UK Retail sector: trading in Rising to the challenge in the year ahead and beyond

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1 UK Retail sector: trading in 2018 Rising to the challenge in the year ahead and beyond

2 Retail: is 2018 the beginning or the end? With turbulence and disruption in the sector, what risks and opportunities lie ahead and what are the priorities for future success? An EY panel with a wealth of retail experience held a webcast in January 2018 to discuss their views and ask participants for their insights.

3 1 Contents The 4 Stress 5 Mapping peak season trading overview retail transactional and IPO market in 2018: the margin vice continues to tighten out the future of retail 7 Summary

4 2 UK Retail sector: Trading in 2018 Rising to the challenge in the year ahead and beyond The 2018 peak season Non-food sales through stores continue to suffer Since the peak season trading results started to come out in early January, the UK retail sector has had blanket coverage in the press much of it negative. However, beneath the unpleasant headlines there has been a fair amount of good news, with pockets of strong performance emerging in many areas of the industry. That said, an analysis of the figures reveals that non-food sales through stores are in sharp decline a particularly worrying trend for all retailers with a heavy reliance on sales through their physical channels. Headline economic statistics underline the key themes that impacted peak season trading in. These include: A 0.4% 1 fall in real earnings in the three months to October. Food inflation running at 3.7% in the three months to December. 2 Consumer Confidence Index (CCI) at -13 in December, 3 its lowest since A 3.5% decline in December footfall, 4 the steepest fall in five years. Black Friday became even more of an online event, as digital sales increased to 27% of the total in November, and discounting intensified in the run-up to Christmas. While overall like-for-like sales edged up by 0.6% in December, 5 this rise was driven almost entirely by online and food spend. This overall picture masks wide variations in performance. Interestingly, compared to, 17 fewer retailers announced their peak season trading by mid to late January Most of those that have reported have seen growth in sales, while some more established names have struggled. Meanwhile, at a subsector level, strong brand owners and accomplished online players came out as winners in the apparel space, while almost all the major food retailers saw sales growth albeit in most cases largely driven by inflation. Despite a strong sales performance across the sector, only the two large discounters gained share in the grocery sector. Looking across the peak season figures, the statistics that spell out the industry s underlying divergence most clearly are that online sales increased by 7.6%, 7 while non-food sales through physical stores dropped by 4.4%. 8 Of course, many online sales are collected from stores and shops are used for browsing and discovering products that are then bought online. But what the peak season figures make clear is that the operational challenges of the decline in-store sales, with largely fixed costs, are becoming more and more intense. UK like for like (LFL) retail sales growth, including online non-food growth % growth Food sales: +2.6% Non-food in-store sales: -4.4% 3 months to Dec. LFL Online: +7.6% Total: +0.6% 12 month mov. avg. (online non-food growth %) Online (non-food) growth (%) 12 month moving average (growth %) Growth (%) -5 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Source: British Retail Consortium (BRC) 1 Analysis of real earnings: December, ONS, (accessed via 19 December ) 2 Bumper Christmas as UK shoppers spend 1 billion more than last year, Kantar Worldpanel, (accessed via 10 January 2018) 3 UK Consumer Confidence drops one point in December to 13, Gfk, (accessed via 24 December ) 4 December trading report, Springboard, (accessed via info/updates/articles/brcfvmnews-december, 17 Jan 2018) 5 Some glitter but no gold for Christmas, BRC, (accessed via 12 January 2018) 6 Result of EY analysis 7 Some glitter but no gold for Christmas, BRC, (accessed via 12 January 2018) 8 UK retail spending dipped in December, Independent, (accessed via 9 January 2018)

5 UK Retail sector: Trading in 2018 Rising to the challenge in the year ahead and beyond 3 The retail transactional and IPO market Still quiet When asked to assess investor and lender confidence in the retail sector for the year ahead, webcast participants gave a decidedly downbeat response with less than 2% rating the mood as positive, and over 80% opting for cautious. Compared with last year s vote, the bright spot is that the proportion characterising investors mood as reluctant declined from 27% to 17.5% suggesting that the prospects for investments into the industry may be improving slightly, as s cost pressures ease off. However, it is clear that funding remains wary of the industry a situation reflected in the sector s IPO activity. While saw notable growth in UK IPO volumes generally, with 77 IPOs generating 13 billion, this total included only two retail IPOs. 9 In fact, similarly low levels of retail IPOs have been a consistent trend since the peak of 13 achieved in A look at the relative performance of quoted retailers against the overall FTSE 350 index from through to January 2018 shows that retail stocks have generally under performed, with general retailers shares in particular well off the pace. Food retailers have been more stable, and actually outperformed the FTSE 350 over the last quarter although this trend has been distorted by two particular stocks with specific events driving an increase. Turning to the transaction environment, the number of retail deals has been at a relatively consistent level since the trough of However, retail acquisitions by UK private equity have generally remained at subdued levels, reflecting the lack of confidence in retail as a whole, the perceived lack of debt capacity in retail, and a reduced willingness to lend to the bricks-and-mortar retail segment in particular. However, one measure that appears possible to increase in 2018 is the number of distressed situations: these are already starting to drive deals, and are likely to do so increasingly in the coming months. Jan. Jan retail share performance vs. FTSE FTSE 350 Index (rebased) Food and drug retailers General retailers Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q (estimate) Source: Capital IQ 9 Result of EY analysis, Mergermarket, (accessed via January 2018)

6 4 UK Retail sector: Trading in 2018 Rising to the challenge in the year ahead and beyond Stress in 2018 The margin vice continues to tighten The challenges faced by the retail industry in were not new. Existing operational and structural issues behind the wellknown margin vice such as the shift to omni channel, increasing overheads, discounting and overcapacity were exacerbated by intensifying external tensions such as the rising pressure on consumer spending, falling consumer confidence, and weaker sterling. As a result, saw the industry s existing issues intensify and have a cumulative effect. Existing operational and structural challenges will continue to be exacerbated by external tensions Top line pressure Reduced consumer spending (disposal income and confidence) Cost base pressure Increasing operating costs e.g., National Living Wage, Apprenticeship Levy Pressure on cash Also brings working capital and capital expenditure challenges Margin vice Funding pressure Margin pressure Promotions and discount landscape, weak sterling Structural change Continuing shift to online and omni channel model Banking facilities Need to manage facilities in an uncertain environment A good indicator of the resulting stress was the level of profit warnings. Some 33% of general retailers issued at least one profit warning in, up from 26% in. 10 This was in stark contrast to food and drug retailers, only 10% of whom warned, down from 25% the previous year. 10 Most of the general retailer warnings came from the home and big ticket spend subsector, 45% of which warned in. 10 A large number of these companies referenced consumer spending, confidence and footfall as problems, indicating pressures on the top line. These factors plus many of those mentioned earlier, such as the pressure on non-food sales in-store appear to be reflected in the webcast attendees view of the subsectors facing the greatest pressure in 2018, with department stores and home and furniture retailers topping the list. Against this background, four key trends are emerging in retail: There is a declining appetite for the sector among some key stakeholders, for example, credit insurers reducing or withdrawing cover. Many businesses have exhausted no-regret self-help measures like reviewing store portfolios, optimising labour scheduling and seeking supply chain efficiencies. Retailers are considering more fundamental measures such as restructuring, disposals, retrenching back to core areas and even Credit Valuation Adjustments (CVA). Businesses are looking for external support from lenders or their shareholders, ranging from cash injections through to renegotiating banking governance. It is not all doom and gloom: many retailers, particularly those with strong brands and operational fitness, are performing well, and certain subsectors will be more resilient than others. But the reality is that the current trading environment for retailers is tough, and that the cumulative weight of these pressures does expose operational and financial weaknesses. 10 Warning signs, Analysis of profit warnings: Issued by UK quoted companies, Q4, EYGM Limited, 2018.

7 UK Retail sector: Trading in 2018 Rising to the challenge in the year ahead and beyond and beyond The changing fabric of retail Given the extreme and ongoing structural pressures on the retail sector s operational and financial state, it is clear that the handle of the margin vice will continue to turn. Faced with such a situation, it is all too easy for retail businesses to look inwards and think about how to react internally to those pressures, rather than directing at least some of their attention outwards to the market, to consumers and the competition. To survive and thrive, this is what they will need to do. The future of retail can be considered through three lenses: 1 The macroeconomic backdrop and here it is vital to remember how critical consumer spending is to the overall UK economy. The good news is that the squeeze on the consumer seen in should ease during 2018 as inflation falls back and real wages start to rise again. However, the upside to consumer spending is likely to be limited by slower employment growth and the uncertainty that Brexit has caused around business investment. So the wallet for UK retail is stable at best and given the rising competitive intensity and proliferating alternative uses for that wallet, stability for traditional retail appears unlikely.

8 6 UK Retail sector: Trading in 2018 Rising to the challenge in the year ahead and beyond 2018 and beyond The changing fabric of retail The changing fabric of retail itself, as the disruptors redefine consumer expectations by bringing them control, transparency and speed. Consumers are looking for the right experience: in a recent EY survey of more than 2,500 UK consumers, 86% of consumers noted shopping experience as the top influencer on their buying behaviour. 11 Given that footfall and online traffic are the new currency, the question is whether retailers can provide an experience that competes with the leisure experience and is also consistent across the micro-moments that make up the customer journey. This requires personalisation, which demands data. Retailers must be able to use data to target customers across channels and segment them by behaviour, while also as General Data Protection Regulation (GDPR) looms maintaining security around their customer data. This brings us to trust, which is increasingly imperative, with 74% of consumers telling us they would boycott a brand that they didn t trust, 11 and 78% saying their purchasing decisions are strongly influenced by how a brand treats its employees What will the UK retail landscape look like in 10 years time? In our view, consumers will become more asset-light, and will shift towards choosing a smaller number of products because the rest will be done for them by algorithms. So, the fight for that small choice will be even more intense, and consumer businesses will need to focus less on product and even more on lifestyle. Similarly, the trust equation will become ever more important. Obviously, this future will bring challenges. But for those players with good brands and good strategic assets, there are exciting times ahead and they absolutely can play to win. 86% 82% 78% Customer experience Brand s clear purpose Good treatment of staff Impact on shopping habits 11 If brand + trust = value, how are you solving the equation?, EYGM Limited,

9 UK Retail sector: Trading in 2018 Rising to the challenge in the year ahead and beyond 7 Summary The time for half measures is over The picture emerging from our retail trading 2018 webcast is of a fast-changing retail environment in which non food bricks-and-mortar retailers are especially exposed, and those with strong brands and differentiated online capabilities and customer experience have the edge. At the same time, the industry challenges seen over Christmas continue to be reflected in limited acquisition lending and lukewarm private equity interest, and the likelihood of more M&A driven by distress situations. Yet, some very interesting and positive things are happening in terms of innovation particularly around consumer experiences and trust. A new retail paradigm demands new thinking and for those able to develop and apply it 2018 is the beginning, not the end.

10 UK 8 Retail sector: Trading in 2018 Rising to the challenge in the year ahead and UK beyond Retail sector: Trading in 2018 Rising to the challenge in the year ahead and beyond8

11 UK Retail sector: Trading in 2018 Rising to the challenge in the year ahead and beyond 9 Contacts Julie Carlyle Partner, Head of Retail UK & Ireland Ernst & Young LLP T: E: jcarlyle@uk.ey.com David Larsson Partner, EY-Parthenon UK & Ireland Ernst & Young LLP T: E: dlarsson@uk.ey.com Jessica Clayton Partner, Head of Retail for Transaction Advisory Services UK & Ireland Ernst & Young LLP T: E: jclayton@uk.ey.com Christian Mole Associate Partner, Transaction Diligence UK & Ireland Ernst & Young LLP T: E: cmole@uk.ey.com Martin Carr Strategic Retail Advisor UK & Ireland Ernst & Young LLP T: E: mcarr3@uk.ey.com

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