General Retailers has outperformed the FTSE All-Share over the past year, building on a sustained period of strength for the sector. Although rising household bills and declining real incomes have long-crimped personal disposal incomes, a buoyant housing market and growing employment levels are driving a recovery in consumer confidence, prompting investors to chase cyclical names higher.

Stark divergence between winners and losers remains however, with the channel shift from bricks and mortar stores to the web leaving investors salivating over internet-based growth stories and those shopkeepers with winning formats, scope for self-help or market-driven forecast upgrades. Names in vogue range from electrical specialist Dixons Retail (DXNS) to web-based fast fashion wonder ASOS (ASC:AIM) and car dealership Lookers (LOOK) . In contrast, struggling retailers such as department store Debenhams (DEB) and High Street bellwether Marks & Spencer (MKS) lag behind.

Overall, the outlook for retail sales is improving with real wages likely to recover while relatively buoyant housing market activity offers some support and household bills are rising less sharply. Yet the sector has rallied hard, suggesting a risk that lower-quality, operationally geared names could disappoint if the recovery falters, or others could derate as earnings expectations play catch-up. Risks to forecasts remain in the form of unpredictable weather patterns, potential for promotional activity or even a rise in interest rates.

Mindful of these dangers, Shares is sticking with its preference for high-quality, structural winners and counters with proven, profitable and cash-generative business models. Our key selections are copiously cash-generative homewares seller Dunelm (DNLM) , expansionist sportswear star turn Sports Direct International (SPD) and reinvigorated car parts-to-bicycles seller Halfords (HFD) .

High-flying street fashion retailer Next’s (NXT) £10.3 billion market value exceeds the £7.6 billion tag of multi-channel rival Marks & Spencer, still looking to regain its general merchandising mojo under embattled boss Marc Bolland. Simon Wolfson-led sector star Next last month (20 Mar) swaggered in with stellar finals to January, its fifth year of 15%-plus earnings per share and dividend per share growth on the spin. Taxable profits rose 11.8% to £695 million, a landmark profits haul, ahead of the £626 million profit forecast for foods-to-fashion giant Marks to produce its annual numbers next month (20 May). A key factor in the rise and rise of Next, in tandem with profitable new space, has been its success in harnessing the benefits of transactional channel shift, as its online and catalogue business NEXT Directory continues to flourish.

On the up

Lord Wolfson’s outlook pronouncements on the state of the consumer economy are always well-followed and while flagging real risks to the recovery, including a rise in credit-fuelled spending, the Next chief highlighted a number of positives for the General Retail sector. Next sees modest improvement in the consumer economy continuing with employment testing new highs and mortgage approvals growing strongly. Furthermore, Wolfson flagged the little or no decline in real earnings seen in January, suggesting real earnings may move into growth for the first time in over five years.

Against this improving backdrop, retailers have been at the front of the queue to test appetite for new issues. Newsagent and convenience stores operator McColl’s (MCLS) was the first retail IPO of the New Year (28 Feb), discounter Poundland (PLND) has enjoyed a positive reception since debuting on the Main Market last month (17 Mar) and Pets at Home (PETS) has also boosted the quoted retail ranks.

Voracious appetite for online growth stories has enabled white goods seller AO World (AO.) and fast fashion retailer Boohoo.com (BOO:AIM) to float with very frothy valuations. Shares has particular concerns about the eye-watering price tag ascribed to the former (see Under the Bonnet, Shares 20 Mar ‘14). Meanwhile others lining up IPOs include casual clothing specialist FatFace, value greetings card seller Card Factory, furniture play DFS and Liverpool-based discounter B&M.

Investors seeking rapid-paced growth will need to pay a premium price to tap into the prospects of the sector’s structural winners. Global online fashion store ASOS set a new and ambitious £2.5 billion annual sales target alongside reassuring interim figures to February. The half-year figures were remiss of any more negative surprises following a sales stumble (18 Mar) and profit downgrades. Confident chief executive officer (CEO) Nick Robertson, highlighting 36% growth in the retailer’s active customer base to 8.2 million shoppers as well as growing website visits, conversion rates and average basket value, is unapologetic about stepping up the pace of spending on everything from warehousing to IT in order to grab global market share. For the year to August, broker N+1 Singer looks for 20%-plus growth in adjusted taxable profits and earnings per share to £70 million and 62.8p respectively. On these estimates and a £50.7p share price, ASOS trades on a punchy prospective price/earnings ratio of more than 85 times which some will find prohibitive.

Shares anticipates positive full-year figures next month (1 May) from key selection N Brown (BWNG) (see Plays, Shares 20 Jun ‘13). The plus-size fashion retailer’s multi-channel strengths are helping it to mop up market share in an improving domestic economy, as consumers become increasingly comfortable using tablets and smartphones to facilitate apparel purchases. Moreover, the Jacamo-to-JD Williams brand owner’s potential for international expansion could prove game-changing. Overseas efforts are focused on the US, where plus-size ladieswear brand Simply Be has a vast opportunity to profit from demographic trends. Tapping into this potential isn’t cheap, though N Brown offers a prized combination of premium growth and forecast upgrades.

Also making fantastic multi-channel strides is key pick Sports Direct, the UK’s biggest sports retailer by sales and operating profit and owner of brands such as Slazenger, Dunlop and Lonsdale. With its pile ‘em high, sell ‘em cheap model chiming with shoppers throughout the recession, the Mansfield-headquartered company’s stock market valuation has soared to £5.4 billion and at a recent 903.5p, the shares aren’t cheap on 29.1 times consensus earnings per share of 31p. Yet further forecast upgrades should sustain the high rating, potentially as early as a strong full-year pre-close (23 Apr) or subsequent finals (17 Jul).

Long-term, Sports Direct is worth owning as one of a select few retailers offering exposure to physical in-store and online sales growth. Europe-wide expansion excites, with the company currently selling into territories ranging from France and Belgium to the Baltics and Austria in a continent flush with acquisition targets. A likely boost from the World Cup in Brazil adds to the near-term attractions of the stock.

Also offering a visible path to growth is Majestic Wine (MJW:AIM) , where weakness following last month’s (20 Mar) shock profits warning offers an opportunity. Watford-headquartered Majestic flagged a sluggish end to the year and cautioned the need for extra spend to enhance its customer proposition would crimp profits for the years to March 2014 and 2015 respectively. Yet Shares is sticking with its positive stance on well-run and cash-generative business, which still offers exposure to growth on a number of fronts. Key strategic pillars of the growth strategy include its new store roll-out, as well as a focus on increasing e-commerce penetration, growing commercial sales to restaurants, hotels and gastropubs and boosting sales of high-end fine wine. Given soft comparatives and this year’s late Easter, Majestic could soon restore investors’ faith with a return to positive like-for-like sales growth for the first quarter.

Recovery counters

Despite the sector having already undergone a seismic shakeout since the recession, retail remains the domain of numerous companies either in the midst of recovery or with self-help levers left to pull. They range from large cap home improvement giant Kingfisher (KGF) , the B&Q DIY chain owner set to distribute an extra £200 million to shareholders this year as part of a ‘multi-year’ programme of extra capital returns, to Home Retail (HOME) , the Homebase-owner driving through transformation at its Argos chain. Others include electrical specialist Darty (DRTY) , mother and baby products purveyor Mothercare (MTC) and even embattled floor coverings seller Carpetright.

Temptation to back the turnaround at bombed-out Mothercare ought to be resisted. Interim CEO Mark Newton-Jones, and an eventual new permanent broom, face an uphill task turning round the structurally-challenged UK business and further forecast woe may lie ahead at the £167 million cap, which posted a severe promotions-driven profits warnings at the start of this year (8 Jan).

Retailers offering a play on rising mortgage approvals and the resurgent housing market should be on watch-lists, although valuation remains prohibitive at floor coverings-to-carpets purveyor Carpetright even after its third profits warning (26 Mar) in six months. The Lord Harris-led retailer has cautioned the pace of recovery seen in the third quarter hasn’t been sustained into the last three months of the financial year to 26 April. Improving UK housing market transactions have yet to benefit the business and trading remains dire in Holland.

As a result, annual pre-tax profits will come in between £3.5 million and £5.5 million, significantly south of the £7.8 million consensus. Even on downgraded estimates, the shares, priced at 617p, are trading on 129 and 95 times Numis Securities’ 4.8p and 6.5p earnings forecasts for 2014 and 2015, a rating that leaves Carpetright looking dramatically overvalued on recovery hopes.

Cash converters

A superior way to profit from the housing market boom is via another structural winner, out-of-town homewares leader Dunelm, which won earnings upgrades following a solid third quarter trading update (3 Apr). Over the 13 weeks to 29 March, total sales rose 9.9% to £195.4 million with the help of ongoing ‘Dunelm Mill’ superstore expansion, while like-for-like sales warmed up 5%, signalling further market share gains. Besides its enviable cash-generation and formidably strong balance sheet which is enabling the business to self-fund UK store expansion, Dunelm boasts huge multi-channel potential and has scope to expand gross margins through increased direct sourcing of lower cost products. The cushions-to-rugs seller trades on a demanding prospective price/earnings (PE) ratio of more than twenty times, though this rating is deserved due to its status as a select structural growth story.

A particularly compelling turnaround is underway at Halfords, leaving the £932.2 million cap looking interesting from a growth and income point of view. Cash-generative Halfords has previously suffered from under-investment in stores and the wider consumer downturn, yet under CEO Matt Davies, the FTSE 250 constituent remains in the early stages of a compelling recovery plan to drive sustainable sales and profits progress. Confirmation of continued momentum driven by self-help success and rising consumer confidence should trigger further earnings upgrades. The next event to watch out for is next month’s (22 May) fourth-quarter and full-year results statement.

Also on the up is another turnaround temptation, the home shopping-to-education supplies specialist Findel (FDL) , where experienced CEO Roger Siddle is doing sterling work in paying down debt through improved cashflow, whilst reinvigorating its four businesses. A key pick for us (see Plays, Shares 19 Dec ‘13) the company last week (1 Apr) issued a reassuring pre-close trading update, stating pre-tax profits for the year ended 28 March will be in line with the £22 million to £22.5 million forecast range. The one sour note was news of a disappointing end to the year at network marketing arm Kleeneze, which offset progress in Findel’s three main divisions and thwarted earnings upgrades, although Shares believes Siddle’s strategy is the right one and further upwards earnings revisions are on the way.

GENERAL RETAILERS

[buy_or_sell]

SUMMARY

Economic recovery provides a positive backdrop for the General Retailers’ sector rally to continue, with a buoyant housing market and growing employment levels driving recovery in consumer confidence.

Number of stocks: 50

Market cap: £65 billion

Sports Direct International

(SPD) 905.3p BUY

Market value: £5.4 billion

Prospective PE Apr 2014: 29.0

Prospective PE Apr 2015: 23.6

Dunelm (DNLM) 985.5p BUY

Market value: £2.0 billion

Prospective PE Jun 2014: 22.6

Prospective PE Jun 2015: 20.2

Halfords

(HFD) 479.5p BUY

Market value: £932.2 million

Prospective PE Mar 2014: 17.5

Prospective PE Mar 2015: 16.1

(Click on images to enlarge)