7 September 2017 Retail - Non Food UK Non-Food Retail Retail Retail - Non Food Recommendation Change Europe United Kingdom Industry UK Non-Food Retail Date 7 September 2017 Deutsche Bank Markets Research Value not value traps UK non-food outlook appears bleak, except for the value and online retailers Two years ago we asked where has the money gone?. Household disposable income had been strengthening but general retail sales growth had not. Unfortunately, the answer was not that households had been re-building the savings ratio: this had fallen from 12% in 2010 to 8% by 2015, and has since tumbled to just 1.7% in Q1 17. Many other economic indicators today are trending similarly to the austerity years of 2011/2 - not a disaster given the political upheaval of the past two years. We think the squeezed consumer will seek out value and we see AB Foods Primark and B downgrading WH Smith to Hold This report changes ratings, price targets, and/or estimates for several companies, detailed in Figure 1. We reiterate our Buy ratings on AB Foods, B second, that consumers were not using healthy cashfl ows to save more. This report argues: 1. The UK environment is tough but not disastrous. Consumer confi dence is at historic average levels (Figure 2), household cashfl ows are broadly fl at year on year (Figure 12), unemployment is at record-low levels (Figure 8), and interest rates remain supportive (Figure 18). There are clear warning signals, of course. Most confi dence metrics have weakened (Figure 25), infl ation has been eroding real wage growth (Figure 11), unsecured lending is at post-2008 peaks (Figure 14) and the savings ratio is at a 20-year low (Figure 13). 2. Overall consumption has not yet slowed materially. Total UK retail sales growth has remained quite healthy, according to both the Offi ce of National Statistics and the British Retail Consortium (Figures 4 and 5). However, food retail sales growth is now outperforming non-food sales growth by a material amount (Figure 23). This last happened during the infl ationary austerity years at the start of the decade and contrasts with the three years between Sep-13 and Sep-16 when the non-food sub-sector was the outperformer. 3. The consumer has less room to manoeuvre and is having to make some tough choices. To us, the current economic situation resembles the austerity years of 2011/2. However, the consumer does not have the fl exibility that, back then, a savings ratio of c.8% aff orded them. The savings ratio was just 1.7% in Q1 2017. The consumers higher spend on food retail relates to higher infl ation in this category, while the continued outperformance of experiences (leisure) over stuff (non-food retail) remains a shift in tastes. For non-food the implications are, in our view, a no-growth environment (Figure 47) and some likely material market share shifts as the consumer struggles. 4. Trading down is happening, though it is not always easy to see. Consumer behaviour is complex and we should not expect to see a clean picture of consumers trading down to lower-priced retailers and goods. One might expect trading down to lead to lower average selling prices in apparel, but actually prices are increasing (Figure 30) as retailers pass on higher input costs and consumers are showing discount fatigue. And yet the mid-market is losing share to value (Figure 35). This suggests that consumers may be shopping less but are comfortable paying full/high price for certain products (e.g. products off ering fashion newness) and also that the retailers have passed on price infl ation caused by currency movements. We do see clearer recent evidence of trading down from our apparel consumer survey (Figure 31) and also in the food retail market (Figure 55). Sometimes the consumer is dialling out infl ation by trading down within the same retailer, rather than switching retailers, but we also show that premium- Deutsche Bank AG/London Page 3 7 September 2017 Retail - Non Food UK Non-Food Retail positioned M * All EPS and target prices in GBp. For December year ends FY17/18 refers to FY17 WH Smith (downgraded from Buy to Hold, TP unchanged at 1950p) We have been long-term bulls on WH Smith, rating the stock a Buy for almost exactly 9 of the past 10 years. In our view, the company remains in good shape, with a number of prospective drivers of future earnings growth. Its Cardmarket discount format trial, which we would describe as being on pause, could prove successful and off er upside, for example. We believe consensus earnings risk Deutsche Bank AG/London Page 5 7 September 2017 Retail - Non Food UK Non-Food Retail is modestly to the upside, and a CY18E FCF yield of c.6% provides downside protection. However, the stock trades on CY18E P/E of 16.6x, EV/Sales of 1.6x and EV/EBIT 14.0x, and is close to our unchanged target price (based on DCF valuation); we downgrade to Hold. Our target price for WH Smith is based on DCF, using a weighted average cost of capital (WACC