This week’s guest editor is Alan Hudson, Head of UK and Ireland Restructuring.
Inflation to the left of me, online rivals to the right…many of our retailers really do look stuck in the middle, squeezed between rising economic and structural challenges in 2017. This week, we’re looking at the EY ITEM Club’s latest thinking on the consumer, in the context of disruptive and structural pressures on the sector, to understand why retail is the subject of so much concern in 2017. And then we ask: what can retailers do to not just survive, but ride the storm?
The economic squeeze
Ask any economist –including our own– why post-BREXIT economic forecasts were wrong, and they’ll almost certainly say – “the consumer”. Given the Referendum’s divisiveness, I don’t think there is a universal explanation as to why UK consumers kept spending. For some, it was clearly a positive move, others may have brought purchases forward because they feared the consequences. What we do know is that there was more money for both groups to spend in 2016 given the continuing jobs growth, low inflation and interest rate cut.
So, why are we so concerned now? Because, as EY ITEM Club’s latest report explains, in 2017 it’s not just about confidence, but spending power. Two fundamental changes in particular look set to make 2017 a watershed moment for consumers and retailers.
1. The end of the long-running inflation holiday
Sterling’s fall combined with rising commodity prices creates a double-whammy for retailers, since it both raises import prices and reduces disposable income. Inflation is forecast to peak over 3% in 2017 – and hit a higher than forecast 2.3% in February.. Pre-BREXIT currency hedges are starting to run their course, with the pound 15% lower against the dollar than this time last year.
2. Slower employment and wage growth
UK employment growth is forecast at just 0.2% in 2017, against 1.4% last year. Low wage inflation will help retailers in their own business, but what they might gain on the swings, many will loose on the roundabouts –especially if their primary customer base is at the lower end of the income distribution scale, hardest hit by price rises and welfare changes.
Put this together and UK disposable income falls by 0.3% in 2017. Consumers use savings and borrowing to keep spending, but spending growth still falls from 2.8% in 2016 to 1.7% in 2017 and to 0.4% in 2018.
Today’s official retail sales figures for February do look surprisingly good at 1.4% growth; but this does come on the back of two months of falling sales. The underlying three month sales figures show a 1.4% decline for the second month in a row – the biggest drop since March 2010. This level of volatility – and unpredictability – have tripped many retailers up in the past
The structural squeeze
If that’s not enough, retailers also face the structural squeeze from rising internal costs – such as wages, the apprenticeship levy and business rates – and the increasing cost of investing to meet rising consumer expectations. It’s harder to draw the line between ‘physical’ and ‘digital’ when the consumer is permanently connected through smart devices and when they are buying and checking prices in-store. Consumer’s aren’t interested in channels, just the experience.
Not much further down the line, retailers will also need to contend with the unpredictable impact of BREXIT on the labour market and their supply and distribution channels. Indeed, when we look across our five UK Restructuring Drivers, retail is exposed at almost every point. The initial work on our EY Disruption Index, due for launch later this year, also highlights retail as one of the most exposed sectors to technological disruption.
So why haven’t we seen more profit warnings or distress? As we wrote last week, retailers have seen their EV/EBITDA multiple fall the most in the UK in the last year and the most against their European peers. Falling market expectations, combined with a better than expected end to 2016, means that we haven’t seen the normal run of first quarter profit warnings or serious issues emerging yet. Most of the impact of the fall in sterling is still to work through currency hedges and contracts. And of course, the retail sector is highly differentiated, with many retailers managing to negotiate the challenges so far.
But what we can say is that – for all the reasons we outline above – it looks like it’s going to get much tougher and this fall in multiples would appear to express investor concern. They have fallen less in food retail, probably due to the expectation that inflation will help supermarkets beat their deflationary demons. But, the structure of the food retail sector has changed in the last five years since inflation last topped 3%, with discounters gaining a further foothold. So pushing prices rises through is by no means a certainty. Pricing pressures continue and seem unlikely to let up significantly in the current climate. The pain has to come out somewhere – if not in retail, then their suppliers.
Riding the storm
So what should retailers be doing? There are six broad areas to think about:
1. Pricing and segmentation
Retailers will need to think about the impact of inflation and welfare changes on their target income and age groups. They may also need to rethink discounting strategies – and therefore their lines and stock levels.
What product lines and pricing will best enable you reach the right customers and to pass on cost increases?
2. Labour market
EU worker rights look set to top the negotiating agenda. But, there will enviably be a period of uncertainty, which may disrupt the EU labour supply and create skill shortages.
How will your business cope if the retail labour force diminishes and wages rise?
3. Supply chain
Imports are becoming more expensive due to the change in the value of sterling – and we don’t yet know what trade conditions will apply.
Can you find cost savings in your existing supply chain? Are there any products that might now be sourced from UK suppliers?
Rising costs provide a big incentive to think about operational improvements. Retailers have been trimming back costs for years, but should revisit in the light of rising labour costs and new technological innovations. Many retailers are still running legacy and online retail systems that aren’t fully integrated.
Where can you integrate and innovate to cut costs?
Retailers need think about what will hold the consumers’ attention and loyalty not just this year, but in five…ten years from now. This may mean being bolder than many retailers are used to: playing to win, rather than no to lose. This is a difficult mental shift to make, especially when companies are under pressure elsewhere.
What capital can you allocate to investigating with advanced technologies? Are there opportunities to collaborate with new start-ups? Can you provide time for your people to try-out new ideas?
Given the number of disruptive forces in their market, we expect retailers to keep transforming their businesses in a variety of ways – from buying to build scale or acquire skills, to the restructuring of underperforming business. Depending on the path of BREXIT, we may see more overseas interest, but any deal will be subject to greater shareholder scrutiny in this environment.