FTSE Friday: Retailers, house builders and broadcasters in the eye of the economic storm

The UK economy contracted by 0.2% in the three months to September - finally putting a figure on the decline that we’ve all been expecting. And with a downhill slide expected in the final quarter of 2022, economists can now say with confidence that the UK will be in an official recession by the end of the year.

This economic woes are trickling through the announcements of many of the countries biggest businesses. This week we’ll be running through the announcements from:

• Consumer facing companies at different ends of the spending spectrum
• ITV - a British broadcaster making the right decisions
• House builders confirming property price fears

Meanwhile, business news this week has been dominated by Elon Musk’s increasingly unhinged behaviour at Twitter and the collapse of Sam Bankman-Fried’s $32bn FTX crypto currency empire.

Headlines like these are adding to the sense of panic in the global markets, but this week we have also seen some sizeable rallies as the interest rate optimism emerges. Still, a shift in the market cycle is not a time for rash decisions. Now, more than ever, is the time for sturdy, well managed, (boring?), businesses. Investors should wait patiently for opportunities.

Economic woes are biting businesses: M&S and Wetherspoons

Marks & Spencer (LON: MKS) and Wetherspoons (LON: JDW) have different clientele, but they’re subject to the same afflictions of economic downturn:

• Inflation boosted prices have caused costs to rise, putting pressure on operating margins.
• The rising cost of living has squeezed demand, meaning sales growth is stalling.
• Base rate hikes have lifted the interest paid on company debt, sending finance costs higher.

Marks & Spencer reported a 24% decline in operating profits in the first six months of the year and a free cash outflow owing to supply chain disruptions in the clothing business. Wetherspoons has seen a decline in sales compared to 2019 in the last five weeks and is expecting £10m of extra finance costs in 2023 owing to new terms on its debt. These are trends we should expect to see peppering British companies financial announcements in the coming months.

The downturn is likely to accelerate the demise of some companies. Those with expensive store estates, a hefty debt burden or wafer thin margins are the most likely to be in the danger zone. Marks & Spencer and Wetherspoons both fall into that camp. The former has more than 100 stores that it wants to close in the next three years and £2.93bn of net debt. The latter’s operating margins averaged 7% even before Covid-19 lockdowns put paid to profits.

Investors have been made their fears known:

But crashing share prices open up opportunities for investors. As the market pendulum swings in favour of value stocks, both M&S and Wetherspoons look enticing - just so long as they can manage their way out of the danger zone and withstand the pressures of the current economic cycle.

M&S: Accelerating the closure of the store estate

Shutting down expensive flagship stores which contribute operating margins below the group average (22% for in-store retail, 26% for online) is key to keeping M&S afloat in the coming years. The company is also busy opening omni-channel stores which include click and collect locations, which will increase the profitability of those stores. Food locations tend to do much better than clothing stores and the company plans to open about 100 of these premises, which include large fresh food sections in key locations.

The acquisition of logistics company Gist is expected to help improve the efficiency of these stores. Gist is M&S’ largest fresh food supplier. This is the first time the company has integrated a part of its supply chain and it is expected to bring more cost control and an ability to accelerate (or decelerate) expansion when needed.

Meanwhile, a big effort has been made to make the company more digitally-savvy. The M&S app now accounts for almost a third of purchases made at the company, while the newly-launched digital-first Sparks loyalty programme now has over 16m members. M&S sees far higher retention and spending among its customers who use multiple digital channels.

Technology and supply chain efficiency alongside the closure of hard-to-run stores are expected to save M&S £150m in 2023/2024. Management seems to be making the right decisions for the long-term health of the business.

Wetherspoons: Firmer financial footing

In September, Wetherspoon's chairman Tim Martin wrote an op-ed for City AM explaining why the UK’s next prime minister would need to tame the bond markets and why - for that reason - it had to be “Dishi Rishi”.

His own financial engineering has seen the company terminate interest rate swaps, taking advantage of the increase in value since the end of the financial year and in order to reduce debt. Net debt currently stands at £745m - £400m of which is financed by a new fixed interest rate of 4.67%.

The company is also making progress with the rationalisation of the pub estate. The five pubs sold since the financial year end brought in a cash inflow of £1.9m and the company has added another seven to its full list of 32 pubs held for sale. Pubs up for sale are close to existing Wetherspoons locations so management isn’t too worried about lost revenue.

Selling pubs doesn’t suggest much optimism about the outlook, but Wetherspoons is at least taking proactive steps to manage the current economic situation effectively. Despite its low margins, it looks better placed than many pub operators to withstand the challenging environment.

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ITV: Small fry in a sea of whales

When Carolyn McCall took the top job at ITV in 2018, no one expected her to maintain the status quo. It’s taken four years of increasingly disappointing numbers, but in 2022 she and her team have decided to throw the kitchen sink at a new digital strategy. To properly compete in the new era of television, ITV will:

• Dispose of its Hub and replace it with a new digital-first streaming service called ITVX (at a cost of £45m this year and £35m in 2023)
• Increase its annual content budget to £1.23bn in 2022 and £1.35bn going forwards
• Invest £20m this year and £160m next in exclusively digital content

Investors did not take kindly to this news when it was announced in March. And the share price has stumbled again on the release of a third quarter trading statement which didn’t even mention the costs.

Manic spending might not work. ITVX which will launch on 8 December is an ad-supported streaming platform, with a premium subscription option. That’s a similar model to Netflix and Disney+ which are both releasing ad-supported tiers this quarter. Netflix is on track to spend about $18bn on content this year. Walt Disney’s direct to consumer arm generated $19bn of revenue in FY2022, but still reported an operating loss of over $4bn due to exorbitant programming and production costs. ITV’s pockets simply aren’t as deep as those the companies it is aiming to compete with.

But surely this strategy is preferable to the perpetual decline into obscurity, which had been been the over-riding theme of ITV’s results before Dame Carolyn decided to pull out all the stops.

ITV’s third quarter numbers show why it needs to try something new:

• Advertising revenue declined 14% in the third quarter and is expected to be down 1.5% on the year, despite the broadcast of the FIFA World Cup (normally a top slot for ads spenders)
• While the exposure to the ads market has dropped thanks to studio revenue growth, the media and entertainment business (where sales are dominated by ads) still accounts for more than half of total revenue
• The studios business is expanding its suite of content, but the company is struggling to monetise that content internally owing to poorly designed digital platforms

And beyond the numbers, it’s good to see a British broadcaster attempting a commercially-driven overhaul which should provide perks for the customers (and perhaps investors if everything goes to plan). That’s a welcome change to the political bickering which clouds the outlook for both Channel 4 and the BBC.

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House builders tighten their belts amid troubling outlook

Higher mortgage rates and other inflationary signals adding to the rising cost of living have put Brits off buying new houses. Updates from Persimmon (LON: PSN), Taylor Wimpey (LON: TW.) and Redrow (LON: RDW) - three of the largest house builders in the UK - have confirmed the downturn and gloomy outlook:

• Taylor Wimpey and Persimmon both confirmed elevated cancellation rates, with Taylor Wimpey executives revealing that the number of buyers pulling out of deals had risen by 50% in the last two weeks
• Persimmon and Redrow both noted falling prices, Persimmon said the average price of new homes had fallen 2% since July and Redrow’s revenue per outlet per week in the first 18 weeks of the financial year was £238,000 compared to £310,000 last year
• And demand continues to fall with Persimmon revealing £770m of sales agreed for next year, down a third on the £1.15bn it had agreed this time last year

The numbers reflect a report this week from Goldman Sachs which forecast a fall in house prices across the UK. This comes after many UK estate agents suggested house prices could fall by double digits in 2023 with interest rates at current levels.

The trouble for the house builders is that they are also facing pressures on the supply side. Redrow revealed build cost inflation would hit profits in 2023, with the cost of building new homes expected to rise 7%.

Thus, these companies have announced alterations to their spending plans, in an attempt to shore up capital and weather out the downturn. Redrow said it will half the rate at which it is buying land, Taylor Wimpey’s land pipeline of about 145,000 plots has allowed it to take a selective approach to new investment, while Persimmon has reined in spending in both land and capital allocation - ordinary dividends have been rebased at “a level that is well covered by post-tax profits”.

Housebuilders’ share prices have enjoyed a little respite from the downturn in the last month as a new government’s spending plans have eased the outlook for interest rates slightly. But these announcements have, unsurprisingly, not been taken well. True, long term demand for new homes remains high, meaning these companies could offer a value opportunity to new investors, but we’d err on the side of caution for now.