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PwC Valuation Index Retailers: Because theyre worth it?

February 2012

Welcome
Welcome to the fifth edition of the quarterly PwC Valuation Index series. We look at the retail sector for this edition, which is timely given the somewhat mixed reports on the level of Christmas trading in the UK. What surprised me when looking at the analysis for this edition was that retail spend in the UK has been close to flat on a real basis over the past 20 years. Some of the larger retailers have succeeded by growing at the expense of other players. In what is a hugely competitive environment, and with challenging prospects for growth, the overall sector looks to be reasonably valued at present. We have rebased our Index for the overall UK economy due to the issues discussed in the previous edition around equity risk. In our view investors require a higher return on equities relative to bonds compared to the recent past and will continue to do so for the foreseeable future to compensate them for uncertainty and volatility. This means the Index stands at 84, so it is likely that some will find value in UK equities.

The PwC Valuation Index stands at 84, down from 891 in Q3 on a like-for-like basis

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Richard Thompson
Partner Head of Valuations
2 PwC Valuation Index

Valuation is a challenging art in the current volatile economic environment and assessing an appropriate cost of capital is becoming more complex. Some of the observations which inform inputs into the Capital Asset Pricing Model, used to construct a cost of capital, have been exceptionally impacted by recent events. This has influenced our thinking for the PwC Valuation Index and the assumptions which should be applied in the analysis. A modified approach may be needed when assessing cost of equity; if this is not given due consideration, there is a risk that deals and investments will not be priced appropriately. The risk-free rate is a key building block of cost of capital analysis, and has typically been based on observed yields on long-term government bonds. In recent times, investors have been turning Figure 1: Implied vs Actual PE ratios for UK equities to government debt of relative safe haven 20 countries such as the UK amid fears of a new 18 global recession. This increase in demand 16 for UK government debt, combined with 14 monetary policy, has resulted in a negative 12 real 20-year bond yield at the end of Q4 2011. 10 We believe that the cost of equity has been 8 broadly flat over the past 12 months. A higher 6 premium for equity risk is therefore likely to 4 be counteracting any decrease in government 2 bond yields. We suggest that in the current market an appropriate range for the Equity Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Market Risk Premium (EMRP) when 07 07 07 07 08 08 08 08 09 09 09 09
PE Ratio

assessing cost of equity would be 6% - 7% (compared to 4.5% - 5.5% in previous Valuation Index analysis). The results of applying this range of assumptions to the Index for the last two quarters of 2011 is shown in Figure 1 this means that the actual PE ratio for the overall UK market is in line with the lower bound of our fundamental PE range, and the PwC Valuation Index stands at 84. The market multiple is therefore 16% below fundamentals. What does this mean for valuers? Firstly, it is vital to consider the above when doing deals or making investment appraisal decisions. Anyone using current spot yields on government bonds and a historical EMRP may be underpricing the cost of capital and therefore may be overvaluing businesses and assets. Secondly, our analysis implies potential upside for UK equities based on fundamentals; some will find value out there even in these uncertain times.

Actual PE ratios Implied PE ratio range

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 10 10 10 10 11 11 11 11

1 We have recalculated the index to reflect updated EMRP assumptions for Q3 11 and Q4 11. The rebased index for Q3 11 stands at 89.

Our view on the retail sector

Surprisingly, since 2002 the value of total retail spend in the UK has been flat on a real basis.
Even over a longer timescale, growth in real retail spending has been weak, growing at roughly half the rate of the overall UK economy since 1990. The growth in consumption between 1990 and 2007 almost exclusively came through increased spending on services (e.g. gyms, restaurants) rather than on consumer goods. EBITDA multiples for retailers are almost as low today as they were at the bottom of the market in Q4 2008, when the average EBITDA multiple for the retail sector fell to below 5x, the lowest level for 30 years.
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Figure 2: Fundamental versus actual multiples for UK retailers

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PE ratio

Fundamental PE multiple range Retailer index (inc. supermarkets) General retailer index (excl. supermarkets)

16.0x 14.0x 12.0x 10.0x 8.0x 6.0x 2000

We have considered the fundamental value2 range of the retail sector since 2000. The lower end of our range assumes retail sales growth continues in line with the low growth rate seen over the last twenty years. The upper end of the range takes a more optimistic view that long term growth for retailers will be closer to growth rates for the economy as a whole. In the past actual retail multiples typically exceeded the fundamental value the market was placing more weight on the short term growth that was available to the larger listed retailers who were able to aggressively pursue market share. The larger retailers have been able to outperform overall UK retail growth as they have taken share from independents, achieved economies of scale, grown in overseas markets and squeezed suppliers. However, as you can see, once you exclude the supermarkets, the PE multiples for retailers are much closer to the lower end of our fundamental value range (our analysis also excludes luxury retailers their
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multiples are typically higher than the retail average, given their growth prospects, etc). We believe that this better reflects the more difficult landscape for growth in the UK for these businesses, given the current economic difficulties and the challenges in competing for market share.

Retailing at an aggregate level for the UK is now a zero sum game given the lack of prospects for real growth in a hugely competitive marketplace. For every winner (and there will undoubtedly be winners) there will be losers.
Our analysis takes account of the quoted retailers. Whilst we recognise some of the UK retail market is privately held, the underlying trends for the aggregate retail market still hold.

Although UK retail multiples may look low at the moment, we do not think the fundamentals for the sector as a whole support the high multiples seen in the past. Those looking to do deals in the UK retail space should be cautious of using quoted multiples as a valuation benchmark. Real, sustainable growth (at a profit level) which will drive value upwards is likely to come through product and channel innovation (including a strong internet strategy) or through international expansion. It will be important to ensure the business has a suitable and flexible operating model along with a credible and sustainable growth story.

Based on the valuation fundamentals, UK retail as a whole appears to be reasonably valued, even at the current low level.
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Earnings before interest, tax, depreciation and amortisation Fundamental value reflects a range of long term growth expectations in line with historical trends

Real retail spend has been flat for 10 years

Although the boom years of the 1990s and 2000s saw strong growth in consumer spending, since 2002 the value of total retail spend in the UK has been flat on a real basis. The growth in consumption between 1990 and 2007 came almost exclusively through increased spending on services (e.g. gyms, restaurants) rather than on consumer goods. Even over a longer timescale, growth in real retail spending has been weak, growing since 1990 on average at only 0.9% per year, half the rate of the overall UK economy over the same period. If food is stripped out of retail sales, real retail growth is even lower.
Figure 4: Retail sales as % of GDP
28% 26% Retail sales as % GDP 24% 22% 20% 18% 16% 14% 12% Retail sales as % GDP Consumption as a % of GDP 63% 62% 61% 60% 59% 58% 57% 56% 55% 54% 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 Retail sales Consumption GDP Source: ONS Household consumption as %GDP

Figure 3: Retail spending, consumption and GDP in real terms (rebased to 1990)
1.8 1.7 1.6 1.5 1.4 1.3 1.2 1.1 1.0 0.9 0.8 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

10%

Source: ONS

Given the general perception that, up until the credit crunch, the 2000s were the years of the consumer boom, these findings appear counter-intuitive. However, the last two decades have seen little growth in real terms for retail, lagging some way behind the growth seen in the wider economy. As a mature sector in a developed economy, growth has typically been achieved by companies in the sector taking market share from their competitors, either through online channels, or by larger supermarket retailers as they diversify into non-food products. UK retail is now a zero sum game for every winner, there will be losers. Many companies on the high street have found their core business is increasingly being pressurised by online retailers and supermarkets, and with a huge fixed cost base in their store network, there are no obvious or quick fixes to resolve these issues. Depending on how quickly companies are able to grow their online business, there will be an impact on their retail return on store space. The results of these trends over the last few years can be seen starkly in the market values of general retailers (the index that excludes supermarkets). The total market cap of retailers in the FTSE 350 general retailers index is currently around 27bn compared to around 41bn at the indexs peak in 2007 (a fall of 34%).

This has meant that over time retail spending has formed a smaller percentage of the overall economy. This was caused by a combination of the deflationary effects of increasingly globalised supply chains and intense domestic competition putting huge pressure on prices. Also, the general trend up until the credit crunch in 2008 was for people to spend more on services and other forms of consumption (e.g. gym membership, eating out at restaurants, foreign holidays) rather than on retail. While consumers may have bought more, they paid less for it.

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Retail multiples are close to an all time low

The UK high street is going through a very difficult period. Against a backdrop of the Eurozone crisis and a sluggish economy, retailers are having to work harder than ever to convince customers to part with their hard earned cash. In addition to the economic climate, retailers face particular difficulties; pressures on the cost base from rising input and energy costs, competition from internet retailers and new challenges as they look to adapt to different sales channels, business models and new ways of reaching their customer base through mobile platforms. Reflecting this highly challenging outlook, EBITDA multiples for general retailers (this excludes supermarkets) are almost as low today as they were at the bottom of the market in Q4 2008, when the average EBITDA multiple for the retail sector fell to below 5x, the lowest level for 30 years. The spate of recent administrations (e.g. La Senza, Blacks, Peacocks, Past Times) has increased the pessimism about the UK retail sector. As valuation multiples typically rebound after a recession as market sentiment improves, we might still expect retailer multiples to rise as the economy recovers (although the timing of this is still uncertain). However, in light of the low growth in the past for the UK retailer sector overall, we think that those looking to do deals in the UK retail space should be cautious if considering quoted retailer multiples as a valuation benchmark.
Figure 5: EV / EBITDA multiples
16.0x General Retailers (excl. supermarkets) 14.0x 12.0x 10.0x 8.0x 6.0x 4.0x 2.0x 0.0x 1990 FTSE All -Share LT average retail multiple Retailers (incl. supermarkets)

Retailer rebound from recession

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Source: Datastrream. The 'General Retailer' index excludes supermarkets

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Are retailers fundamentally undervalued?

We have explored how fundamental measures of value, based on longer term expectations for companies in the retail sector (such as the long term expected dividend stream) compared to the actual share prices for retailers. The former measure will tend to be relatively stable across a diversified portfolio but the latter, in comparison, will reflect to a greater extent factors such as short term growth prospects, considerations of equity risk, and speculative behaviour. In performing this fundamental analysis we have considered a range for the long-term growth prospects for the retail sector. The lower end of the fundamental value range assumes retail sales growth continues in line with the low growth rate seen over the last twenty years. The upper end of the range takes a more optimistic view that long term growth for retailers will increase to be closer to growth rates for the economy as a whole.
Figure 6: Fundamental versus actual multiples for UK retailers
22.0x 20.0x 18.0x PE ratio 16.0x 14.0x 12.0x 10.0x 8.0x 6.0x 2000 Fundamental PE multiple range Retailer index (inc. supermarkets) General retailer index (excl. supermarkets)

In the past actual retail multiples typically exceeded the fundamental value the market was placing more weight on the short term growth that was available to the larger listed retailers who were able to aggressively pursue market share. The larger retailers have been able to outperform overall UK retail growth as they have taken share from independents, achieved economies of scale, grown in overseas markets and squeezed suppliers. However, as you can see, once you exclude the supermarkets, the PE multiples for retailers are much closer to the lower end of our fundamental value range. We believe that this better reflects the more difficult landscape for growth in the UK for these businesses, given the current economic difficulties and the challenges in competing for market share.

What this suggests is that as and when the UK economy returns to more robust health, there will be no compelling reason for a rebound in multiples for companies in the UK retail sector. Multiples for UK retailers currently reflect their limited prospects for growth and negative market sentiment. The historical data suggests that there will be no significant increase in the overall level of retail spend on a real basis even as the economy returns to growth.

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What next for multiples?

We see two competing forces in retail multiples as the economy recovers wider stock market recovery pulling retailer share prices up, while the poor prospects for real growth in the overall sector act to drag multiples down. However, amidst all the doom and gloom, there will be success stories. Whilst the index highlights the difficulties faced by UK retailers overall and how the market has reacted to these conditions, the retail sector has many diverse constituents and subsectors, each with their own unique set of challenges and growth opportunities. There are companies that are well placed to exploit opportunities for growth beyond capturing greater market share; however, achieving this growth may involve higher risk strategies, such as expanding into new territories, a strategy that has proved successful for some but less successful for others. Companies that have a strong brand, understand their proposition and embrace the multichannel opportunities it presents and are innovative enough to adapt to an economy in flux will always find ways of reaching their customers and growing their businesses. But to sustain growth over a long period in such a competitive market will be extremely challenging. Those companies that do not have the operational flexibility to react to changing circumstances will struggle to maintain market share, and inevitably some will lose the confidence of the markets, their lenders, and their customers. Although UK retail multiples may look low at the moment, we do not think the fundamentals for the sector as a whole support the high multiples seen in the past. Those looking to do deals in the UK retail space should be cautious of using quoted multiples as a valuation benchmark. Real, sustainable growth (at a profit level) which will drive value upwards is likely to come through product and channel innovation (including a strong internet strategy) or through international expansion (for example, the luxury retailers). It will be important to defend the domestic business from inbound competition from overseas, and investors should ensure the business has a suitable and flexible operating model along with a credible and sustainable growth story. Based on the valuation fundamentals, UK retail as a whole appears to be reasonably valued, even at the current low level.

The authors
Romil Radia T: +44 (0)20 7804 7899 M: +44 (0)7930 573 999 romil.radia@uk.pwc.com Richard Thompson T: +44 (0)20 7213 1185 M: +44 (0)7711 495 236 richard.c.thompson@uk.pwc.com Simon Harris T: +44 (0)20 7804 9413 M: +44 (0)7841 490 474 simon.harris@uk.pwc.com Nick Barlow T: +44 (0)20 7804 6498 M: +44 (0)7841 561 027 nicholas.j.barlow@uk.pwc.com James Morrish T: +44 (0)20 7804 8027 M: +44 (0)7801 651 824 james.morrish@uk.pwc.com Mosa Barlass T: +44 (0)20 7804 8388 M: +44 (0)7515 005 723 mosa.barlass@uk.pwc.com

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Our UK Valuations Team

Our team of dedicated valuers assist and advise our clients in understanding the value of assets, including shares, intangible assets, tangible assets or entire businesses, making us one of the UKs market leading valuation practices.

We structure ourselves around discrete industry sectors and we leverage the strength and expertise from our entire firm. We understand the drivers behind value creation and dilution and, as a result, our clients receive deeper insights into value and how value drivers can be leveraged and understood.
UK Leader Richard Thompson
020 7213 1185 richard.c.thompson@uk.pwc.com

Financial Services Nick Rea

020 7212 3711 nick.rea@uk.pwc.com

Energy, Utilities, Mining and Infrastructure Ian Coleman

020 7804 5533 ian.coleman@uk.pwc.com

Thomas Romberg
020 7804 0860 thomas.romberg@uk.pwc.com

Telecoms, Media & Technology Simon Harris

020 7804 9413 simon.harris@uk.pwc.com

Telecoms, Media & Technology Adam Sutton

020 7804 8124 adam.sutton@uk.pwc.com

Consumer, Industrial Products & Services Kellie Gread

020 7213 1303 kellie.gread@uk.pwc.com

Consumer, Industrial Products & Services Romil Radia

020 7804 7899 romil.radia@uk.pwc.com

UK Regional Leader John Rugman

0121 265 6674 john.rugman@uk.pwc.com

Tax Valuations Ed Higgs

020 7213 2586 ed.da.higgs@uk.pwc.com

Real Estate Charles Sword

020 7212 3391 charles.a.sword@uk.pwc.com

Nick Croft
020 7212 6729 nicholas.h.croft@uk.pwc.com

This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication, and, to the extent permitted by law, PricewaterhouseCoopers LLP, its members, employees and agents do not accept or assume any liability, responsibility or duty of care for any consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it. 2012 PricewaterhouseCoopers LLP. All rights reserved. In this document, "PwC" refers to PricewaterhouseCoopers LLP (a limited liability partnership in the United Kingdom), which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity. ML3-2012-02-01-1316-DW