Kingfisher could be a surprise performer in the long run

Investing in a retailer with exposure to the UK economy may seem foolhardy given the prospects for UK plc. Consumer confidence is weak, Brexit talks are about to begin and inflation is now at its highest level in four years. These are hardly the conditions which are conducive for positive like-for-like sales growth or rising profitability.

At least, that’s the short-term view. For the long-term investor, 2017 could be similar to the financial crisis of 2008/09. Back then, UK retailers saw their sales and profitability turned upside down by declining consumer confidence and a negative outlook for the economy. Buying shares in retailers in 2008/09 may have caused severe pain for investors over a period of months, but the majority of retail stocks recovered and posted high returns over a period of several years.

This discrepancy between the short-term difficulties facing retailers such as Kingfisher (LON:KGF) and their long-term investment potential could be a rare opportunity to profit. As well as a low valuation, Kingfisher also has a debt-free balance sheet, sound strategy and international exposure which may offset weakness in its UK trading operations.

A perfect storm

The problems facing the UK economy could create a perfect storm for retailers such as Kingfisher. Inflation has already risen from 0.9% in July 2016 to 2.3% in February 2017. This is perilously close to the average rise in wages, which is currently 2.7%. If inflation increases as per Bank of England forecasts to almost 3%, it would be likely to surpass wage growth. The result of this may be similar to the situation which last occurred during the financial crisis of 2008/09, when consumers reduced spending on some items and postponed the purchase of other, mostly non-essential, items.


As with the financial crisis of 2008/09, a significant event is affecting the UK economy. Last time it was a global banking crisis. This time it’s Brexit. While leaving the EU may sound like a simple idea in theory, the difficulty of securing a successful divorce should not be underestimated.

That’s particularly the case because the UK and EU are a long way from agreement on issues such as immigration. Therefore, uncertainty may build and hurt consumer confidence, business confidence and market sentiment. An even weaker pound may push inflation higher and cause greater difficulties for retailers as consumer spending power declines.

A perfect opportunity

As usual, opportunities often come disguised as failure. During the financial crisis, a range of retailers including Kingfisher reported lower sales and profitability. In terms of the latter measure, Kingfisher’s pre-tax profit fell from £450 million in financial year 2007 to just £90 million in financial year 2009. At the time, there were fears that things could get even worse, and the company therefore put in place a self-help programme to improve its overall performance.

However, it was an upturn in the economy which was the main catalyst in Kingfisher’s resurgence. Its pre-tax profit was £671 million by financial year 2011, which is quite a turnaround in two years. During the calendar years 2009 and 2010, the company’s shares increased in value by 90%. From their low of 99p in 2008 to their recent high of 438p in 2014, they have risen 342%.

…buying during a ‘perfect storm’ can be among the most profitable decisions an investor can make.

This time around, similar gains may or may not be possible. The company’s share price and profitability may not be hit as hard as they were during the credit crunch. However, the point is that buying during a ‘perfect storm’, such as the one which seems to be developing for UK retailers at the moment, can be among the most profitable decisions an investor can make.

A better business

In my opinion, Kingfisher wasn’t well prepared for the 2008/09 financial crisis. It found the right strategy at the right time, but it was caught unaware of the challenges facing the UK economy. The same could be said about a whole host of other retailers, so it was by no means on its own.

This time around, Kingfisher is better prepared for a consumer slowdown. It has a balance sheet which is exceptionally strong. Net cash increased from £546 million in financial year 2016 to £641 million in financial year 2017. This gives the company significant financial flexibility to conduct an enlarged share buyback while its shares are cheap, take advantage of low valuations in the sector by making acquisitions, or reinvest in its current business for future growth.


Kingfisher is also one-fifth of the way through its five-year transformation plan, which will see greater investment in its digital capacity, as well as improvements to operational efficiency. The goal is to create £500 million of sustainable operating profit uplift by 2021. This would be above and beyond the gains which may (or may not) be made from improvements to the macro backdrop in the countries in which it operates.

Further, Kingfisher now relies on the UK for 47% of its sales. This is down from 49% in the financial crisis and less reliance on the UK could be a good thing if retailers experience a ‘perfect storm’. Additionally, its P/E of 13 indicates its shares may already factor in a period of at least some difficulty during 2017/18.

Outlook

Undoubtedly, Kingfisher and other UK retailers face a difficult period. The ‘perfect storm’ looks to be gathering pace, with higher inflation and greater uncertainty likely to cause a return to difficult days of 2008/09 for the retail industry. This could lead to declining profitability and share prices which fail to match the returns of the main index.

However, I feel it is during periods of short-term difficulty that the best buying opportunities present themselves. As Kingfisher’s performance in the aftermath of the financial crisis showed, recovery can be swift with the right strategy. This time around, Kingfisher’s balance sheet is stronger, it is less reliant on the UK and its strategy seems to be more robust and focused. This should allow it to weather a retail storm better than most. While it is set to be a difficult share to hold in the short run, in the long run it could be very profitable for those investors who are bold enough to buy.