From the frying pan into the fire? U.S. retailers to feel the heat in 2018
Earlier this year, S&P Global Ratings said adverse secular trends were far more likely to accelerate than abate. Our view, which we discussed in a February 2017 research entitled “Distressed U.S. Retailers: 2017 Is Shaping Up To Be A Tipping Point,” has proven to be accurate as measured by the number of downgrades, defaults, lowered earnings guidance and merger activities that have occurred since then.
As we head into 2018, here are the key trends we believe will drive the U.S. retail sector:
Consumers will continue to seek value. The strong performance and continued growth of discount retailers demonstrate that U.S. consumers remain focused on value a decade after the great recession. Retailers have also had to compete with larger-ticket items such as autos and housing (including higher rents), and other pressures on consumers’ wallets such as health care, student loans, technology and “experiences” (e.g. travel, dining out). With wage growth sluggish, shifting consumer preferences and competition for share of wallet have confounded the best efforts of many retailers. Rampant growth in online sales has created more price transparency and has made comparisons easier for a range of products. At the same time, in the U.S., the millennial generation’s evolving retail behavior is both an opportunity and risk for retailers.
Rapid e-commerce growth has created a severe strategic challenge. Many retailers across subsectors lack technological capabilities and are still in the early stages of addressing the shift to e-commerce. We are seeing strategic shifts with large investments in online commerce and delivery logistics and continued growth of successful retailers with world-class supply chains. Many retailers face difficulties in changing parts of their business models including supply chains and distribution networks, while also enhancing customers’ store experiences.
E-commerce is disrupting almost all segments of retail to greater or lesser degrees with no end in sight. Its evolution has already shown that previously successful retailers may not remain so. However, it’s not all downside for those retailers that can manage their physical footprint while building successful online capabilities. Signs of winners and losers are emerging now, although the upheaval of the retail landscape will continue.
While e-commerce sales are still only around 10% of total U.S. retail sales, it has a disproportionately large impact on the traditional retail sector. For example, any news of Amazon entering a segment of retail is usually sufficient to trigger a drop in market value of even well- established players in that sector. At the same time, retailers are building out their capabilities – with significant fanfare. Two dramatic examples in the last two years were Wal-Mart’s purchase of Jet.com in 2016 and Amazon’s purchase of Whole Foods in 2017.
One analogy to consider is FedEx and UPS – FedEx started off mainly in the air and moved into ground, while UPS was almost exclusively ground based and moved into the air. Both have grown and co-existed to serve the customer base. We think consumers are comfortable with multiple channels and that many retailers are working to catch-up. Because of this, we do not see e-commerce penetration diminishing, but neither do we imagine the vast majority of sales in most segments occurring online. Grocery is a good example of how the mixture of bricks and mortar and online channels are evolving. In the U.S., grocery online penetration is low, Amazon is not dominant and large traditional grocers have all been investing in and testing different online formats such as “click and collect“ We would not be surprised to see similar e-commerce ramp- up in other retail segments such as pharmacy and auto parts.
Excess real estate still needs to be addressed by most retailers. The U.S. is far more oversaturated than other countries with too much retail real estate that is costly and cumbersome to sharply reduce for those that need to do so. In 2016, we noted the acceleration of the pace of store closures and we think this will continue into 2018. Many store closures in the challenged retail segments, reflecting the over-saturated U.S. retail sector, will be a necessary but not sufficient condition for future success.
Downgrades and defaults in a growing economy will continue. The economy or consumer spending hasn't suddenly worsened – and it might even be better in 2018. However, we have had more rated defaults in the retail sector in 2017 than during the financial crisis. A good swath (but not all) of the rated U.S. retail sector is running out of room to maneuver towards a business model that looks sustainable in the evolving retail landscape.
As of late-November 2017, 35% of outlooks were negative versus just 4% positive. The specter of defaults continues to loom large over the rated universe: About 17% of the rated portfolio was in the ‘CCC’ category (implying substantial future defaults), about double the level of the financial crisis. The performance of issuers in the department store and specialty apparel are the most challenged, along with a mixture of other retail concepts.
Downgrades have not been limited to lower rated credits – in 2017 S&P Global Ratings took many negative rating actions involving investment-grade rated entities and most have a negative outlook, meaning further downgrades are possible. The amount of debt trading at distressed levels remains elevated.
Geopolitical shifts – they could still impact retail
Changes following recent U.S. presidential elections have not yet triggered the extreme scenarios on trade flows, tariffs, and taxes that could influence or disrupt the global retail sector such as margins and supply chain. Regardless, we think many rated retailers need to up their supply chain game, and many are working on it, but more needs to be done in 2018. Supply chain effectiveness has always been a key to success in retail, but the stakes are even higher now with the consumer so focused on value and e-commerce. The benefits and economics from timelier merchandise flow and lower inventory are tangible. The discounters, supported by their supply chain and logistics skills, have benefitted from consumers’ greater sensitivity to price and/or private labels and the sector has expanded rapidly, hurting traditional apparel retailers.
Who will do well in 2018 and what can retailers do to compete effectively?
Discounters will continue to do well and the dollar store segment will continue to expand. We assume the 2017 holiday season will be weak for the segments that have struggled over the last few years. There will not be a slowdown in the growing preference for shopping online, so adapting to shifts in consumer preferences is critical.
Meanwhile, millennials' buying habits (including brand choices) are affecting retail in new and complex ways that retailers are trying to address. Technology has driven a high degree of price transparency and go-to market preferences to which many traditional retailers are struggling to adapt. Few segments are immune from e-commerce or the shifting consumer preference, so successful retailers will be ones that adapt to the new landscape.
As we head into 2018, here are the key trends we believe will drive the U.S. retail sector:
Consumers will continue to seek value. The strong performance and continued growth of discount retailers demonstrate that U.S. consumers remain focused on value a decade after the great recession. Retailers have also had to compete with larger-ticket items such as autos and housing (including higher rents), and other pressures on consumers’ wallets such as health care, student loans, technology and “experiences” (e.g. travel, dining out). With wage growth sluggish, shifting consumer preferences and competition for share of wallet have confounded the best efforts of many retailers. Rampant growth in online sales has created more price transparency and has made comparisons easier for a range of products. At the same time, in the U.S., the millennial generation’s evolving retail behavior is both an opportunity and risk for retailers.
Rapid e-commerce growth has created a severe strategic challenge. Many retailers across subsectors lack technological capabilities and are still in the early stages of addressing the shift to e-commerce. We are seeing strategic shifts with large investments in online commerce and delivery logistics and continued growth of successful retailers with world-class supply chains. Many retailers face difficulties in changing parts of their business models including supply chains and distribution networks, while also enhancing customers’ store experiences.
E-commerce is disrupting almost all segments of retail to greater or lesser degrees with no end in sight. Its evolution has already shown that previously successful retailers may not remain so. However, it’s not all downside for those retailers that can manage their physical footprint while building successful online capabilities. Signs of winners and losers are emerging now, although the upheaval of the retail landscape will continue.
While e-commerce sales are still only around 10% of total U.S. retail sales, it has a disproportionately large impact on the traditional retail sector. For example, any news of Amazon entering a segment of retail is usually sufficient to trigger a drop in market value of even well- established players in that sector. At the same time, retailers are building out their capabilities – with significant fanfare. Two dramatic examples in the last two years were Wal-Mart’s purchase of Jet.com in 2016 and Amazon’s purchase of Whole Foods in 2017.
One analogy to consider is FedEx and UPS – FedEx started off mainly in the air and moved into ground, while UPS was almost exclusively ground based and moved into the air. Both have grown and co-existed to serve the customer base. We think consumers are comfortable with multiple channels and that many retailers are working to catch-up. Because of this, we do not see e-commerce penetration diminishing, but neither do we imagine the vast majority of sales in most segments occurring online. Grocery is a good example of how the mixture of bricks and mortar and online channels are evolving. In the U.S., grocery online penetration is low, Amazon is not dominant and large traditional grocers have all been investing in and testing different online formats such as “click and collect“ We would not be surprised to see similar e-commerce ramp- up in other retail segments such as pharmacy and auto parts.
Excess real estate still needs to be addressed by most retailers. The U.S. is far more oversaturated than other countries with too much retail real estate that is costly and cumbersome to sharply reduce for those that need to do so. In 2016, we noted the acceleration of the pace of store closures and we think this will continue into 2018. Many store closures in the challenged retail segments, reflecting the over-saturated U.S. retail sector, will be a necessary but not sufficient condition for future success.
Downgrades and defaults in a growing economy will continue. The economy or consumer spending hasn't suddenly worsened – and it might even be better in 2018. However, we have had more rated defaults in the retail sector in 2017 than during the financial crisis. A good swath (but not all) of the rated U.S. retail sector is running out of room to maneuver towards a business model that looks sustainable in the evolving retail landscape.
As of late-November 2017, 35% of outlooks were negative versus just 4% positive. The specter of defaults continues to loom large over the rated universe: About 17% of the rated portfolio was in the ‘CCC’ category (implying substantial future defaults), about double the level of the financial crisis. The performance of issuers in the department store and specialty apparel are the most challenged, along with a mixture of other retail concepts.
Downgrades have not been limited to lower rated credits – in 2017 S&P Global Ratings took many negative rating actions involving investment-grade rated entities and most have a negative outlook, meaning further downgrades are possible. The amount of debt trading at distressed levels remains elevated.
Geopolitical shifts – they could still impact retail
Changes following recent U.S. presidential elections have not yet triggered the extreme scenarios on trade flows, tariffs, and taxes that could influence or disrupt the global retail sector such as margins and supply chain. Regardless, we think many rated retailers need to up their supply chain game, and many are working on it, but more needs to be done in 2018. Supply chain effectiveness has always been a key to success in retail, but the stakes are even higher now with the consumer so focused on value and e-commerce. The benefits and economics from timelier merchandise flow and lower inventory are tangible. The discounters, supported by their supply chain and logistics skills, have benefitted from consumers’ greater sensitivity to price and/or private labels and the sector has expanded rapidly, hurting traditional apparel retailers.
Who will do well in 2018 and what can retailers do to compete effectively?
Discounters will continue to do well and the dollar store segment will continue to expand. We assume the 2017 holiday season will be weak for the segments that have struggled over the last few years. There will not be a slowdown in the growing preference for shopping online, so adapting to shifts in consumer preferences is critical.
Meanwhile, millennials' buying habits (including brand choices) are affecting retail in new and complex ways that retailers are trying to address. Technology has driven a high degree of price transparency and go-to market preferences to which many traditional retailers are struggling to adapt. Few segments are immune from e-commerce or the shifting consumer preference, so successful retailers will be ones that adapt to the new landscape.