12 Apr 2018
With many household retail names coming under scrutiny in recent months, are there opportunities to be found by the discerning bond investor?
Recent months have seen non-food retailers in the news for all the wrong reasons, particularly in the UK. Whether seeking lower rents and closing stores (New Look and House of Fraser), or even entering liquidation (Maplin and Toys R Us), traditional retailers are under considerable pressure. But the news is not all bad. Some retailers are thriving – particularly at the top and discount ends of the market – and the past year has seen a number of successful operational turnarounds and refinancings.
Retailers face a number of specific challenges at the moment, most notably changing consumer habits. Established retailers have struggled to adapt to the structural challenges that online competitors have created. This is particularly the case with branded goods, technology, and toys, all areas where direct price comparisons are easy.
In fashion, consumers are more short-term oriented than has historically been the case. Instead of buying in predictable seasonal patterns several months ahead, shoppers are increasingly adopting a “buy now, wear now” approach. This change represents a challenge for supply chain managers and puts upward pressure on costs, but also offers the opportunity to maintain leaner inventories and in theory reduces the impact of fashion missteps.
Other retailers find themselves the victims of competition from discount competitors. Most of you will be familiar with Zara’s quick-to-market, low-cost business model, but this group also includes the likes of Poundland, who are expanding beyond their traditional areas of focus into grocery and clothing.
Finally, department store operators are finding it hard to stay relevant. Their challenges differ somewhat by geography – for instance, the US has proportionately much more square footage devoted to the category than the UK and Continental Europe – but every player is working hard to stay relevant. In the UK, John Lewis has probably had the most success, while Debenhams and House of Fraser have struggled.
In the UK, these challenges have been exacerbated by the weakness in sterling, which has driven up the price of imported goods, while at the same time rising business rates and increases in the National Living Wage have pushed domestic costs higher.
Yields in the sector have risen, both in absolute terms and relative to the broader market. I have been gradually increasing exposure in the Invesco Perpetual High Yield Fund, from 4% (with an aggregate yield of 6.2%) when I started co-managing the fund with Paul at the end of 2016 to 9% currently (with an aggregate yield of 7.2%). The positions I have added to the portfolio are generally trading higher than the entry price. Some companies are effectively managing through the challenges that they face, and in my view are trading unreasonably cheap because of investors’ discomfort with the sector overall. It is my belief that, while we will see more insolvencies in the sector over the next couple of years, those retailers that navigate this difficult period will end up better placed to grow earnings and cash flow in the new consumer landscape.
Below, I offer a few comments on some of the issuers I hold in the fund, and one that I cover but do not own.
The new management of this US department store chain are executing a realistic turnaround plan given the challenging backdrop, closing unprofitable locations, focusing on their core customers, and offering services to complement the retail offering and drive footfall in stores. They are also prioritising creditor concerns, paying off debt with cash from operations and asset sales, and selectively extending maturities. I am supportive of their plans and have been pleased to see them begin to bear fruit as leverage has started to drop and the company begins to take market share from competitors like Sears. However, as yet the market does not seem to agree with me, and the bonds we own have traded soft. I hold a previously IG rated bond they issued in 2007 and a recent new issue. Both priced are around 3 points below where I added them, yielding 11.5% and 9.6% respectively.
John Lewis is a name I do not hold in my fund, but I cover the credit and we own the bonds elsewhere. The bonds have historically traded closer to investment grade yields in spite of being unrated. The company has not issued bonds since 2014, when it came out with a £20yr bond at 4.25%; these currently yield 4%. Despite – or perhaps because of – operating at the upper end of the high street, JL continue to see gross sales growth and an increase in customer numbers and market share. Net debt has also been reduced, and the company has made progress in reducing its pension deficit. While the Waitrose business has faced challenges, particularly related to pass-through of cost inflation, JLP is a business that I think will seek an investment grade rating in the near future, probably when they refinance an existing bond next year. I believe that the bonds would trade somewhat tighter if the company took this step.
This is a company I followed for some time before getting involved. Matalan went through a difficult period operationally in 2015-16 before addressing internal logistics problems and launching a much-needed (and so far successful) store refurbishment programme. I believed that as a family-oriented discount retailer, Matalan was well placed to succeed in the changing UK clothing and homeware market, and that the company would be able to refinance its £6.875% bond maturing in 2019. These bonds traded down several points in January following weak Christmas trading announcements by several competitors, and I was able to build a position at a price of ~97.5. Soon thereafter, Matalan reported good Christmas results, called these bonds at 101.7, and refinanced at £ 6.75%. I believe that the company is in the right corner of the market, is growing revenue and earnings and will be able to generate cash. Furthermore, its main shareholder has demonstrated support for the company in recent years.
Takko is a German discount clothing retailer whose earnings are recovering following a period of poor results. The issuer’s €9.875% bonds traded as low as 30 in 2015. I added at a price of 81 in April 2017, taking profit at around 98 as the company’s improving prospects came to be reflected in bond pricing. I continued to hold some paper, on the view that a refinancing was likely, but the timing uncertain. Takko ultimately refinanced in October and called the remaining notes at 102.5. We participated in the new deal, and Takko went on to announce strong sales in December. Cash flow has been robust and debt and leverage have declined. The newly issued € 5.375% and € FRN are currently 98-100. While acknowledging the company’s rocky history, I believe current management are doing a good job in positioning Takko to compete effectively in the German retail market. I also think that Takko’s private equity owners will look to exit their investment at some point, which could provide a path to further deleveraging and upside in the new bonds.
This post originally appeared on the Invesco Perpetual site.
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