Retail: buy, hold, and lose

It’s hard picking long-term winners in the ever-changing retail sector

Photo by the blowup

Britain’s high streets are in a sorry state. A short walk around Norwich city centre a few weeks ago revealed a rather grim picture of an otherwise ancient and splendid City – several thousand square feet of vacant Top Shop, another few thousand square feet of vacant Debenhams and a plethora of smaller shops, bars and restaurants long boarded up.

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Why the FANGs are losing their bite

Netflix’s horror show quarter is a reminder that there are limits to the technology industry’s rate of growth

Photo by Michael Dziedzic

Big tech has been carrying the US markets for some time now. Since Jim Cramer coined the acronym FANGs in 2013, the market’s very biggest boys have, until recently, just got bigger and bigger. FANGs became FAANGs, then FAANG+ or – another Jim Cramerism – MAMAA as names and market caps changed, before finally the Muppets inspired MANAMANA, incorporating Nvidia and Adobe and name changes. Apple – bizarrely excluded from the first FANG definition – became the world’s first trillion-dollar company in Aug 2018 and then the world’s first three trillion-dollar company in January. Microsoft, Alphabet/Google, Amazon, Meta/Facebook, and Tesla (a story for another time) have all since joined the trillion-dollar club.

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Watches of Switzerland: a luxurious valuation

The luxury watch retailer has had a great pandemic, but abating tailwinds mean the shares now look too expensive

Luxury watch retailer Watches of Switzerland (WOSG) was the deep dive subject of the last Investability podcast, and if you’ve already listened, you’ll know that Michael and I both gave it the thumbs down. As a trader, Michael didn’t like the chart set up. And as an investor I didn’t like the valuation, especially in the context of our preferred quality and growth metrics, or the outlook in the face of a possible slowdown in the global economy triggered (or, as I believe accelerated) by the War in Ukraine.

Since then, the shares have bounced sharply after a statement from WoS stating that it has “negligible exposure to Russian and Ukrainian customers” and that its latest guidance issued at the time of its Q3 trading statement in February remains unchanged. Did Michael and I get our assessment wrong? I don’t think so and here’s why.

What it does

WoS is a retailer focusing on the sale of luxury watches and some luxury jewellery (c.8% of UK sales, 5% of US) mainly through a network of physical shops in the UK (roughly two-thirds of revenue through c.120 stores) and the US (the rest, via c.40 stores).

That store-base is split between multi-brand chains – Watches of Switzerland, Mappin & Webb and Goldsmiths in the UK, and Mayors in the US – and 46 mono-brand boutiques i.e., outlets dedicated to selling just one brand of watch (32 in the UK, 14 in the US). The group has a multi-store presence at Heathrow airport, and is also targeting expansion into Europe, adding six mono-brand boutiques in Sweden, Denmark and Ireland which will open in the first half of the 2023 financial year, its first European stores.

The company doesn’t split out ecommerce sales, but the company does give a sales per store figure - £5.4m across 148 stores in 2021, implying overall store sales of £800m and presumably the remaining £100m via online channels. The channel has been growing quickly, largely the result of stores closures during pandemic lockdowns, although online sales did fall back slightly in Q3.

But shops are unsurprisingly the most important channel – if you’re spending £88k on a Hublot Big Bang MP-11 you probably want to try it on.

Current Trading

Since the trading update on 10th February there doesn’t seem to have been much change to the trajectory of this year’s trading – the company is sticking to its guidance that profit will be at the top end of the upgraded sales and profit guidance from November 2021. According to SharePad, that means sales of over £1.2bn, up 34% on 2021, and EPS of 40.8p, an annual rise of 69%.

Source: SharePad

Christmas trading was solid, with decent growth in both luxury watches (+21%) and the smaller luxury jewellery category (+88.4%), although overall revenue growth of 27.9% in the 13 weeks to the end of January does represent a slowdown from the half year rate of 40.8%. On the basis of current forecasts, year to date revenue growth of 38% over 2021 mean Q4 growth is expected to be slower still.

The big question is whether this leaves room for upgrades – the company does have a good track record of raising guidance as the chart shows, but the latest statement would suggest we shouldn’t expect one for a while. Whether that matters in the context of the long-term growth story is another matter altogether, but the premium valuation certainly demands continued high growth rates.  

Source: SharePad

Bull case

That said, the growth rates on display remain well in excess of what most retailers could hope for, especially in a tough consumer market. That’s unsurprising to an extent, given WoS largely caters for a wealthier audience that’s less likely to be feeling the current squeeze on household finances – as the group puts it, it has “a thriving domestic clientele”.

It’s doubly impressive as the pandemic meant many luxury watch makers were forced to halt production, limiting supply to partners such as WoS, while high street and travel stores were forced to close for many months, the latter still far from fully recovered. There could still be some pent-up demand from this scarcity.

The group has also been adding new partners in both watches and luxury jewellery which broaden its ranges and audiences. Average selling prices of £6000 in the UK and £10,000 in the US suggesting a good mix between higher and lower priced luxury watches (classed as any watch over £1000).

These partnerships are offer a significant barrier to entry, and partners work with WoS on marketing initiatives and, importantly, store fit outs, helping it stretch its capex budgets, which across maintenance and expansionary capex is expected to be around £50m this year.     

And as it gets bigger, profitability metrics improve, suggesting a degree of operational gearing – in other words, sales grow at a higher rate than costs. Gross margins have also been driven higher by increased selling prices, which were up by nearly a fifth in 2021 and offset lower transaction volumes.

Wos Gross and EBIT Margins

That’s helping it generate strong free cash flow growth and simultaneously reduce borrowings, as can be seen here. 2021’s unusually high free cash flow isn’t expected to be repeated this year, but analysts do expect a permanent step-change in free cash flow going forward as the UK estate matures and despite continued expansion in the US – an underdeveloped luxury watch market with a very fragmented retail industry and the big prize for WoS.   

Wos FCF and Net Borrowing

Bear case

I started the bull case talking about the market, and I’m going to start the bear case talking about the same thing, because markets change and especially markets like luxury - not necessarily structurally, but certainly cyclically as the chart from WoS’s own annual report demonstrates.

So, could WoS’s strong performance in 2021 be a cyclical peak? Arguably the luxury market has enjoyed several tailwinds that have more than offset the difficulties posed by the pandemic, not least booming equity and cryptocurrency markets, the profits from which must surely have made their way into the real economy. To put it bluntly, people got lucky and felt rich.

Lockdowns had also brought about a so-called ‘Covid dividend’ for many in work – helicopter money in the US, and money saved as a result of working from home and both markets. Many have been unable to resist the resulting urge to splurge. Weakening markets, spreading economic worries, and a return to previously low savings rates suggest that dividend has been spent.

WoS’s own annual report highlights two key risks that I also think are more than boilerplate. The first is that any further economic disruption could see a repeat of supply constraints – that’s a real risk given the current soaring demand for precious metals as a safe haven, even if the corollary of that is that hard assets included watches and jewellery may see higher demand as a result of concerns about inflation. Adding new watch partners and a ‘pre-owned’ offer goes some way to mitigating this, but risks dilution of the luxury Swiss watch proposition, and brings it into competition with other retailers and, more worryingly, e-tailers.

Indeed, the second risk is that WoS could see business suffer if watch brands decide to sell direct to consumer, as other subsectors of the luxury goods industry are exploring. Luxury purchasing is still ‘experiential’ – in modern retail speak – but traditions change, especially as younger, digitally native shoppers begin to dominate, and any channel shift could eat into WoS’s growth.

And then there’s the boring financial bit, and especially the lower quality metrics compared to manufacturers of luxury goods. WoS might sell a luxury product, but at the end of the day it’s still a retailer, albeit a very good one. But as the tailwinds that have supported massive outperformance against luxury peers abate, it may find it harder to live up to aggressive expectations. 

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Covid testing: a cautionary tale

The woes of the UK’s listed Covid testing companies is a reminder that investing in biotechnology is hardly ever a licence to print money

Photo by Jan Kopřiva

You’d think that two years spent obsessing over our health would be good news for the biotech industry. Yet the share prices of many companies involved in the business of protecting us from Covid, especially those at the smaller and more exploratory end of the market, suggest that it has proved quite the opposite for most, with many investors left bearing the brunt of the swing from incredible optimism to the pain of undelivered promise.

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The burning issue for big oil

Can Shell and BP emerge from the energy crisis unscathed by windfall taxes?

Photo by KWON JUNHO

The last few weeks of news has been dominated by the unedifying spectacle of a highly unpopular PM trying to save his political skin. Mostly, the method seems to have been mainly to confuse everyone by wheeling out Nadine Dorries, or otherwise divert attention away from the whole mess with a series of apparent giveaways from his team of ministerial acolytes. Most of them – not least the levelling up plan, a story for another time - look like they’ve been put together by rehashing existing policies on the backs of various fag packets and which only seem to be cranking up the opprobrium to eleven. The Thick of It meets Spinal Tap if you like.

The main difficulty the PM and his government face apart from working out whether he was or wasn't at a party in his own house is deciding what to do about the savage cost of living crisis that’s hitting many households as bills of all kinds rise faster than wages.

Energy bills are a particular pain point, exacerbated - as we speculated may happen when we discussed on the podcast last year when the gas crisis was still in its infancy – by Ofgem increasing the energy price cap from £1,277 to £1,971 a year to cover the soaring costs of wholesale natural gas, the price of which has quadrupled in the last year.

That will raise average household bills by 54%, far higher than the £200 rebate offered by the Chancellor – essentially a loan (or as money saving expert Martin Lewis described it “a loan-not-loan”) that will have to be taken whether you want it or not and paid back anyway over four years. It barely even warrants the definition of sticking plaster, and anger is building at rising fuel poverty – eat or heat - especially as a portion of the rising bills will be used to cover the cost of the winding up the 27 domestic gas suppliers and counting that have gone bust this year. Once again, privatised profits and losses for the taxpayer.

Anger is also building at the lack of a windfall tax on the profits of the energy companies that have been on the winning side of the gas price rise, such as Shell – no longer royal or Dutch – which saw its adjusted earnings hit $6.4bn in its last quarter thanks largely to a 15% jump in average liquid gas prices. Along with BP, which also reported this week and whose chief executive rather insensitively described it November as “a cash machine at these types of prices”, the two UK oil majors have generated operating cash flow of $70bn this year.

With those numbers in mind it’s now wonder that many seem to think a windfall tax makes sense, but remember that no one was suggesting that we help the oil majors and their embattled shareholders out when their profits slumped as the world locked down for Covid, or in the years running up to the pandemic when few wanted to touch their ESG-unfriendly shares. Between them, Shell and BP reported post-tax losses of over $40bn in 2020, and the sacrosanct dividends were slashed. Both companies have seen their shares rocket in the last year but look back further and shareholders had previously seen the value of their investments plummet, in Shell’s case dropping from a peak of around £28 a share in mid-2018 to less than £10 a share at the height of the pandemic in late 2020. Politicians have short memories, it seems – or maybe they just want to have their populist cake and eat it.  

Source: Statista

The current energy crisis reveals that they also appear to lack any clear understanding of how the very necessary transition to cleaner energy will actually work in the real world, still so dependent on fossil fuels which accounted for 83% of global energy consumption in 2020. The latest update from SSE highlights one reason behind this - renewables output in the first 9 months of its financial year had achieved only 81% of its targeted 7,304-gigawatt hours, with most of the shortfall the result of a lack of wind throughout the summer.

Its profits are nevertheless still going to be ahead of previous expectations, but that’s only thanks to its gas generating capabilities, which still account for nearly two-thirds of its generating mix. SSE is building more wind farms than any other company in the world, and with £12.5bn of capital expenditure planned up to 2026, the direction of travel is towards a fully renewable portfolio. But it won’t happen overnight - and in the meantime, without gas – and in my case kerosene – we’d all be freezing to death and reading by candlelight.  

Indeed, whether politicians like it or not, big energy companies are going to be doing what they’ve always done for a while yet, and taxing one year’s profits is, as the oil majors argue, hardly encouragement for them to think longer term and make the investments in green fuels the planet needs, and many consumers want. BP is aiming to increase annual investment in low-carbon energy to between $4 and $6bn by 2030, around half of its capital investment; Shell expects to see what it calls energy transition investment to hit that level by 2025.

Nevertheless, there’s enough political noise that shareholders in big oil would be forgiven for feeling slightly nervous, and producers must be careful not to be hoist by their own green petard and tempt the government into targeting their profits in some other way. Indeed, the argument put forward by the majors that every penny is needed to fund green investments falls flat on its face if excess profits are redistributed to shareholders in the form of buybacks and dividends. Both Shell and BP have accelerated their buyback programmes, surely a red rag to the Labour party bulls.

Besides which, panicking politicians – even those ministers currently dismissing calls for a windfall tax - can always be relied upon to make a mess of things whatever the data in front of them, the energy price cap that has contributed so much to the UK’s current energy market troubles being case in point.

And let’s not forget that curbs on fossil fuel investments in the UK are exactly why we’re feeling the crisis more than any other nation – North sea decommissioning, no fracking, limited gas storage, a stalling nuclear programme, and few new gas turbines to plug the gap when the wind stops blowing. Energy stocks still look cheap, as I’ve previously argued and activist investors have noted, but that increasingly looks like a fair reflection of the political winds starting to howl against the sector.

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Should you follow the activists into Unilever?

The consumer goods giant faces a major turnaround, but may be being judged too harshly

Photo by CHUTTERSNAP

Readers of Investability will know that we’ve never been the biggest fans of Unilever, and it seems several long-term investors are losing patience, too, including Nick Train of Lindsell Train and Terry Smith of Fundsmith.

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Games Workshop: buy the dip?

Slowing growth has put pressure on the fantasy gaming company’s shares – but is the blip temporary?

Photo by Jack B

Something strange happened on Tuesday afternoon. At about 1.30pm, shares in Warhammer owner Games Workshop – which had released somewhat lacklustre half-year figures to the market earlier that morning to an initially muted reaction, suddenly nosedived from 97p, where they had hovered for several hours, to a low of 85p.

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Why I’m putting Biffa in the bin

Waste management is big business, but Biffa is looking too financially stretched to capitalise

Photo by John Cameron on Unsplash

I have been asked by one reader to talk rubbish – not the kind I usually do in my bulletins, but about the actual stuff we throw away and how that’s managed. It’s a subject I touched on a month or so ago, when the lorry driver shortage had made its way into the world of refuse collecting, and black sacks had started to pile up on some city streets.

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