BREXIT BRIEFINGS 4: Impact on US and European Retailers

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1 BREXIT BRIEFINGS 4: Impact on US and European Retailers In the short to medium term, the UK and the eurozone will likely see slower GDP growth as a result of the UK s vote to leave the EU. Consumer confidence may be dented by post-referendum economic shocks and this could result in a retrenchment in consumer spending. US retailers with exposure to the UK market could be negatively impacted by lower store traffic and lower transaction conversion, as well as by the financial statement currency translation effect from a weaker pound versus the US dollar. Euro and pound currency weakness versus the US dollar negatively affects purchasing costs for EU and UK retailers that source primarily from Asian suppliers. EU and UK retailers are likely to continue to suffer from gross margin erosion due to the strengthening of the US dollar. The continued strength at Amazon, TJX Companies, Nike, Inditex, Zalando and ASOS gives us confidence that these retailers will likely continue to generate robust top-line growth and earnings. However, the Brexit vote consequences could further weaken demand for European luxury goods. DEBORAH WEINSWIG Managing Director, Fung Global Retail & Technology deborahweinswig@fung1937.com US: HK: CHN:

2 The Brexit vote comes at an unfortunate time, given that the global economy was already struggling with postcrisis sluggishness, European banking system weakness and terrorist attacks. Brexit Briefings 4: Impact on US and European Retailers The UK s vote to leave the European Union (EU) continues to cause international turbulence, from currency fluctuations to stock market volatility. We are publishing a Brexit Briefings series of regular reports that examine the impact of the UK s decision to exit the EU. This is the fourth report in our series. The first considered the macroeconomic ramifications of the vote, and the second and third reports examined the possible impact on British retailers and sectors. In this report, we analyze the short- and medium-term impact on US and EU retailers with UK and EU exposure. In the short to medium term, the UK and the eurozone will likely see slower GDP growth as a result of the UK s vote to leave the EU. Consumer confidence may be dented by post-referendum economic shocks and this could result in a retrenchment in consumer spending. US retailers with exposure to the UK market could be negatively impacted by lower store traffic and lower transaction conversion, as well as by the financial statement currency translation effect from a weaker pound versus the US dollar. Euro and pound currency weakness versus the US dollar negatively affects purchasing costs for EU and UK retailers that source primarily from Asian suppliers. EU and UK retailers are likely to continue to suffer from gross margin erosion due to the strengthening of the US dollar. The continued strength at Amazon, TJX Companies, Nike, Inditex, Zalando and ASOS gives us confidence that these retailers will likely continue to generate robust top-line growth and earnings. However, the Brexit vote consequences could further weaken demand for European luxury goods. At the time of writing, the overriding sentiment in both the UK and the eurozone is one of continued economic and financial uncertainty regarding the timing and nature of the UK s exit from the EU. It is not even known when the UK will formally notify the EU of its plan to leave. Furthermore, once the UK has advised the EU of its intention to leave, it has up to two years in which to negotiate and complete the process. Other EU member states may also decide to hold Brexit-style referendums, increasing political risk in the union, and the UK s vote may have other negative repercussions, political and economic, on other EU member states. Some believe that the initial economic and financial effects will be driven by uncertainty rather than by any changes in economic arrangements or trade. Naturally, economic growth estimates vary substantially, but the vast majority of forecasters have made downward revisions to their GDP growth estimates for both the UK and the eurozone for the next few years. The Brexit vote comes at an unfortunate time, given that the global economy was already struggling with postcrisis sluggishness, European banking system weakness and terrorist attacks. Muted economic growth forecasts could result in lower household, business and financial market sentiment. This could have a negative effect on business 2

3 investment, employment activity and wage growth and, in turn, increase precautionary savings by households. We expect UK and EU retail sales volumes to soften due to weaker consumer demand. Furthermore, the British pound has weakened following the Brexit vote, and capital flows have strengthened safe haven currencies such as the US dollar and the Swiss franc. The European Central Bank will likely implement additional policy easing initiatives and extend its quantitative easing program to continue to support the lagging EU economies. This measure will, in turn, serve to maintain the euro s weakness relative to the US dollar and the Swiss franc. Finally, and most importantly, not enough time has yet passed since the vote for us to analyze hard economic data points. It will not be possible to closely examine the initial impact of the referendum for a few more months. US RETAILERS FEEL THE EFFECT OF THE BREXIT VOTE The strong US dollar could negatively impact US retailers that rely heavily on foot traffic and sales from foreign tourist flows. Given the Brexit-induced volatility in the global economic backdrop, US retailers could face uncertainty in the coming months, in terms of both earnings results and share prices. US retailers with exposure to the UK market will be particularly impacted in terms of lower store traffic and lower transaction conversion, as well as by the financial statement currency translation effect from a weaker pound versus the US dollar. Share prices of many US retailers, particularly those with a strong presence in the UK, have already declined in the face of potentially negative economic fallout. In the context of ongoing uncertainty, these exposures must be considered a risk. However, the majority of US retailers are mainly domestically focused and do not have any presence in the UK or EU markets. Below, we show the regional composition of revenues for the top 15 USdomiciled retailers, as ranked by US revenues. Of these, Walmart, Walgreens Boots Alliance and Amazon are the most exposed to the UK. Walgreens Boots Alliance, Amazon and Apple are the most exposed to Europe, excluding the UK. However, Amazon and Apple have faster total revenue growth than traditional store-based retailers do, which suggests that they have room to offset weakness in Europe by accelerating growth elsewhere. Figure 1. US: Distribution of FY16 Revenues of Top 15 US-Domiciled Retailers with Exposure to UK/EU Markets, by Geography Rank Retailer US UK Non-UK Europe Rest of World 1 Walmart 74.2% 11.1% 0.0% 14.7% 2 Kroger 100.0% 0.0% 0.0% 0.0% Notes 3 Costco 72.6% 2.0% <1.0% 24.4% Est. FY15 data 4 Home Depot 91.0% 0.0% 0.0% 9.0% 5 Walgreens Boots Alliance 78.3% 8.9% 11.0% 1.8% 6 Target 100.0% 0.0% 0.0% 0.0% 7 CVS Caremark 100.0% 0.0% 0.0% 0.0% 8 Lowe s 100.0% 0.0% 0.0% 0.0% 9 Amazon 65.9% 8.4% 13.3% 12.4% Est. FY15 data 10 Safeway 100.0% 0.0% 0.0% 0.0% US incl. Canada 11 Best Buy 91.0% 0.0% 0.0% 9.0% 3

4 Rank Retailer US UK Non-UK Europe Rest of World 12 Publix 100.0% 0.0% 0.0% 0.0% 13 Apple Store/iTunes 40.2% 5.0% 16.5% 38.3% 14 Macy s 100.0% 0.0% 0.0% 0.0% 15 Rite Aid 100.0% 0.0% 0.0% 0.0% Source: S&P Capital IQ/company reports/fung Global Retail & Technology Notes Est. US is Americas total; FY15 data Looking beyond this top 15, many major US retailers have limited UK exposure and so should expect minimal negative impact. Among these are American Eagle Outfitters and L Brands. Meanwhile, Kohl s and JCPenney will also likely see very minimal impact, as 100% of these companies sales are US based. The same can be expected for Ross Stores, Target and Ulta Beauty. On the flip side, these companies will all likely see partial benefits on the sourcing side from the strengthening US dollar. Source: FashionBeans Within the US, the strong dollar could, however, negatively impact retailers that rely heavily on foot traffic and sales from foreign tourist flows, such as Hudson s Bay Company (parent company of Saks Fifth Avenue) and Macy s, as well as luxury and aspirational goods companies such as Tiffany & Co., Michael Kors and Coach. As hardlines are a domestically focused sector, retailers such as Lowe s, Home Depot, Tractor Supply Company and Dick s Sporting Goods are less likely to feel the effects of the fallout from the Brexit vote. Nike is one of the US companies most exposed to the UK, operating 42 stores in the country. While the drop in the pound s value could affect Nike, the company stated that it still expects to meet its 2016 fiscal year sales targets, aided by the boost from the Rio Olympics and the UEFA Euro 2016 soccer championship. Deckers Outdoor derives 10% 11% of its total revenues from the UK, representing one of the highest percentages among US retailers. Fossil Group 4

5 operates 16 retail stores in the UK and derived one-third of its total sales from Europe in its fiscal 2015 year. In the long term, the Brexit vote could have a positive impact on US off-price retailers like TJX. TJX Companies, the parent company of the T.J. Maxx chain in the US and the T.K. Maxx chain in Europe, has 5% exposure to the UK and could expect nearterm sales to be negatively affected by the weaker pound. In the long term, however, the Brexit vote could have a positive impact on TJX Companies, as consumers tend to shop at off-price retailers more often during economic slowdowns. Aside from Walmart s ownership of Asda in the UK, US grocery retailers have virtually no presence in the UK or EU markets, which are mainly dominated by national or regional incumbents. Finally, it must be stated that, despite the relative insulation of a large swathe of US retailers, even those companies that have no presence in the UK and/or EU could eventually see some trickle-down effect from the Brexit vote uncertainty, particularly if economic growth in other markets across the globe deteriorates. BREXIT VOTE CONSEQUENCES COULD FURTHER PRESSURE STRUCTURAL TRENDS IN UK/EU RETAIL Even prior to the Brexit vote, the apparel market in continental Europe and the UK was experiencing challenges, with apparel sales slowing and a deflationary apparel price environment. It is expected that this trend could persist and that the European clothing market could continue to underperform in parallel with consumer spending weakness resulting from post-vote uncertainty. Understandably, consumers have a greater propensity to save versus spend during times of economic and market turbulence. Currency effects on input costs will remain a headwind for companies that source goods predominately from Asia. European apparel retailers that report in euros could suffer from gross margin contractions due to the strengthening of the US dollar and a weak euro. Source: VisitLondon However, non-uk EU fashion retailers are in a better sourcing position than their UK peers, who are purchasing with a weaker pound. Should the pound remain at its current level, margins at Next, M&S, New Look and Primark could be unfavorably impacted, as they pay Asian suppliers with US dollars for the vast majority of their goods, but sell them mainly in pounds. It is unlikely that 5

6 Currency effects on input costs will remain a headwind for EU and UK companies that source goods from Asia. consumer demand will be strong enough to enable these fashion chains to raise prices to offset costs, and they therefore could see a hit to their gross margins. Macroeconomic, currency and structural pressures could impact all retailers through reduced footfall and consumer spending. More consumers could turn to price-competitive Internet pure plays and more could shop at discount stores. Retailers that can combine a strong e-commerce proposition with low prices will be best positioned to outperform. Inditex and H&M both derive approximately 62% of their total revenues from the European market, including the UK. Inditex is better positioned due to more domestic European manufacturing exposure. H&M, which has a large presence in Scandinavia and Germany, sources more of its US dollar denominated inventory from Asia than Inditex does. H&M will continue to suffer from gross margin erosion due to the strengthening US dollar/weakening euro trend. Source: Bluewater.co.uk Zalando management has said that the UK accounts for only a small portion of its total sales, but that it will keep investing in its UK business even though the post-vote decline in the pound has dented the value of revenues in the region. UK-based ASOS is a potential Brexit winner, as pound depreciation permits the retailer to price products more competitively in EU markets. ASOS recently reiterated its forecasts that fiscal 2016 revenue growth will be at the upper end of its previously estimated 20% 25% range BREXIT IMPACT COULD EXACERBATE LUXURY GOODS STRUGGLE Zalando will continue to invest in its UK business despite post- Brexit pound weakness. European-based luxury goods companies are heavily exposed to London and EU markets. European revenues, including UK revenues, comprise about a third of these companies total revenues (please see the figure below for specific company numbers). The luxury goods sector is already challenged on many fronts. Sales in China and Hong Kong have decelerated sharply due to economic slowdowns and a crackdown on ostentatious gift giving. In addition, tourist flows into Europe have been volatile due to terrorist attack fears. The Brexit vote will likely only heighten near-term uncertainty regarding the luxury demand outlook. Negative sentiment due to weaker GDP growth 6

7 following the Brexit vote will affect the forecast, as will slower wealth creation due to volatile equity markets in the UK and continental Europe. Luxury shoppers are likely to postpone luxury purchases both at home and while traveling. However, a weaker pound attracts US and EU visitors to London. The euro will also probably remain weaker than the US dollar, as the European Central Bank will likely continue its quantitative easing program in the near future. Hard luxury goods will continue to be particularly negatively impacted, as production costs for Swiss watchmakers Richemont and Swatch are likely to continue to escalate as a result of the Swiss franc s strength as a safe haven currency. Swatch recently issued a profit warning due to drastic sales decreases following weak demand in Hong Kong and parts of Europe, especially France and Switzerland. However, it is still too early to ascertain the long-term impact of the Brexit vote on luxury shopping in Europe. Note that some of the companies listed below do not split out UK revenues from other European revenues. Figure 2. Distribution of FY16 Revenues of Top EU- and UK-Domiciled Retailers with Exposure to EU Markets, by Geography Retailer UK Non-UK Europe Rest of World Notes Tesco 77.2% 14.5% 8.3% Alliance Boots (H&B Division) 87.4% 10.0% 2.6% FY14 data UK incl. Ireland; Dixons Carphone 68.0% 25.1% 6.9% FY15 data Kingfisher 47.0% 53.0% 0.0% UK incl. Ireland Primark 52.0% 48.0% 0.0% Est. H&M 7.6% 62.3% 30.1% FY15 data Inditex* N/A 61.7% 38.2% FY15 data Sports Direct 79.5% 20.5% 0.0% FY15 data LVMH** N/A 28.0% 72.0% FY15 data Prada** N/A 35.0% 65.0% FY15 data Adidas** N/A 27.0% 73.0% FY15 data Swatch** N/A 33.0% 67.0% FY15 data Kering** N/A 31.0% 69.0% FY15 data Richemont** N/A 31.0% 69.0% Est. Major Internet Pure Plays Zalando** N/A 94.4% 5.6% FY15 data ASOS* 42.3% 26.2% 31.4% FY15 data Boohoo.com 66.6% 11.6% 21.8% Non-UK Europe broadly matches the boundaries of the EU (it excludes Turkey and Russia, for instance), but may include some presence in non-eu countries such as Switzerland. *Figures do not sum to 100 due to rounding. Includes UK revenues in non-uk Europe revenues **Includes UK revenues in non-uk Europe revenues Source: S&P Capital IQ/company reports/fung Global Retail & Technology 7

8 KEY TAKEAWAYS Among the top US retailers, Walmart, Walgreens Boots Alliance and Amazon are the most exposed to the UK. Walgreens Boots Alliance, Amazon and Apple are the most exposed to Europe, excluding the UK. Within the US, the strong dollar could negatively impact retailers that rely heavily on sales from foreign tourist flows, such as Hudson s Bay Company (parent company of Saks Fifth Avenue) and Macy s, as well as luxury and aspirational goods companies. Currency effects will remain a headwind for companies that source goods predominately from Asia, in US dollars. European apparel retailers that report in euros could suffer from gross margin contractions due to the strengthening of the US dollar and a weak euro. However, non-uk EU fashion retailers are in a better sourcing position than their UK peers, who are purchasing with a weaker pound. In Europe, macroeconomic, currency and structural pressures could impact retailers through a weakening of consumer spending. More consumers could turn to price-competitive Internet pure plays and more could shop at discount stores. Retailers that can combine a strong e-commerce proposition with low prices will be best positioned to outperform. 8

9 Deborah Weinswig, CPA Managing Director Fung Global Retail & Technology New York: Hong Kong: China: John Mercer Senior Analyst Eva Kubicka Senior Research Associate Rachael Dimit Research Associate HONG KONG: 10th Floor, LiFung Tower 888 Cheung Sha Wan Road, Kowloon Hong Kong Tel: LONDON: Marylebone Road London, NW1 6JQ United Kingdom Tel: 44 (0) NEW YORK: 1359 Broadway, 9 th Floor New York, NY Tel: FBICGROUP.COM 9