UK retail stock comeback has best before date

• Caution creeps back into sentiment on biggest UK retailers

• Tesco halts Aldi and Lidl market share grab

• M&S faces another year of slim food sales growth, fragile Clothing & Home

• Morrisons sets a high bar; well-defended for year ahead

• Argos saves Sainsbury’s Christmas

British retailing names kept up this week’s stream of robust Christmas updates on Thursday, but cautious industry voices were heard too, sending shares of institutions Tesco and Marks & Spencer lower, despite successful trading in the High St’s most important season.

The whole sector paused, having strengthened over 20%, on average, in 2016, reminding investors that the industry had only recently returned to firmer ground, just in time for renewed threats from bêtes noirs Aldi and Lidl, and looming inflation.

Whilst a new year customarily prompts investors to decide whether to rotate within and outside of sectors, we think the particular challenges facing UK retailers could narrow the breadth of returns across the industry even further.

Tesco turns tables on Aldi and Lidl

Tesco’s festive and quarterly trading, like Morrisons‘, hit the sweet spot where buoyant consumer confidence and fine-tuned pricing meet. This enabled the group to confirm that it grew market share for the first time since 2011. It’s a significant victory against incursions by discounters Aldi and Lidl, which have been aggressively appropriating large chunks of Britain’s grocery purse for around three years. If Tesco can sustain this current quarterly pace of low-single-digit percentage underlying sales growth—we are cautiously confident of its chances—it will be on track to meet a retail operating profit growth target of at least 60% earlier than the 2020 date foreseen by CEO Dave Lewis. That would point to continued recovery of Tesco’s shares. However, whilst Q3 sales were robust and, to quote Lewis, “ever so slightly more” than £1.2bn operating profit is now as good as in the bag, after a near-40% advance in 2016, nearby catalysts for more stock price gains are being judged as too flimsy by investors.

Tesco shares were also not helped by further cautious comments by its CEO this morning. Even so, we expect the shares to consolidate rather than deteriorate significantly from here.

We see another respectable double-digit rise by the stock this year as feasible.

A flash in M&S’s pan

In contrast to Britain’s biggest overall retailer, shares of the UK’s biggest clothes seller, Marks & Spencer rose as much as 6% on Thursday after it said it beat forecasts for Christmas trading. The group also saw some milestones of its own, including the first quarterly rise in underlying Clothing & Home sales for two years. It’s significant however that the group itself did not spotlight the achievement in its trading statement, instead noting that “c.1.5%” of a 3.1% gross sales rise was “was due to the shift in reporting period.” Unwillingness to crow, yet, suggests that CEO Steve Rowe is wary about how easy it will be to repeat the feat at a division where sales have persistently sunk despite millions of pounds of investment and several revamps. He is “absolutely clear”, he said this morning that there is lots more to do.

On the food side, Marks remains on firmer ground, posting 0.6% like-for-like growth in the 13 weeks to the end of December, continuing a virtually unbroken run that weathered the grocery sector downturn with fractional growth each quarter in similar modest increments. The challenge for the group’s food business now is to accelerate, particularly as the UK enters an inflationary environment which will challenge all grocers anew, and one for which rivals like Tesco and Morrisons—at least judging by their recent performance—have found a formula for more emphatic sales progress.

Either way, M&S’s likeliest growth driver remains Clothing & Home, a division where it will be the most difficult to protect shoppers from input price rises, as has been discovered by Next and others already.

All told, the balance of uncertainty for the year ahead seems slightly greater at M&S than at Tesco and Morrisons.

Morrisons sets high bar

Supermarket No.4 reaffirmed its transformation last year from an ‘also ran’ into a serious threat to rivals like Sainsbury’s. Morrisons gave Tesco, which emerged as a winner in the latest grocery industry survey by Kantar Worldpanel, a run for its money too.

Morrisons was no laggard in Kantar’s independent data, with sales up 1.2% over 12 weeks to 1st January, but the group’s own figures from stores open more than a year over 9 weeks to the same date were up  2.9%.

Whilst a broader strengthening is afoot among all big British grocers after years of painful efficiency drives and soul searching (and a little help from fading deflation) rivals will struggle to match Morrisons’ milestones, including its best underlying sales growth for seven years and unquestionably firm transaction volume. Less positively, the group has still not achieved a compelling rate of Internet growth (only a 0.6% like-for-like contribution at Christmas).

Fresh worries, stale threats

More seriously the group’s sales release also brought the first signs of retailers’ wariness on the return of inflation and its uncertain impact on consumer spending and margins, damping investor enthusiasm after last year’s strong share price rebounds. UK market and consumer inflation expectations are now running between 3%-4% over the next 12 months, pointing to a perceived threat as much as a real one.

The other central worry is that supermarkets’ bêtes noires—discount chains Aldi and Lidl also redeemed themselves over Christmas after 2016 saw their slowest sales growth for years. Aldi sales surged 15% compared to 2015, whilst Kantar’s survey revealed growth of 11.8% and 7.5% respectively. Still, Tesco and Morrisons have come a long way since being challenged significantly by the German upstarts for the first time around three years ago, and their share price gains over the last year–60% and 40% respectively—indicate that investors now see them as capable of withstanding a tougher environment.

All it’s difficult not to be impressed by CEO David Potts’ retooling of Morrisons, which was rewarded by a near-60% share price return last year, the best amongst close rivals.

We also expect the group to outshine peers on free cash flow growth, another important differentiator of retail resilience.

Argos does Sainsbury’s heavy lifting

A weak, but better-than-expected 0.1% quarterly rise in grocery sales at Sainsbury’s set the stock on course for its best day since May 2016—but it closed just 1% higher on Wednesday.

The short-lived bounce is worth scrutinising in given that rivals are building on stronger showings over the last 12 months compared to Sainsbury’s, which had an uneven quarter and uninspiring 2016. For the 15 weeks to 7th January, the group said it trumped forecasts of a like-for-like dip of a similar magnitude to the 1% decline seen over its last half-year. But that’s against a backdrop of what is looking like an outright revival around the other Big 4 grocers, and was also Sainsbury’s first positive like-for-like sales performance since the fourth quarter of its 2015/16 year.

Kantar Worldpanel had a similarly tepid reading on Tuesday of the No. 2 grocer’s recent performance. Its data has Sainsbury’s overall sales ticking 0.1% lower in a retailing environment that showed “the fastest recorded growth since June 2014″.

Under the circumstances, the group’s acquisition of Argos was further confirmed as a strategic success given the slow-motion snap back on the food side. Argos’ like-for-like sales increased 4%, well ahead of The City’s 1.5% expectation, with the home ware and electronics business continuing to offset unresolved concerns over volume growth in food in Q3.

This led CEO Mike Coup to say Sainsbury’s Christmas performance “reinforced the case” for acquiring Argos. It should also not be overlooked that ‘general merchandise’ proved to be the most deflation-resistant retail segment during the High St downturn. That does need to be balanced, however, with likely higher-sensitivity to input price inflation.

And whilst CEO, Coup’s Argos comment was a pat on the group’s own back for getting ahead of increasingly demanding consumer trends, it was also an admission that traditional supermarket sales were a let-down during one of the best Christmas seasons for years. With management directing investors’ attention to the strength of Argos, we can expect increased scrutiny of how well Argos is defended against competition from Dixons Carphone, Amazon among others.

Partly for these reasons, initial relief propelled Sainsbury’s shares 7% higher at one point on Wednesday, but the move faded. It follows a low-flying 6% lift for the stock in 2016, the weakest of the ‘Big 3′ supermarket stocks.

To be fair, Sainsbury’s online and convenience store volume growth were great in Q3: up 9% and 6% respectively. And clothing and general merchandise also jumped: by 10% and 3%, suggesting an outright sales rebound could be close. The group said it was ‘comfortable’ with analysts’ 2016-17 profit forecasts. However, if consensus for underlying pre-tax profit at £587m is accurate, income will just be flat against 2015/16, after two years of falls.

Investors are likely to prefer clear comeback stories to themes of running in place.