'Squeezed middle' of UK fashion retailers to suffer in 2017, share prices drop

The worst start to a trading year for Next shares since 1991 underscores the plight of mid-tier UK retailers hit by a combination of fierce online competition and higher costs driven by a weaker pound.

Traditional British stores, particularly those relying on clothing, risk getting caught in no-man's land as bargain-hunting consumers find cheaper alternatives while the rising popularity of online shopping, now nearly a fifth of UK retail sales, eats into their business.

Profit margins, already crimped by heavy discounting in efforts to maintain market share, now face additional headwinds as sterling weakness pushes up sourcing costs.

Next shares, down 18 percent in the first two trading days of 2017, have fallen 41 percent in the past year. Debenhams and Marks & Spencer are down about a quarter and short-selling, where funds borrow shares and sell them in the hope of buying back later at a lower price, has ticked higher in recent months.

The troubles echo a trend seen across UK grocers where discount chains such Lidl and Aldi ate into the profits of long-established chains such as Sainsbury, Tesco and Morrison.

While Next warned of tough times, B&M European Value Retail said it enjoyed record Christmas sales.

At the top end of the market, John Lewis, Britain's biggest department store chain which also runs upmarket grocery brand Waitrose, saw sales in the week before Christmas soar 36 percent.

"It mirrors what happened in the supermarket space," said Richard Marwood, a fund manager at Royal London Asset Management. "It was the people in the middle who struggled."

Marwood, who owns B&M shares, said that the company is enjoying the benefits of recent expansion but the jump in like-for-like sales suggested it was attracting more consumers looking for cheaper alternatives to traditional stores.

B&M, which sells products from toys to soft furnishings, is a top pick in the European retail sector for analysts at Deutsche Bank and Bank of America-Merrill Lynch.

Higher inflation and lower wage growth looks set to make 2017 "the year of value" in UK retail, according to analysts at Deutsche Bank, which this week downgraded Next and Debenhams.

UK wage growth will fall below 1 percent in 2017, according to the OECD, while inflation in food and fuel is set to pick up - meaning consumers will have less to spend on discretionary items like clothing.

DOLLAR DILEMMA

Retailers buy a significant proportion of their goods in U.S. dollars from manufacturers in Asia, selling on to British consumers in pounds. "The fundamental issue is that you’ve seen a nearly 20 percent trade-weighted depreciation of sterling over the course of the last 12 months," said Jeremy Lawson, chief economist at Standard Life Investments.

A weaker pound is a direct hit to profits. And in an already tough environment retailers have little wiggle room on prices. "They can hold the shop prices and hit margins, or they can put up prices but will have an impact on volume of sales," RLAM's Marwood said.

Next is among those worst hit by currency moves, according to analysts at HSBC, as it pays in dollars for around 70 percent of its cost of goods sold.

Rivals like ASOS and Inditex, which source more of what they sell closer to home, are poised to benefit and grab market share by being even more competitive on prices, analysts at Bank of America-Merrill Lynch said in a note to clients.

VALUE BUY

Five hedge funds have significant short positions on Debenhams totalling 7 percent, an all-time high, according to latest data from the UK's market regulator, the Financial Conduct Authority. On M&S, the ratio has more than doubled to 2.2 percent over the last three months of 2016.

High levels of bearishness do leave stocks susceptible to bounces, however, if there is a rush of short-covering. Also, with valuations already depressed, some investors are not as downbeat on the sector.

Retailers "trade close to financial crisis multiples", suggesting sentiment may be too pessimistic on some companies, according to Tineke Frikkee, a fund manager at Smith & Williamson who owns shares in Debenhams and M&S.

For brave investors, bargain-hunting in shares of beaten-down retailers might just pay off. In 1991, the last time shares of Next started the year with a double-digit decline, they ended up more than 250 percent.