profits. Time will tell if their brand ever recovers but at least the business has no debt. CEO Julian Dunkerton owns 18% of the shares and has plenty of skin in the game for any recovery here.
Halfords is in a similar position. It trades on a prospective 6x multiple 5 years from now and on our worst-case scenario it trades on only 11x. Despite a recent dividend cut, Halfords offers a dividend yield of over 7% . We believe that you are being paid to wait for the new strategy to bear fruit.
As WH Smith did many years ago, Halfords is re-focussing its retail offer away from highly competitive lines. It is also significantly improving the range of fitting services it offers. Recovery is likely to be several years away and significant investment is needed but debt levels are low. The scope for re-rating as the servicing strategy succeeds is substantial, something which we have also seen come to fruition with the recent revival of Pets At Home.
To conclude, despite the prevailing doom and gloom, history suggests that troubled retailers can recover and the rewards to investors in such turnarounds are huge. Whilst our recent purchases of Superdry and Halfords may well hit further bumps in the road, we believe that there is substantial upside to come over the long term in both. Black Friday bargains indeed.
Scott McKenzie & David Clark, Co-Managers, TB Saracen UK Income Fund & TB Saracen UK Alpha Fund