Are UK consumer businesses ‘uninvestable’?

It’s been a painful few years for the UK retail and hospitality sectors. The pandemic, followed by an inflationary surge and higher interest rates, proved too much for Wilko, Ted Baker and Homebase, to name just three. For those left standing, life is a daily struggle.

And I think their task will get even harder from 1 April.

That’s when the National Living Wage will rise again, by 6.7%. This was expected. However, the 1.2% increase in employer National Insurance Contributions (NICs) announced in the Autumn Budget definitely wasn’t. Will that prove one blow too many for some businesses?

Most UK consumer businesses rely heavily on low-cost labour. However, this labour is not as low cost as it used to be.

Rising wages over the last 10 to 20 years mean labour costs as a proportion of sales have trended steadily upwards. For example, a decade ago, employee costs for pub group J D Wetherspoon accounted for around 29% of sales. In 2024, this had risen to around 39%.

Put simply, every £1 increase in labour costs today has a bigger impact on profits than 10 years ago. In fact, Wetherspoons expects taxes and business costs to increase by £60 million in the wake of the Budget, including an estimated 67% increase in NICs. To put this in context, the business made an adjusted profit before tax of £73.9 million in its last financial year.

Companies will have to respond to these cost increases, or risk seeing their profits wiped out.

Price increases appear inevitable. But there is only so far these can go without consumers voting with their feet, especially given that the price of everything has already risen a long way since the pandemic.

Companies will also need to find efficiencies. But again, there is only so far these can go. Self-service checkouts, more effective staff scheduling and tough negotiations with landlords can all help. But the impact is likely to be relatively small, especially since the low-hanging fruit will probably have been captured during the pandemic years.

This suggests to me that, without a meaningful increase in sales, many companies in these industries will see profit margins come under significant pressure.

Christmas trading updates from retailers indicate a marked shift to online sales towards the end of 2024.

Tesco saw a 10.8% increase in online sales in its most recent quarter, almost triple the rate of growth it achieved in stores. Fashion retailer Next reported UK online sales growth of 6.1% in the nine weeks to 28 December 2024, while store sales fell by 2.1%. Primark, which doesn’t have a meaningful online presence, suffered a like-for-like sales fall of 6% in the UK and Ireland in the 16 weeks to 4 January 2025.

Online sales gaining share from stores is nothing new.

In the years leading up to the pandemic, online sales participation rose steadily, accelerating rapidly as the virus spread. But in the last couple of years there has been a notable return to shopping in stores, with online participation falling for the first time in 2022, and holding relatively steady since then.

The increase in online sales participation in the fourth quarter of last year may just be a blip. Or it could mark a return to the previous trend – with online sales gradually gaining share. If the latter, it could present an additional headache for many retailers.

For some retailers it isn’t.

Online-only retailers like Amazon clearly benefit from this trend. And some multi-channel retailers like Next are well positioned, given the strength and profitability of its online business. But for many retailers and hospitality businesses, it compounds the pressure.

Cafés, bars and retailers without much online presence (like B&M and Primark) rely on footfall. More consumers clicking away at home rather than visiting high streets and shopping centres could make it harder to grow sales.

Even for businesses offering online delivery, I’m not convinced the shift to online is a ‘good’ thing.

Online sales are costly to fulfil. For a small delivery fee, I can get groceries picked and delivered right to my door. It’s hard to see how major supermarkets can make much profit on this. Clothing retailers fulfilling online sales face an even greater challenge due to the high return rates, which are especially complex and costly to deal with.

Even if online sales are profitable, the cost of operating stores doesn’t go away, because these costs are largely fixed. This means, for many businesses, £1 of sales switching from stores to online leads to lower profits, all else equal (see illustrative example below):

Given the cost pressures facing UK consumer businesses, revenue growth has never been so important to preserve profitability – especially in stores. But with consumer confidence having taken a hit following the Budget and online sales participation potentially reverting to its long-term trend, this could be a severe challenge.

I wouldn’t go that far. But I think many are exceptionally challenged and investors need to be highly selective.

There are, of course, retailers that have been doing well, considering, and could conceivably weather the storm. An example in my view is Next plc, which benefits from a highly profitable online business, strong margins, cash flows and balance sheet. It also has a proven leader at the helm. In his 24 years as CEO, Simon Wolfson has helped the business to navigate many testing periods.

But in general, investing in anything other than the strongest operators in this sector, with the best business models, balance sheets, cash flows and management teams seems a big risk to me.

That said, sentiment towards UK consumer businesses is very poor and has worsened considerably since the Budget. This arguably leaves valuations looking a lot more enticing.

The share prices of discount-retailer Primark (owned by AB Foods), pasty-maker Greggs and pub group J D Wetherspoon, for example, have fallen significantly in recent months. They all generate a lot of cash and their scale arguably positions them better than most to weather the storm.

I look for companies that are (as much as possible) in charge of their own destiny. And I try to avoid those that can see profits significantly impaired by the swipe of a Chancellor’s pen.

I didn’t foresee the changes announced in the Autumn Budget, but my investment process steers me away from the vast majority of retailers and hospitality businesses; especially those solely dependent on the UK economy.

The Quality Shares Portfolio has very little exposure to the UK consumer. It’s possible the current malaise could throw up opportunities, but I will be extremely selective. For now, I am content watching from the sidelines.

The Quality Shares Portfolio, managed by Charlie Huggins, is specifically designed for experienced investors genuinely interested in investing.

It currently invests around 15 companies Charlie considers exceptional. All are highly established industry leaders providing critical goods and services, with market capitalisations ranging from several billion dollars to over a trillion.

These companies are the type of businesses where you can bury the share certificate in a drawer, dig it out 10 years later and, hopefully, find the profits and cash flows are materially higher.

Once you invest, Charlie shares with you an unparalleled level of information. You can see a full list of every holding, with explanations on why it’s included. Every month, you receive a detailed update with views on the portfolio, companies, and market developments.