Rehana Khan

Portfolio Manager

February 2017

SA retail stocks looking more attractive

Now that share valuations are cheaper, it’s time to look more closely at buying SA apparel retailers, according to Rehana Khan, Portfolio Manager at Prudential Investment Managers*

2016 was a tough year for the “big four” South African apparel retailers on the JSE – Truworths, Woolworths, the Foschini Group (TFG) and Mr Price. Added to the increasingly competitive environment for these companies were changes to the affordability regulations for providing credit, drought-induced food inflation, and the rand blowout following the “Nenegate” scandal. Sales growth has slowed, gross margins are coming under pressure and forecasts for earnings prospects keep being downgraded. This has resulted in share prices coming under a fair amount of pressure, and in addition to the earnings downgrade cycle, the ratings of the stocks have also been coming down from high levels. Could this be the time for valuation-based investors like Prudential to buy?

Where will meaningful sales growth come from?

The government has long been the primary support for consumer spending through new job creation, decent real wage increases and social grants.  However, going forward government must manage its budget much more tightly, which means no more government job growth – new jobs will need to come from the private sector. Yet it's tough to see businesses growing in the current environment, given the political uncertainty and slow economy. At the same time, the ability to leverage consumer debt as a big structural driver for retail sales going forward no longer exists due to the new regulations.

The competitive landscape in the South African apparel space has become tougher due to new international entrants such as Cotton On, H&M and Zara, which have been discounting quite aggressively. Despite this, profit margins in the sector have actually been trending upwards over time. Gains in gross margin coupled with strong cost control by local retailers have benefitted their earnings growth, even with sales growth slowing in recent years. However, due to the extent of the sales slowdown during 2016 and the increasingly competitive market dynamics, the companies are currently struggling to hold on to their gross margins – and costs have been so well managed that there is very little fat left to take out. Their recent struggles have resulted in falling share prices and de-ratings by the market.

Underweight the clothing retail sector

Prudential has been underweight the retail sector in general in our portfolios due to its previously expensive valuations: the average 12-month forward Price-to-Earnings (PE) ratio for the big four apparel retailers has fallen from nearly 20x, well above its long-term median level of just under 13x, to around fair value. Our only active retail holding during the year has been TFG, which has outperformed the other clothing retailers: its share price has risen by nearly 30% in 2016, while its competitors’ shares have taken a knock, some falling by over 20%.

Although the retailers’ valuations have fallen to around fair value, there may still be some downside risk to the forward earnings forecast by the market consensus, given the headwinds that the sector faces. A tough medium-term outlook awaits these companies in the absence of higher economic growth and job creation. At Prudential we always base our investment decisions on a medium-term view, and from this perspective, we must judge whether the local growth environment over the next three to five years will support even the lower prospects reflected in the retailers’ current valuations. We are certainly watching the sector closely given its improved valuation signals, but patience and caution are required before significantly increasing retail exposure in our funds.   

*Read the full version of this article, with more background and analysis, in Prudential’s Consider this client magazine, Summer 2017 edition.     


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