For 2009, Fitch expects that these trends will continue as consumers curtail discretionary spending and look to maximize value. Comparable store sales growth for operators selling clothing, home related goods, and other discretionary categories is expected to continue to be negative while those companies that have built a strong value perception and have strong private and exclusive brand offerings will outperform their peers. While the weak sales will be geographically broad based, sales pressure will be more acute in those markets most impacted by housing and job related weakness. Similar to the 2008 holiday season, promotional activity is likely to be prevalent as retailers look to stimulate demand and clear overstocks.
This view is based on Fitch's outlook for consumer spending which is expected to further decline through the fourth quarter of 2008 and into next year. The growth in personal consumption expenditures is projected to be -1.6% in 2009 and the rate of growth is expected to remain below trend into 2010. Consumer's wealth, incomes and capacity to borrow are being constrained by rising unemployment and job uncertainty, higher cost and reduced availability of household credit and falling real estate and equity prices. These negative pressures will far outweigh any benefits consumers get from a decline in energy and commodity prices.
As a result, Fitch has recently taken a number of negative rating actions and expects negative rating pressure for its U.S. retail coverage in 2009. This is reflected by the number of Negative Rating Outlooks across the portfolio with 10 companies or 36% of the portfolio having Negative Rating Outlooks compared to 15% in the year ago period. Negative rating activity is more likely for retailers selling discretionary products such as department stores and specialty retail, where the Negative Outlooks are concentrated.
KEY RETAIL TRENDS IN 2009:
Fitch expects retailers will continue to focus on several ongoing initiatives in 2009 which includes maintaining or increasing market share by emphasizing their value proposition, managing profitability in the face of declining sales, and preserving liquidity and maximizing capital efficiency. In addition, Fitch expects further retail consolidation as retailers that do not manage these initiatives effectively are forced to reduce their retail footprints or exit the market.
Emphasizing Value to Gain Share
Value oriented offerings will be the focal point as retailers try to capture more share of the consumer's shrinking wallet. Promotion and pricing will be prevalent across the spectrum of retailers in 2009. Key beneficiaries of this shift in consumer behavior will be the discount formats, particularly those selling food such as Wal-Mart and Costco. In addition, companies that have built a strong value perception and have strong private and exclusive brand offerings should also outperform relative to their peers.
Preserving Operating Margins - Inventory and Operating Cost Management
Further cost cutting measures will be another significant area of emphasis for retailers as they look to offset margin compression from heightened promotional activity, mix shifts to lower margin products and lower leverage of fixed costs. Inventory management, supply chain efficiencies, labor productivity and other operating costs are expected to continue to come under increasing scrutiny.
Some companies in the more challenged department store and specialty retail segments such as Macy's, Kohl's, and Gap have done a good job of managing gross margins despite the weak sales levels. In general, comparable inventory levels are down, but weak holiday sales will necessitate higher levels of promotional activity. In addition, even those retailers that have appropriately managed inventory levels are likely to be impacted as competitors with excess inventories or those liquidating use promotions to clear store shelves. In 2009, Fitch expects inventory planning will be challenging and a key focus for companies. Companies with shorter lead times, such as Best Buy and Kohl's, will be better positioned to react quickly than those, such as the luxury retailers, with lead times as long as six to nine months.
Companies have been cutting operating expenses and certain companies, such as RadioShack and Limited Brands, have been able to cut costs as an offset to gross profit weakness. However, given the significance of the expected revenue declines in 2009 operating margin deterioration is likely to accelerate and profit declines may be substantial.
Liquidity Focus and Capital Efficiency
Another key area is preserving liquidity and maximizing capital efficiency. As external availability of credit is challenged, internal and committed external sources of liquidity are critical to meet upcoming commitments. For retailers in Fitch's coverage, long-term debt maturities are relatively moderate with around $40 billion maturing over the next three years out of a total of almost $150 billion outstanding. In 2009, non-investment grade retailers have less than $2 billion maturing, and investment grade retailers, while more significant, also have a relatively modest $11 billion.
Companies are working to maximize free cash flow and maintain cash balances by reducing working capital needs, lowering capital expenditures, and halting share repurchases. Working capital, which typically peaks in the October/November time period for most discretionary retailers, has been reduced as companies have lowered inventory levels in anticipation of soft sales. Capital expenditures in 2009 are expected to be well below 2008 levels as companies preserve free cash flow and work to improve capital efficiency and have had more time to adjust their development plans. Therefore, Fitch expects companies to reduce the number of new store openings, remodel activity and information technology expenditures in 2009. Several companies that have already announced reduced capital expenditures include Wal-Mart, J.C. Penney, Macy's, Target, Lowe's, and Staples. In addition, minimal share repurchase activity is expected in 2009.
Fitch expects some companies, particularly those that are investment grade, to access the long-term debt markets or utilize committed bank facilities to refinance existing debt during 2009. For example, Staples is expected to refinance commercial paper it issued to complete its acquisition of Corporate Express. Longer term, companies will need to access external credit markets to refinance maturing debt and renew bank facilities. However, as bank facilities are renewed, it is likely that availability will be reduced, particularly for weaker operators, and that the cost of these funds will increase substantially.
Retail Consolidation Accelerates
An acceleration of retail consolidation is another trend expected in 2009 as strong operators gain share and weaker operators get rationalized out of the market. We have already seen significant store closing activity during 2008 following several bankruptcies with announced closures of 155 of Circuit City's 721 stores as well as liquidation announcements by Linen's 'N Things which had 589 stores and Mervyn's which had 175 stores. Fitch expects further announcements of store closings after the holiday season as retailers close underperforming stores or as further bankruptcies are announced.
SECTOR SPECIFIC OUTLOOKS
Discounters
The strong value messages of the discounters will continue to draw consumers from all income levels. Food and consumables will continue to drive store traffic and those operators, such as Wal-Mart and Costco, with broad grocery offerings will outperform. Fitch expects operating profit margins to remain relatively steady as a result of the discounters' efficient supply chain management and low cost operating structures. While store base expansion will continue, it will be at a slower rate to reflect the weaker operating environment. Given the strong financial flexibility of the discounters, rating movement is expected to be generally limited and driven by broad capital structure decisions such as the level of debt-financed share repurchases.
Supermarkets
Supermarkets will continue to benefit from their broad non-discretionary product offerings and convenient store locations. Having a strong price message will be fundamental as consumers look to maximize value. Identical store sales will continue to be pressured by trade down to discount formats and value priced products including private label. Price investments will also weigh on gross margins but the stronger operators are expected to offset these investments with operating cost reductions. For example, Kroger's strong value image has resulted in it continuing to report industry leading mid-single digit non-fuel identical store sales, and Safeway and Kroger have both been able to offset price investments with operating cost efficiencies. Store base investments will continue to be central to long-term operating strategies, and this along with capital structure management will be key rating drivers over time. Opportunistic mergers and acquisitions may emerge in 2009 although transactions are expected to be small and market based.
Drug Stores
Drug retailers are also expected to benefit from their mainly non-discretionary merchandise offering despite the challenging environment. Given the significant pace of merger and acquisition activity over the past few years, both CVS Caremark and Rite Aid will continue to focus on integrating acquired units and leveraging their increased scale and breadth of services. There is a lack of large scale acquisition opportunities in the drug retail sector and therefore share gains will increasingly depend on generating above average organic growth, store closings or share losses by weaker independents and regional chains, and smaller market fill-in acquisitions and prescription file buys. Fitch expects drug retailers to further develop their multi-channel distribution strategies in areas such as pharmacy benefit management and specialty pharmacy where merger and acquisition activity could continue. In addition, enhanced service offerings such as additional in-store clinics will help these retailers win share from other healthcare venues. CVS Caremark is already well-positioned with leading market shares in all prescription distribution channels (retail and in-store clinics, mail, and specialty), and Fitch expects CVS Caremark to continue to drive share gains and leverage its integrated platform, generating incremental revenue longer term. However, industry participants could experience slowing top line growth if prescription volumes decline. In addition, profit margins could be pressured by weakness in front-end categories and potential changes in pharmacy reimbursement rates although an offset will be the growth in higher margin generics.
Department Stores
Fitch expects department store same store sales trends to be considerably weak through 2009 and credit metrics to weaken from current levels. Promotional activity will continue to be prevalent as retailers seek to align inventory to anticipated sales and drive traffic in their stores. This coupled with the deleveraging of fixed costs will pressure operating profit margins. Key to ratings will be a company's ongoing ability to prudently anticipate and manage inventory, expenses, and capital spending in the face of top line deceleration. For example, Kohl's has been able to drive positive gross margin this year on negative sales trends through its success with higher margin private and exclusive brands and conservative inventory management. Fitch expects well-run and well-capitalized operators to increasingly consolidate share as weaker operators with thin operating margins and liquidity issues exit the market. There have already been a number of announced bankruptcies, such as Boscov's and Mervyn's, and the pace could accelerate in a prolonged downturn. Luxury retailers have seen a significant deceleration in top line growth that goes beyond weakness in aspirational consumer spending and higher inventory levels from longer lead times. As such, these retailers could face significant gross margin pressure in the upcoming quarters until inventory is better aligned with sales growth. Fitch expects overall capital spending in the sector to decline meaningfully in 2009 as companies pull back or delay store openings, remodels and information technology investments, as well as close underperforming stores, with a few announced by Dillard's and Sears. Share repurchase activity should be minimal next year as investment grade retailers have essentially halted share buybacks to preserve cash flow.
Specialty
Consumer electronics demand is expected as much of the new product adoption has already taken place and incremental price declines will not be adequate to stimulate demand. In addition, competition will remain intense as a result of the discounters' expanded electronics offerings and the expected negative effect of liquidation sales from struggling operators such as Circuit City and Tweeter. Given the weak sales trends, Best Buy's and Radio Shack's abilities to adjust inventory levels and operating costs as well as preserve liquidity will be key rating drivers.
Home improvement retailers are anticipated to remain pressured by weak sales as consumers continue to cut back on spending in this category. Nonetheless, these retailers will focus on improving customer service levels and product offerings to capture market share. Share consolidation for Home Depot and Lowe's, which account for less than 20% of the market, is possible despite these companies slowing their store growth to focus on strengthening existing operations. Share repurchase activity has been halted as companies preserve cash in a weak operating environment. Nevertheless, continued weakness in the housing market would further pressure operating results and credit metrics.
Specialty apparel retailers, particularly those with poor fashion content, will continue to experience negative sales growth on weak demand. A focus on operating efficiencies and conservative inventory levels to limit promotional activity, which has allowed these companies to maintain operating profit margins to date, may not be sustainable, and margin erosion is possible. Fitch expects sales for toy retailers to show relative strength as parents continue to purchase toys for their children although the transaction size is expected to decline. Fitch expects office products retailers to be pressured as small business spending tightens in line with a slowing economy, but retailers that provide an easy shopping experience and strong execution are expected to outperform their peers.
