Retail Industry Analysis – Chapter 1

This Chapter 1 provides an overview of the
principal characteristics and salient features highlighted by the rating agencies for the
global retail sector. The three principal documents we use in this
module are (i) Moody’s Global Retail Industry Rating Methodology, dated June 30, 2011 (hereinafter
referred to as “Moody’s 1”), (ii) S&P’s Key Credit Factors: Business and Financial
Risks in the Retail Industry, dated September 18, 2008 (hereinafter “S&P 1”), and (iii)
S&P’s Criteria Methodology: Business Risk/Financial Risk Matrix Expanded, dated May 29, 2009,
which amends parts of the S&P 1 document (and is hereinafter referred to as “S&P 2”).
These documents and any others we mention in this module can be accessed via links you
will find in the Course Outline that opens if you click the bottom left icon below this
video. In total, Moody’s rates 109 companies in
the retail industry globally at least as of June 30, 2011; these are defined to be companies
whose principal business is to act as the final sales point to end-consumers for wholesalers
and manufacturers of food and non-food products, and representing approximately $330 billion
of rated debt outstanding. The methodology described in Moody’s 1 resulted as of the
date of that document in senior unsecured credit ratings ranging from Aa2 to Caa3. We
note that some of the ratings appearing in that publication may have changed since its
date. The retail industry is very diverse according
to both credit rating agencies. In Moody’s 1, the rating agency emphasizes that retail
covers a large number of segments (including grocery store retailers, specialty apparel
stores, and department stores), and also spans different business models (e.g. direct marketers,
vertically integrated manufacturers versus pure distributers), and a wide range of formats
– such as quote unquote “big-box” retailers and internet- or catalog-based direct-sales
operators. Accordingly retailers globally exhibit very diverse operational and financial
dynamics. Most retailers however exhibit typically the following financial characteristics:
1. The purchaser of the retailer’s goods is a private individual or small trader.
2. The goods being purchased are principally physical goods or media content, although
some retailers sell services such as financial services as a secondary component of their
merchandise offering. 3. Purchasing frequency of goods can vary
significantly, ranging from near-daily food purchases to less-than-annual purchases of
large consumer electronics or home goods. 4. A retailer can sell its products via a
number of different selling channels, from physical brick-and-mortar stores to a direct
channel such as catalog or internet; and 5. Some retailers solely focus on retailing
while others may also be manufacturers that retail merchandise that they manufacture in-house. S&P similarly acknowledges the variety of
sub-sectors in which retailers operate and the similarities and differences between them.
S&P groups together sub-sector types that have similar traits and that compete directly
with each other for the consumer wallet for purposes of industry risk analysis. In North
America, for example, S&P groups the following sub-sectors together analytically:
• Supermarkets, pharmacies, and convenience stores;
• Department stores, general merchandise discounters, and apparel stores; and
• Non-apparel retailers (including electronics and appliances, home improvement/hardware,
furniture and housewares, books, music, hobbies, sporting goods, and other specialty goods
and services). S&P views the effect of cyclicality as the
main risk differentiator between subsectors. Retailers selling staples, such as supermarkets
and pharmacies, are less susceptible to economic downturns than retailers in home improvement,
appliances and apparel, where consumer purchases can be postponed when economic times become
tougher. Key industry characteristics that one or both
of the rating agencies comment upon include the following:
1. A wide range of business risks: Business risk is a function of the products a retailer
sells, the market segment in which it operates, the competitive environment overall, and the
retailer’s positioning within its product and geographic markets.
For example, companies which focus on products with less demand variability (such as food
and basic consumables) generally exhibit lower business risk. Conversely, specialty retailers
have higher business risk due to cyclicality and seasonal volatility, product obsolescence
and fashion risk. The positioning of a retailer within its segment, and the rise or fall of
entire segments of retailing relative to others, also add dimensions of risk. Discounters,
for example, have globally taken meaningful market share in numerous product categories
over the past decade. 2. Critical importance of execution, including
tight logistics and customer service: a retailer must provide customers with the right product
at the right time and price. Competition is often fierce, partly due to overcapacity or
oversupply, and customer loyalty can shift rapidly – especially to the negative – if
the value proposition of the retailer changes. Adding to this, the increasing commoditization
of many retail product offerings has brought operating margins under significant pressure.
Finally the rapid growth of online shopping is beginning to erode traditional store sales,
exacerbating retail space overcapacity. 3. High fixed cost, capital intensity and
operating leverage: Retailers typically require significant investments in fixed cost, including
rent for retail outlets and employment costs. Growing retailers often become even more capital
intensive due to investments in warehouses, distribution infrastructure and high-tech
inventory management systems. These fixed assets need to be updated, refurbished and
relocated frequently to provide optimal returns. 4. Different growth models: Organic growth
is the principal growth strategy for most operators, consisting of either new stores
or growth in existing stores, although some acquisitions occur when organic growth is
limited, including via international expansion. Retail formats do not always travel well,
however, and international expansions typically take time and multiple iterations before being
deemed successes or failures, leading to substantial write-offs in the latter case. In addition,
overseas infrastructure requires significant upfront investment, limiting some of the benefits
of size. 5. Relevant markets are, in any event, usually
local or regional in nature: while a few large retailers boast significant geographic diversification,
most retailers remain predominantly local or regional businesses. It is important to
understand the regional context in which a company operates to properly evaluate its
business model. We will say more shortly about important regional differences exhibited by
the retail industry. 6. Significant seasonality and fashion risk:
Non-food retailers in general face significant seasonality, with a high concentration of
cash flow during holiday seasons. Severe seasonality can result in a make-or-break period for a
retailer, magnifying the financial impact if the retailer misses a trend, carries obsolete
inventory, or cannot price its products at a competitive advantage during a key season.
And finally 7. Strong influence of consumer spending & employment:
the retail industry is severely affected by macroeconomic factors, including unemployment,
housing prices, and consumer spending. Retailers that sell non-discretionary products tend
to weather economic downturns more easily, but no retailer is immune from such downturns.
When times are difficult retailers may be forced to lower prices, reduce margins and
write-off inventory. Mall traffic, on which many retailers are dependent, may vary for
reasons such as changing consumer preferences or changes in local demographics, and even
due to weather variations. Consumer credit purchases, finally, have been a major driver
of sales in recent years, particularly in developed markets, but are likely to become
increasingly constrained by record levels of household debt. Key strengths of the retail industry include
the following: 1. The pivotal role of the retailing sector
and consumerism in the economy, 2. The rapid industrialization of China, India,
Eastern Asia and the former Soviet block, which is spurring demand and overseas growth
opportunities, 3. The substantial improvements in operating
supply and inventory management capabilities, which have lowered costs, inventory and working-capital
risk, 4. The advent of low-cost, high-quality goods
from emerging industrial countries has spurred consumer demand, and finally
5. The substantial consolidation in various industry sub-sectors – such as electronics
and books – has given survivors significant leverage over suppliers and increased economies
of scale and name brand recognition. Before completing this introduction, we summarize
Moody’s observations on important industry differences across the principal regions of
the world. In the United States, Moody’s notes the
very high fragmentation and overcapacity of the industry, driven in part by the lack of
regulatory or geographical barriers to entry. This gives US consumers a high level of substitution
for both goods and venues in their buying decisions.
In Latin America, some countries like Brazil are enjoying high consumption due to their
strong economic growth, boosted by notable events such as the 2010 World Cup.
Moody’s considers the European market to be more regulated, with more restrictive planning
permission impeding the entry of sizeable new competitors and providing a degree of
qualitative support for the rating agency’s assessment of existing retailers. In food
retail in particular, the concentration of the major operators is significant, and is
reflected in high market shares. Japan is characterized by the continuing co-existence
of strong and weak performers, and by investor and lender tolerance of low profit margins.
There are very few instances of predatory pricing strategies that kill off weaker companies
so the country remains overstored. At the same time, the greater commitment to long-term
relationships at every stage of a business’s development results in a more stable operating
environment for rated Japanese companies. External shocks, such as unexpected foreign
exchange moves and rising material costs, are often vertically shared by retailers,
wholesalers, manufacturers and material suppliers, with no single participant in the chain expected
to take on the full impact of a shock like this on its own. Consequently, operating margins
of Japanese retailers are relatively narrow but stable, and profitability and efficiency
are lower than those of peers elsewhere. More generally, senior executives of Japanese
retailers, with the acquiescence of their shareholders, prioritize operating continuity
to balance the interests of all stakeholders – including shareholders, lenders, local
communities, employees and trade partners. In China, the overall shopping experience
rather than price differential is becoming more important, especially for mid-to-high
end non-discretionary retailers. Wide geographic coverage and execution capability are critical,
with consumer taste and spending power varying considerably across different regions.
Australia lastly is a good example of a highly concentrated market with a small number of
very large supermarket chains, such as Woolworths and Coles. These have significant national
retail footprints and marketing power, and entrenched real estate positions, all of which
allow them to maintain dominant positions. As of early 2011, Coles and Woolworths had
been engaging in an aggressive price war over basic staples (such as milk, bread and eggs),
raising the specter of margin compression; but the industry remains strong and highly
profitable by global standards. This completes this chapter one.

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