Diverging valuations make stockpicking key in European retail, RBC says

Investing.com -- Europe’s retail sector is showing a clear split, with defensive and interest rate-sensitive retailers outperforming while large softline names lag — making stockpicking increasingly crucial, according to RBC Capital Markets.

Sector valuations have risen on better sales trends and a benign sourcing outlook. However, “we have seen a bifurcation year-to-date between more defensive retailers and interest rate cyclicals,” RBC analysts led by Richard Chamberlain said.

They pointed to Tesco, Next and Kingfisher among the rerated names, while some large-cap softline retailers such as Inditex and Zalando have derated amid slowing top-line momentum.

Analysts expect like-for-like (LFL) volume and earnings per share (EPS) momentum to be key share price drivers over the next year.

They noted that disposable incomes should continue to grow, albeit at a slower rate, as the tailwinds from strong wage gains fade. The lagged impact of interest rate reductions should help consumer demand, while high savings rates “appear to have peaked and have potential to fall further.”

The team also sees potential for gross margin upside in 2026, citing a favorable foreign-exchange backdrop and stable raw material and freight costs.

“Buying gains should give retailers flexibility to reinvest in their offers to support revenues next year,” the analysts wrote, but warned that more price-conscious consumers may drive higher discounting, particularly given tough early-season comparisons.

Digital and social media remain “key battlegrounds,” as online penetration in apparel and home improvement resumes its pre-pandemic growth trajectory. The analysts said the shift is expected to favor companies such as Next in the U.K. general retail space and Zalando in mainland Europe.

The sector’s strong cash generation means shareholder returns are likely to play a growing role. “Over half of our coverage is in the process of returning excess funds to shareholders,” the analysts said, highlighting JD Sports, Avolta and food retailers as beneficiaries.

Overall, RBC’s preferred stocks are JD Sports and Kingfisher , both seen as attractively priced with underappreciated sales and earnings potential.

The bank also upgraded Dunelm to Outperform after a period of underperformance and downgraded Frasers Group to Sector Perform, citing limited upside to its price target.

It also raised forecasts for Next and Halfords and trimmed Avolta’s earnings estimates.