Prospects for 2008 02/04/2008 Glossary of Terms Demand Demand for retail goods and services Primary historical indicators – retail sales, volumes and prices Gross Margin Sales less cost of sales Cost of sales include product purchase costs, associated costs of duty and other indirect taxes, discounts, markdowns and shrinkage Costs All other operational costs including freight and logistics, marketing, property, people 2007: What really happened? 2007 was a tougher year for retailer than many before it, especially for the non-food sector. Right from the off, RTT members feared that the outlook for the year looked poor. A heavy cost base continued to do retailers, with swinging increases in both utility prices and business rates particularly telling in quarter 1. Thankfully though, the rate of growth was slowing, after the onslaught of double-digit price inflation in fuel costs of 2006. However, the real concern at the start of the year majored on speculation over a slowdown in the rate of demand growth, driven by the three 2006 interest rate rises the anticipated impact on consume confidence and raised public consciousness of personal debt. In the event, demand growth did not weaken in quarter 1 – it accelerated. For the quarter, the BRC-KPMG Sales Monitor registered a 3.5% like-for-like year- on-year basis, up strongly from 1.9% on the previous quarter. This set the tone for much of the year: consumer resilience flying in the face of growing economic pressure, buoyed on, the RTT decided, primarily by the ongoing strength in the housing market – enabling growth in mortgage equity withdrawals and the possibility of individuals restructuring their personal borrowings. Two more interest rate rises by the Bank of England in quarter 2 did little to curb retail spending. Food sales remained very strong, seemingly untouched by conditions, but non-food goods, particularly clothing, struggled in the rain deluge that besieged the country in May and June. As a consequence the overall rate of sales growth slowed. Costs remained the key worry to retail health during quarter 2. Notwithstanding slowing rental and energy price growth, the true like-for-like growth in retail costs was up to 3.5 – 4% and sales were struggling to keep up. During the autumn it was a matter of retailers sticking it out amidst fears that a downturn in consumer demand was imminent. There was consensus among the RTT members that a change was on its way, but there was disagreement as to when. The broader impact of the Northern Rock debacle and a slowing in GDP helped create a general air of uncertainty. The most telling data discussed at the October meeting, perhaps, came from the housing market, where a step increase in the number of households (up from 70,000 to 120,000 a month) coming off existing fixed rates and onto more expensive deals was feeding through the pipeline. In actual fact the rate of growth in retail sales did indeed flatten in quarter 3, (the BRC-KPMG Sales Monitor saw growth slow from 2.5% like-for-like in quarter 2 to 2.1% in quarter 3), but this certainly didn’t represent the free fall situation that had been feared as early as from the start of the year. A continued slowing of rental increases, alongside subdued staff costs rises in the sector helped ease cost pressures in quarter 3, though they remained a negative influence on overall retail health. By quarter 4, for the first time of the year, the RTT acknowledged that three key drivers of demand, margin and costs had all contributed to the deteriorating overall state of health in the UK retail sector. This was borne out by the difficult trading conditions which were widely reported and the subsequent downbeat trading statements from retailers. For the first time in the year, the RTT’s spotlight settled on margins. A weak dollar had helped to protect retail margins throughout 2007. Food retailers had also continued to strengthen their buying-muscle with suppliers, limiting the passage of any cost of sales inflation. However, on the non-food side, higher prices of goods sourced from China were beginning to damage margins, particularly as they were generally not being passed onto the consumer. Equally, as demand growth weakened, the need to incentivise through discounts and promotions in order to stimulate sales became increasingly necessary. With the exception of high street fashion and footwear, most managed to avoid going to full Sale before Christmas, but many deployed selective damage-limitation campaigns to nurture consumer spend. 2007 began with accelerating demand growth, but by the end of the year this had finally given way to a slowdown. The impact of interest rate rises on mortgages, the credit crunch, a reported leveling off of house prices, rising inflation and a disposable income level expanding at its slowest pace for 25 years were all considered as key contributing factors by the RTT. For quarter 1 2008, the RTT expects the state of health to deteriorate further and at a faster rate. RTT expectations were downgraded further in two of the three drivers, margins and demand, with the impact on health of costs still being negative. Consequently the RTT produced its most pessimistic set of predictions since it was formed in mid 2006. The next section of our annual review gives the perspectives of each of our members on the prospects for 2008. Prospects for 2008: Prospects for 2008 – Volatility ahead The stockmarket, as one venerable sage once put it, acts like a voting machine in the short-term, but in the long-term it is a weighing machine. The market is sentiment driven and can over-react, but in the long term it tends to get things right and discounts the future rather efficiently. So, what does the brutal and savage de-rating of the general retail sector, which has accelerated since last autumn tell us? It may imply that the future for retailers will be brutal and savage…The stockmarket is clearly factoring in a significant chance of a hard landing, as the global credit crunch undermines consumer spending power and consumer confidence and deflates the housing market. How much of the consumer downturn that began last October is a long-term adjustment to excessive debt-financed spending in the past and how much is a short- term reaction to recent events is hard to say, but there is no doubt that 2008 will be a challenging year for retailers and the stockmarket is taking no prisoners. Falling sales, rising costs and weakening margins spell only one thing and that is falling profits and the stockmarket is pricing in that risk by lowering retailer’s valuations across the board. Food retailers are still seen as a different breed, but most general retailers, even those with freehold properties are now trading on price-earning ratio’s of below 10 for the 2008/09 year. But what about the ‘E’ in the PE’s? Earnings are expected to come under some pressure this year, as like for like sales flatten or dip slightly, but in a real recession sales would fall by more than that, particularly for household goods retailers. Uncertainty rules and stockmarkets hate uncertainty. Stockmarkets love interest rate cuts, but there comes a point, when consumer confidence is really low, when cutting interest rates is like pushing on a string. Retailers live in interesting (and volatile) times… Prospects for 2008 – A very different banking market At the beginning of 2007 retailers had just enjoyed a much better than expected Christmas and many banks were prepared to commit large sums of money to highly leveraged retail transactions. As a consequence prices being paid by venture capitalists (VC) were high. By the second half of 2007 the picture looked very different as the credit crunch developed. With a reduction in institutional liquidity in the leveraged finance markets the volume of transactions supported by banks fell, especially at the higher end of the market. So what does 2008 bring? Generally this is likely to be a challenging year, although we are also seeing some encouraging signs. The market for retail leveraged debt should remain open for mid market deals. At the high end of the market, the backlog for leverage deals is immense and whilst liquidity is likely to return, the timing remains uncertain. The terms on which banks lent in 2007, both price and amount of leverage, increased and reduced respectively and this is unlikely to change in 2008. Consequently the price that a VC house is prepared to pay will either reduce, to enable them to achieve their financial returns, or they will have to accept lower returns. Price reductions will enable trade buyers to once again compete in the acquisition marketplace. So what else? At present there is certainly less demand from retailers to borrow and this is likely to continue as they rein back on capital expenditure in order to conserve cash for the tougher times that are expected this year. Fortunately the high street is generally in good shape and this conservative approach should minimise the risk of failures. Banks will remain keen to support the sector but will, as ever, be looking to find the winners. Prospects for 2008 – Consumer trends shape retail Last year saw the intensification of pre-existing trends in the needs and aspirations of UK shoppers. The relatively good performance of the food sector against the non food sector is one example, and is consistent with UK consumers’ growing emphasis on the quality of the food they consume, and in trading up to ‘better’ options, for a combination of health and feel good reasons. Another trend in clear evidence was UK shoppers ever heightening expectations of value, convenience and quality. The John Lewis Group epitomised the success that flows from consistently delivering against these fundamental consumer needs. Arguably the newest and fastest moving trend on the High Street was the rise of ethical and environmental activity. Henley Centre HeadlightVision’s own research shows that a majority of UK consumers have ethical and environmental concerns on their radar, but these concerns are not yet driving widespread and consistent changes in shopping habits. This gap between aspiration and actual behaviour is creating a window of opportunity for leading retailers to shape future shopping patterns. Marks and Spencer’s Plan A and high profile initiatives and commitments from Tesco and Sainsbury’s are the tip of the iceberg. The congruence of the above trends will prove particularly interesting in what looks set to be a tougher economic environment on the High Street in 2008. To what extent will consumer motivations around health, indulgence and ethical concerns, among others, hold sway in the face of pressure on wallets? Which retailers will be most adept at navigating through this uncertain environment and emerging as winners? 2008 looks set to be a fascinating and challenging year for UK retailing. We can expect some drama on the British High Street this year. Prospects for 2008 – British retailing in a wider world With many retailers considering the UK to be a ‘mature market’ so the retail-grass can appear greener elsewhere. 2008 will see UK retailers opening more stores outside the UK. And, in the same perceptual mindset we will see some new retailers, from their own ‘mature markets’ outside the UK, opening stores in UK. Central Europe and China are likely to continue to attract investments together with pioneering interest into Eastern Europe and Russia. India is the big attraction but is unlikely to be a realistic destination in 2008 because of entrenched governmental constraints. For retailers with a substantial presence in the East Asian and Central European growth markets, major expansion opportunities remain. Strong sales performances in these markets will help soften the negativity in the UK. 2008 will also give us a better perspective on the performance of Tesco in USA. Whilst full critical mass is unlikely to be achieved during 2008 nonetheless the post- entry adaptations in response to local markets will become apparent and a clearer view of the responses of Wal-Mart and other local retailers will be seen. Despite fierce competition in the UK, the market size has attraction for foreign retailers. Fashion retailers from outside the UK will continue to develop their brands and offerings with growth of those with a limited presence, for example Fast Retailing, and new entrants. The pressures for pan-national sector consolidation are likely to provide opportunities, encouraged by weaker sterling or low share price, for a few substantial acquisitions by non-UK retailers. These companies will be looking beyond the current short term low growth to make investments that fit with their own strategic objectives of broader international expansion. Prospects for 2008 – Footfall to fall The anticipated softening of sales growth in 2008 won’t automatically be driven by fewer shopping expeditions. People’s motivations to shop and to buy are very different. However, I expect footfall entering shops to be lower than 2007, by as much as 3%, influenced by key economic and social changes: More opportunity for non-food shopping at grocery stores will continue to influence footfall into specialists. The growing strain on consumer’s budgets will increase people’s desire for lower prices, particularly on goods other than everyday consumables. More price-checking on the internet before venturing out to inspect/buy. Paradoxically, more of us will turn towards old-fashioned legwork for reconnaissance purposes, which will actually stimulate footfall. More diversity in store traffic levels between retailers and across sectors, as consumers’ choice and favour become polarised. Both value chains and luxury stores will punch above their weight, but the specialist middle-market might suffer. The sectors set to see the steepest decline in footfall are those associated with housing. Price realignment combined with a reduction in mortgage offers will depress house sales and home improvement projects. Less affordability of big ticket items from carpets to kitchens will translate into fewer visits to sheds and showrooms. Consequently, other retailers sharing these retail park locations could also suffer a decline in traffic. The irrepressible impact of busier lives causing recreational shopping to get marginalised is an ongoing social trend. Finite leisure time and discretionary income at a time of expanding choice of competing activities will continue to suppress casual browsing. Whatever else 2008 brings, retailers will be determined to make every customer count. Prospects for 2008 – Leaner and fitter There is no doubt that the year ahead will be a challenging one. It may represent the worst trading conditions for over 20 years – although the market will still grow, albeit marginally, cost base inflation is likely to outstrip growth in the top line for many. I see three key challenges for retailers. Those managing them effectively will emerge from this difficult time leaner and stronger. It’s all to play for! Delivering value: Two camps – finding growth, either from new markets (a challenge given difficulties at the current time) or increasing market share, and optimising costs and cash. The best performers will have ongoing plans to realise 5-10% cost savings in certain areas which will offset rises in the remainder of the business. They will also act decisively to ‘fix’/exit the worst performing units to mitigate value leakage. Preparing for uncertainty: A robust plan is critical but it will also have in-built contingency plans which can be enacted under different trading outcomes. The quality of up to date and accurate information will be key to enable speed of response. The ability to flex supply and respond quickly and effectively to changing market conditions will be a differentiator. Lack of experience: Many of the leaders and key stakeholders in the sector today will not have seen such trading conditions in their career. Drawing on the knowledge and experience of some of the ‘longer serving’ players will be hugely valuable as will ensuring management teams stay focused and respond as conditions change. Sounds easy? Indeed, it does, but in this environment, those with the broader and all encompassing retailing skills, who are already well down the road to responding to these challenges, will shine through. Prospects for 2008...a year to forget? All the ingredients needed for a nightmare 2008 are aligned to make this a year to forget for most retailers. The portents are bad: history shows that however weak consumer’s appetites were over the December period, they will be considerably weaker still as 2008 unfolds, particularly the first half. Year-on-year retail spending at Christmas is rarely lower and the 2007 festive season was no exception. Depending on which source one uses the value of spending only grew year-on-year for December by 2.3% (BRC) or 1.4% (ONS). Spending growth at this level has failed to keep the wolf from the doors of many retailers. Given that people pull out many of the stops for Christmas it is safe to conclude that something of a hiatus will follow. With so many people on fixed rate mortgages, rising interest rates in 2007 failed to impact fully on consumer’s spending. This will only percolate through as 2008 unfolds, even if rates are now starting to come down. I expect the value of retail spend in 2008 to be just below 2%. This figure needs to be viewed alongside some other key metrics. First, floorspace. I expect selling space (net of closures) to grow by nearly 1.5%. Second, I think costs across the industry will increase by around 4%. In combination, these numbers will mean everyone has to run much faster just to stand still, and driving sales will be critical. In spite of this unpromising background, some retailers will prosper. Those that do will all have one thing in common: a fundamental understanding of demand and the skills to turn that into sales growth. Prospects for 2008 – Economic pressure intensifies The economic pressures on consumers are set to intensify this year. Most importantly, cracks are finally starting to show in the housing market. The credit crunch has made lenders far more picky about who they lend to, while the previous interest rate rises mean that many potential buyers had lost interest anyway. Significant house price falls are looking increasingly likely. Not only will this reduce the amount of housing equity available for households to withdraw and spend, but consumer confidence will take a knock too. Household saving fell to a record low last year but with the housing market no longer doing people’s saving for them, I expect people to start to think twice before blowing their pay packets on the High Street. Rising unemployment is likely to dampen the feel-good factor too, as weaker economic growth prompts firms to work harder to lower staff costs. And as if all that wasn’t enough, the renewed rise in the oil price has meant that many consumers have started 2008 with the news that their gas and electricity prices will go up again. On the bright side, the Monetary Policy Committee has already been quick to reduce interest rates, cutting them in December of last year. And more rate cuts are on the cards. But the Committee will be constrained in how quickly they can act by the likely prospect of inflation rising back significantly above its target over the next few months. And consumer spending takes up to a year to respond to interest rate cuts anyway. Accordingly, rate cuts will not stop consumer spending growth from weakening sharply this year. Prospects for 2008 – Rental inflation here to stay? At the time of writing, the sharp deterioration in trading conditions, that set in during second half of 2007, looks set to worsen. Retail property markets have meanwhile experienced a rapid fall in capital values. Allusions to property market conditions in the early 1990s are perhaps inevitable, but misplaced. This time around value corrections have little to do with retail market fundamentals. Or, at least, it was not events in retail or consumer markets that triggered the recent decline in retail property values. The yield compression seen over the last two to three years occurred despite the poor rental and sales growth outlook prevailing at the time (growth prospects have been poor for a long while). Indeed, current rental forecasts are not a lot worse than they were a year ago or more. And nothing much has changed on the supply or retailer demand side either. True, the jump in interest rates last year worsened an already weak sales outlook. But downward pressure on property values has traditionally come after, not before, recession sets in: perhaps the reason why property bargain-hunters, in spirit at least, have emerged so speedily. Of course the current wave of value corrections are not restricted to retail. Yields have moved out in all commercial and industrial property sectors: a knee-jerk response to the turmoil in financial markets. Some further softening of yields looks likely, though – in retail markets – value corrections, in the absence of recession, should be played out well before the end of the year. With the supply-side picture benign, and no sign at all of the kind of retail sector retrenchment that blighted leasing activity during the early 1990s, rental growth may stay muted but is set to remain in positive territory.
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