Retail Industry Rating Methodology

April 2015 Retail Industry Rating Methodology Summary This rating methodology introduces the key rating factors of retail industry adopted by China Chengxin (Asia Pacific) Credit Ratings Company Limited ( CCXAP ). CCXAP defines a retail company as one with over 80% of its revenue coming from retail sales, for example, supermarkets, department stores, home-appliance chain stores, etc. Overview of Retail Industry Macroeconomic fluctuations Macroeconomic fluctuations have different impacts on the sub-sectors of retail industry. When the economy booms, household consumption surges and organic growth improves the profitability of retail companies. During this period, upscale department stores and retailers of consumer durables achieve higher sales growth. When the economy slows down, supermarkets selling daily necessities are more resilient, while department stores perform worse than supermarkets but better than retailers of consumer durables. During the downturn, only those companies with profitable stores and better management are able to maintain certain level of organic growth and acquire other stores at a low cost for external growth. Differentiation of operational risk Operational risk is a major risk faced by the retail industry, and the assessment should combine the product types, the competition environment and the company positioning. For example, retailers selling food have lower operational risk. In contrast, retailers selling luxuries have higher operational risk due to cyclicality and seasonality, and product obsolescence risk. The positioning within the industry, including geographic distribution of stores, the acquisition method of stores, and the ability of accurate positioning, also reflects operational risk. Professional back office support and strong management execution Fundamentally, a successful retail company is able to provide the right products at the right price and at the right time to customers. Competition in the retail industry is often intensive. If the value of the retail company changes, the consumer loyalty will be affected. Therefore, retailers unable to provide satisfactory products to consumers are likely to have declining operating performance and deteriorated financial condition. Development combining internal and external growth The development of a retail company usually relies on a combination of internal and external growth. Internal growth focuses on the improvement of existing stores to attract more customers through China Chengxin (Asia Pacific) Credit Ratings Company Limited Rating Methodology 1

strengthening back office and enhancing management efficiency. External growth focuses on the opening of new stores to increase network. Bargaining power The bargaining power of retail companies includes two aspects, of which one is the bargaining power of leasing or acquiring stores and the other is that of negotiating with suppliers. The bargaining power directly determines costs and expenses, and thus affects profitability. Bargaining power comprehensively reflects a company s position within the industry, brand awareness and management capability. Capital strength The retail industry is a capital-intensive industry. For retail companies acquiring stores to expand their business, capital strength is particularly important. Specifically, they need to purchase fixed assets including retail stores and equipment, and construct warehouses and distribution networks. They require disciplined assets management to generate maximum return. For ongoing operation and development, stores also need to be refurbished, which requires significant capital investment. The capital strength of retail companies is important for sustainable expansion and development. Rating Methodology on Retails Industry 2

Introduction of Rating Methodology In this methodology, 4 key rating factors comprising of 10 indicators are listed as follows. Rating Factor Size and Diversification Indicator Volatility of product demand Market presence and execution Total revenue Operating Capability Sales growth rate Expense ratio Return on assets Financial Policy Total capitalization ratio Total debt/ebitda Financial Strength EBITDA interest coverage ratio FCF/Total debt Key Rating Factors To illustrate our rating methodology for the retail industry, key factors and their indicators are discussed in details in this section, including rationale, measurements and how they will affect the rating. Rating Factor 1: Size and diversification Given the regular operation of retail companies, their cost of capital is relatively fixed; on the other hand, companies selling different products have different levels of volatility in earnings and cash flows. When the macroeconomic fluctuates, the characteristics of products are particularly important for assigning a credit rating. This rating factor is only minimally affected by the internal management of companies, but mainly focuses on the volatility of product demand, market presence, and the revenue of recent one year. Measurements (1) Volatility of product demand. The assessment of the volatility factor is mainly based on the types of products sold by retail companies. Sales of different products affect the volatility of retail business operations. We believe that supermarkets selling food are less volatile and more resistant to macroeconomic cycles; department stores selling clothes and shoes are more sensitive to macroeconomic cycles; retail companies selling luxury goods have the highest volatility, especially in a period of macroeconomic downturn when sales will be severely affected. (2) Market presence. The market presence aims to capture the competition environment of product categories as well as the geographic diversification of stores. Retail companies with dominant position in a single product category or diversified exposure to multiple product categories will be scored higher. Moreover, since economic cycles in different regions vary, the breadth of store locations partially offsets the impact of cyclical effect. For the market presence of retail companies, we consider their monopoly position and market share within their product category and operating region. Rating Methodology on Retails Industry 3

(3) Sales size (total revenue). Sales size of retail companies is an important indicator to measure market position. Consumer goods suppliers select retailers that are compatible with the characteristics of their products. Once the retail channel is established, the possibility of manufacturers choosing a retailer increases as the retailer s size increases. For the low-margin retail products, business owners expand their business to attract more customers in order to make more profits and gain more market share. Therefore, size of retail companies reflects their competitive advantage over suppliers when negotiating purchase prices, obtaining discounts, and conducting marketing and promotion, and thus the companies can leverage their operating expenses. Size of retail companies also represents brand strength and loyalty between retailers and customers. The operation of retail companies mainly relies on their distribution network, development of supply stores and retail stores, and internal control and management systems. Based on experience, large-scaled companies have more stable revenue. Rating Factor 2: Operating capability A retail company should continuously provide the right products at the right price and at the right time to customers, in order to develop and maintain customer loyalty. Even for retail companies with higher scores on previous indicators, any mistake made by management can immediately ruin consumer loyalty, operating performance and credit level. The operation of retail companies should ensure the effectiveness of the back office, maintain a reasonable size, and meet consumer demand in a timely and accurate manner. Taking supermarkets as example, if there are many products out of stock, consumers may change to other supermarkets. A retail company having efficient management who is responsive to consumer demand will achieve higher sales growth, enabling it to have stronger bargaining power during negotiations, and therefore better growth and profitability. Operational capability comprehensively reflects the business operation, competitiveness and bargaining power with suppliers of retail companies. When evaluating the operational capability of retail companies, we mainly measure their selling capability and management efficiency. Measurements We believe that the selling capability of retail companies reflects the depth and width of management expertise in the industry and their ability to follow market trends. When evaluating this factor, we mainly consider three quantitative indicators: (1) Sales growth rate. This indicator measures the revenue increase brought by the effective management to capture market trends. (2) Expense ratio. This indicator is expense divided by sales, and measures the control over three types of expense and the efficiency of back office management. In addition, whether stores are owned or leased will also affect the expense ratio. (3) Return on assets. This indicator is EBIT divided by average total assets, and measures a company s profitability. In addition, we take the following qualitative factors into account: The content, duration and background of purchasing agreements with suppliers, and whether these agreements reflect a "win-win" situation between suppliers and retailers The continuity of consumers purchasing power in specific areas Rating Methodology on Retails Industry 4

The persistency of price and quality of goods sold The operating results and the portfolio management ability in special trading periods (such as Christmas and Chinese New Year) Furthermore, we have noticed that some retail companies focus on product differentiation for sales and marketing, such as selling their own brands, which will also increase profits. Rating Factor 3: Financial policy The rating factors mentioned above mainly measure the sales growth and operating stability of retail companies. This rating factor focuses more on the influence of strategic and financial decisions on future credit. We believe that the ability to manage risk indicates the management skill of financial and strategic planning. This rating factor measures the balance between different investors, whether the financial policies will directly increase return to creditors or other stakeholders, and the ability of companies to repay debt. The quantitative measures of financial policy for retail companies are based on a company s capital structure and repayment ability, which include total capitalization ratio (total debt/total capital) and total debt/ebitda. Measurements (1) Total capitalization ratio. This indicator is total debt divided by total capital. Total debt means interest-paying debt, which includes short-term and long-term borrowing, bonds and bills payable; total capital means the sum of total debt and shareholders equities (including minority interest from consolidated statement). In addition, we do not use net debt (i.e., subtracting cash from total debt) for measuring capital structure because companies usually hold cash for daily operation, maturing debt and expected capital expenditures. (2) Total debt/ebitda. This indicator is total debt divided by EBITDA, which reflects the ability of retail companies to cover debt by cash flow. Even for companies with the same financial leverage ratio, they are exposed to different levels of financial risk if they have different profitability and ability to generate cash flow. Rating Factor 4: Financial strength The previous three credit factors measure credit quality based on fundamental operation and financial policy. The final credit rating should also consider the companies financial strength. Two companies with similar operation and management may have different credit ratings due to different financial strength. Since no single indicator can perfectly predict the probability of default, we mainly use coverage ratio to measure interest repayment capability for financial strength. We use different measurements of cash flow and different indicators of repayment. Measurements Two key indicators are used. In some circumstances, financial indicators also involve expectations of future performance. Based on experience, we assign equal weight to historical and expected indicators Rating Methodology on Retails Industry 5

in our assessment. (1) EBITDA interest coverage ratio. This indicator is EBITDA divided by interest expense. Interest expense means the sum of interest expense accounted in the financial fee and the capitalized interest expense. This indicator measures the coverage of interest by profitability, excluding non-recurring items. We do not use EBIT, the reason being that most stores are leased and the capital expenditures of maintenance and development stay low, so depreciation and amortization become non-recurring items. (2) FCF/Total debt. This indicator is free cash flow divided by total debt, which measures the coverage of debt financing by the cash flow from operating activities taking out capital expenditures and dividends. Other rating considerations For retail company credit rating, we also consider other factors that are important to credit but difficult to quantify. From the industry perspective, we adopt a similar evaluation method for these factors so that they are not further elaborated. Retail format selection and positioning Retail format means the different operation combinations of relevant elements for retail companies to meet consumer demands. Retailers are classified based on operating model, product structure, service function, location, business district, size, store infrastructure, target customer, and with/without fixed operation place. The retail formats include but not limited to traditional grocery store, convenience store, discount store, supermarket, hypermarket, department store, exclusive shop, and shopping center. Different formats meet different consumer demands, resulting in competitive differentiation, so the accuracy of positioning and the matching between locations and consumers is one of the important factors we use to assess retail companies. Business model of retail companies The business model of retail companies is an important qualitative factor during our rating process. Business model indicates whether retail companies use outright purchasing or association. In general, the business model of supermarkets and home-appliance stores is basically the same, where most use outright purchasing, i.e. purchasing goods from suppliers, selling these goods at higher price, and making profit from the difference in price. Under this type of business model, retail companies are exposed to inventory risk, so we use the inventory turnover rate as one of the measurement indicators. Most department stores use the association model and earn profit from sales revenue, so they face no inventory risk but possess a higher requirement of brand awareness. Amount and location of opening stores The way of retail companies to manage their retail stores is a key factor for their business and financial success. From operating perspective, strategic investment in retail stores directly determines whether the retail company uses the appropriate business model to meet local consumer demands. Consumers are sensitive to store quality, so the operating performance of retail stores is important for retail companies competitive positioning. Rating Methodology on Retails Industry 6

E-commerce business Global e-commerce market is growing rapidly in recent decades. With the popularization of e-commerce and its applications to various fields, conventional physical retailers are undertaking operating pressures. Therefore, retail companies are actively involved in the e-commerce market, combining online and offline business. The competitive position of retail companies in the e-commerce market influences their future development. Furthermore, the reputation and market position of e-commerce business depend on the reliability of payment, the establishment of logistics system, and the helpfulness of customer service. Real estate assets Given the intrinsic value of real estate, we believe that a real estate portfolio can provide an extra source of financial flexibility. Unrestricted and valuable real estate owned by retail companies is likely to obtain mortgage financing when demands increase, which provides an additional source of liquidity; the opposite is the case for leased stores. In addition, if retail companies lease stores, the average remaining tenor of the leasing contract is one of the factors we consider. Establishment of a supply chain The establishment of a supply chain is also one of the qualitative factors we consider. Especially for retail companies positioning to develop regionally, those with a better supply chain will have better overall operating efficiency and cost savings brought about by economies of scale. Support of shareholders For the retail industry in countries like China, due to the different background of shareholders, the support of shareholders is important for a company s future competitive position. We differentiate the degree of support from shareholders by their characteristics, type and region. Rating Methodology on Retails Industry 7

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