Why aren’t the tills ringing in 2018?

This week we’re sharing insights from Jessica Clayton, Head of Retail Transactions and David Larsson, a Partner in EY Parthenon. 

It’s been a tough few months on the high street, but this week has really put its trials and tribulations in focus with two major retailers going into administration and further restaurant CVA. In this week’s blog, we ask “why now?” and set out what consumer-facing companies can do to combat the increasing economic and structural headwinds.

Because, it’s not just about how much consumer have to spend. The equally important issue is how and where they spend it.

Hard times

When we last covered the retail sector here, in ‘Black Friday…Red January’ – we were, as the title suggests, concerned that 2018 would bring further distress. And, as feared, it’s been a tough start to the year with six major retailers going into administration, news of further store closures, increasing retail profit warnings and further restaurant CVAs all underlining the increasing difficulties for consumer-facing sectors.

The latest EY Profit Warning data shows that 17% of the FTSE General Retailer sector has warned so far in 2018. This is the highest quarterly percentage in over six years – with a month still to go in the first quarter.

profit warnings in the retail sector since 2007

Why now?

In terms of the timing of the latest restructurings, the post-Christmas period is a tough one for companies reliant on the Christmas rush. A large amount of cash needs to flow out all at once to pay for Christmas stock on top of the usual rent payments and overheads. If companies have performed below expectations over the festive period, it is now that the crunch comes.

All the signs were there that Christmas was going to be tough, as wage growth slipped below inflation and consumers felt the pinch. According to EY ITEM Club, consumer spending only grew by 1.4% last year, less than half the 2.9% recorded in 2016 and the smallest increase since 2011. Growth in retail sales volumes (accounting for around one-third of consumer spending) slowed to 1.9% from 4.7% in 2016. Meanwhile, retailers costs are rising due to the fall in sterling and rise in wage and operating costs – not least the cost of keeping up in the digital race.

What about 2018?

In 2018, inflation should fall and a tighter labour market and improving productivity should feed through to higher pay growth. But, this will be partially offset by at least one, probably two quarter-point interest rate rises in 2018. Savings are at historic lows, while unsecured debt is higher than before the financial crisis. Therefore, while we don’t quite know how consumers will react to the first sustained rate rise in over a decade – or any further Brexit uncertainty – it seems unlikely that consumers will go out and spend significantly more.

Because, it’s not just about the amount consumers have to spend, but how willing they are to spend it. Consumer confidence rose in January, but slipped back in February, according to GfK, with respondents slightly lowering their outlook for their personal financial situation and the economic outlook. EY ITEM Club are forecasting a similar rate of consumer spending this year as last. Meanwhile, operational costs will remain an issue across consumer sectors. Sterling has recovered some ground, but remains weak whilst further increases in the National Living Wage and a tighter labour market will continue to hit margins.

It’s as much about HOW as HOW MUCH

But arguably the equal – if not tougher – challenges to both retailers and restaurants are in the deeper structural issues that lay at the heart of the sector – in particular the impact of the seismic shifts we’re seeing in consumer behaviour. These forces will continue to reshape consumer sectors even in the good times. And, with less spare cash, consumers are likely to be even more discerning – potentially accelerating the pace of change.

As we discussed in our previous blog on the troubled restaurant sector, most of the growth since 2010 has come in  ‘fast causal’ and ‘casual’ dining’ with expansion relying on substantial levels of debt finance.  At least five transactions since 2014 were backed by debt levels of over £100m. Most of the restructurings we’ve seen in the last few months have come in this sector – which is also seeing its business model challenged and margins eroded by online delivery services. Restaurants lose margin in commission – which is usually around 10-15% – but they also need to provide the capacity to meet demand and can only really benefit if they have a menu that is suitable for delivery.

Most struggling retailers have also failed to find a niche or stand out in crowded markets – especially when that market has dominant online competitors. Retailers that haven’t re-engineered their business model to consumers’ ever-growing digital expectations have fallen behind. Those left with large legacy stores have struggled to compete with nimbler online rivals. Those who haven’t adopted smart inventory solutions and made the best use of data to manage stock and personalise their service lag their more agile competitors.

Capital problems

Therefore, although we may seem the economic backdrop improve, the consumer sector will be completely reshaped in the next decade and beyond. Companies will need to keep reinventing their business models. This is proving especially tough for long-established businesses, but those that can’t adapt quick enough will fail.

This raises the question of capital that we discussed last week. It will be a struggle to raise capital and refinance debt in troubled sectors, unless businesses are at the top of their game. Companies with capital to invest will be in a good position to make the most of any upturn; but they need to think carefully about how to invest it – be that in developing technology in-house, buying-in skills, creating alliances or engaging in deals within the sector to create scale. We expect to see more M&A and more distressed investors coming into consumer sectors as more companies struggle to meet their capital needs.

Management teams also need to aware that whilst a Company Voluntary Arrangement (CVA) can buy much needed time to turnaround performance and successfully streamline leasehold portfolios and legacy liabilities, unless the underlying issues are addressed too, that extra time will still run out. This is shown all too clearly in the large number of retail CVAs that have subsequently gone bust.

Building on the basics

It is still – will always be – vital to get the basics right. In any consumer-facing business, it is vital to know your customer, get the product right, manage inventory, identify the right location/platform etc.  But, the difference is now that companies have so many more technologies at their disposal in each of these areas. Companies who aren’t collecting and analysing the data generated across their business, who aren’t integrating these insights and predictive capabilities and who aren’t learning and adapting are falling behind.

This need for capital and the constant reinvention of business models will continue to create divergence between the winners and losers. There are many companies across the consumer sector who are out-performing. But, the constituents of these groups can change.

Disruptive companies can be themselves disrupted.

To find out more about the prospects for the consumer economy, please join the @EY_ITEMClub webcast on Thursday, 8 March, 3.30pm – 4.15pm to hear their latest findings https://go.ey.com/2FkrPxh

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