US retail: Battered and bruised, but on its way back

It is quite obvious that the recent economic climate has hit US retail very hard with numerous bankruptcies, deteriorating equity and credit markets, and declining sales growth. But our hopes of recovery were reinforced a fortnight ago when Federal Reserve chairman Ben Bernanke declared we may have seen the technical conclusion of the US recession.

As our economy eases out of its worst condition since the great depression, a few promising trends have emerged that are worth noting, including guarded optimism related to the upcoming holiday season, well positioned market segmentation and the return of the equity, credit, M&A and IPO markets.

While we should remain hopeful that the worst is behind us, we must proceed with caution, as troubling evidence remains that recovery could falter.

Following stronger than anticipated retail sales growth of 2.7% for the month of August, expectations have risen for the festive season. While these results prove to be assuring, strong sales growth for the 2009 Christmas period might be unattainable.

A common theme among retailers has been the drastic reduction in inventories, and the effects of these initiatives will undoubtedly be felt in the festive shopping period. Over the past year, many retailers have reduced inventory more rapidly than their rate of sales decline.

For example, Staples’ latest 12-month sales declined 9% while it reduced inventory 14% over the same period. Gap experienced sales declines of 7% with slashed inventories of over 13%.

Based on recent sales trends, there is little reason to believe that with these lower inventory levels retailers will be able to make up the difference and achieve exciting comparable-store sales.

Large capitalisation retailers are not the only ones pursuing this strategy.

In a recent Forbes survey of 110 chief executives and financial decision makers at mid-level retailers, 66% of respondents claimed lower inventories than a year ago, with 43% asserting significant inventory declines since the 2008 Christmas season.

Retailers are taking additional measures to ensure a stronger Christmas. Sales are anticipated to begin earlier and offer greater discounts. According to Forbes, 46% of retailers have already cut prices to increase inventory turnover.

While lower prices will adversely affect revenue, companies are still poised to maintain healthy margins through better inventory tracking, decreased spending with current suppliers, ensured delivery of merchandise and a focus on a more profitable product mix. Moreover, retailers plan on increasing their diminished advertising budgets and expanding their ecommerce and direct sales platforms to capture market share.

Wholesalers are preparing for the Christmas period as well. For the upcoming season, proper cash flow management should be emphasised.

It is extremely important for wholesalers to minimise exposure to slow-

paying customers, as their inventory turns have declined. In addition, companies must implement tighter credit controls, monitor questionable accounts carefully and apply strong collection efforts. Wholesalers must also check their own payments and renegotiate new payment terms and periods with suppliers.

That said, supplier credit protection has become more important than ever. A number of companies have turned to factoring and credit insurance to guard against delinquent payments and customer bankruptcies.

But the impact of the credit crisis has created constraints on factoring companies, providing additional challenges for suppliers. Current factoring relationships and credit lines have suddenly been eliminated or are at risk of being curtailed, creating an immediate working capital shortfall that could be fatal. To prevent such an outcome, business owners must be proactive in a search to supplement or replace their existing facilities.

Similarly, households have made their Christmas intentions known; they expect to take a more strategic approach this year, with shopping lists in hand and a budget in mind. Information Resources Inc, a provider of market information and services, surveyed about 1,000 households regarding their Christmas shopping rituals, with the results providing another bit of optimism for retailers.

According to the survey, consumers feel their shopping will be less affected by economic factors such as gas prices, job stability and the recession this year compared with last year. While last festive season consumers just simply did not spend, this year they plan on spending - albeit carefully. 23% percent plan for a gift budget of more than $800 (£498), while 11% plan on capping their expenses at $500 (£311) more than last year.

Aside from the Christmas season, other retail statistics have pointed to some positive signs. The consumer confidence index increased 54.1 in August from 47.4 in July and, according to Global Hunter Securities, retail footfall traffic for the first three weeks of August had increased 7.8% from the last three weeks of July. We will take whatever positive news we can get.

It is no surprise the discount market is poised to capitalise on these favourable trends. Not only has middle America looked to trade down, the affluent have followed suit. Ipsos Mendelsohn’s 2009 annual affluence survey report confirms this notion. The survey polled about 13,000 households with an income of more than $100,000 (£62,229) and found 80% have been shopping at Target and 70% at Wal-Mart.

This demographic is the lifeline of the luxury sector, so it is troubling only 10% of those surveyed had visited Saks, Neiman Marcus and Bloomingdale’s.

Conventional wisdom in the past two decades has spoken of the over-storing of America at all market levels. We are now seeing the troubling ramifications of this.

New retail construction has come to a halt as developers scurry to figure out what to do with vacant property.

Many retail operators are capitalising on this phenomenon and focusing on the reduction of occupancy cost. According to Forbes’s middle-market survey, 40% of respondents claimed they have been able to renegotiate rent and 38% have been granted concessions. As retail has seen an unprecedented number of store closures, many landlords are finding ways to accommodate clients.

From a financial markets perspective, we also have some glimmer of positive news. Over the course of the past few months the equity, capital, M&A and IPO markets appear to be gaining traction.

Retail stocks have experienced quite a run over the past few months. Cost cuts and the tightening of inventory have helped a number of companies exceed earnings expectations and an easing of the credit markets has slightly calmed the bankruptcy frenzy.

As a result, the S&P retail index has grown nearly 70% since the equity fallout in March, outpacing the Dow Jones Industrial Average and the S&P 500.

While this rapid growth remains promising, a few considerations must be addressed. Retailers are facing significantly easier monthly sales comparisons than last year.

Moreover, consumers still face tight credit, contracted retirement funds and unemployment, which rose in August to an astounding 9.7%. For retail equities to sustain this pace, customers must return to stores - cost-cutting initiatives have been exhausted and sales numbers need to rise. And when the customers return to the stores, retailers are primed for explosive growth.

There are some signs that the credit markets appear to be opening up as well. Spreads have recently tightened as market worries about credit risk and liquidity risk have eased slightly. Junk bond spreads have closed by close to 10% since the peak in December and even investment grade spreads have recently contracted.

In addition, bond issuances have sprung back to life. Investment grade bond issuances have reached $829.8m (£516.4m) in the year to date, compared with $808.8m (£503.3m) in all of 2008. High yield issuances, an important indicator of the health of the credit markets, have seen a substantial ramp up.

Grabbing opportunities

Since a low of $3.4bn (£2.12bn) in the fourth quarter of 2008, issuances have risen to $30.5bn (£18.98bn) in the third quarter to date - a figure that has not been seen since the credit booms of 2007. The retail sector has taken advantage of this trend. Last week, Blockbuster announced a $340m (£211.6m) note offering to pay down its existing revolvers and fund corporate activities.

Merger and acquisition activity appears to be on the rise as well. Following weak fourth-quarter 2008 and first-quarter 2009 periods, 12 transactions closed or were announced in the second quarter of 2009 - double the volume in the first quarter and in line with the second quarter of 2008.

The current quarter has shown similar promise, with two notable transactions: Amazon’s $823m (£512.1m) acquisition of Zappos.com and Charlotte Russe’s takeover by Advent International - one of the first large, healthy private equity buyouts in several months and potentially a sign of things to come.

Two prominent trends have emerged from this flurry of activity. First, distressed sales have dominated the market, accounting for more than two thirds of the total transactions. Second, a majority of the buyers have been strategic players, bucking the recent trend of a private equity-dominated market.

Private equity-backed deals have dropped below 20% of the total retail transactions over the past nine months, with concerns over weak sales numbers and tight credit.

The IPO markets might be providing the most promising signal of an uptick in the economy. Since June 2009, the IPO markets have shown signs of improvement, with a number of retail offerings.

Several strong names have recently come to market including KKR’s Dollar General, which intends to raise $750m (£466.7m), Bain Capital’s Dollarama, which filed for a $250m (£155.6m) offering on September 10, the Vitamin Shoppe, a $144m (£89.6m) IPO, and Apax’s Rue 21, which will be the first retail chain IPO in the US since Ulta Salons in October of 2007. This trend is global as well - TPG’s Myer, a leading Australian department store chain, expects to raise about $2.2bn (£1.37bn) in its pending IPO, the country’s largest public offering in two years and an indication valuations might be trending up.

Active investment back

Private equity involvement has been central to the recent IPO activity, signifying a fresh appetite for active investment as opposed to a mere investment exit. While private equity is vulnerable to a correction in market sentiment, a lot of its current strain has been lifted from its balance sheets, allowing it to refocus priorities and participate in the IPO process.

Overall, every day retailers face reasons to see the glass half empty. However, a careful look shows there are signs of recovery out there. As we emerge from the economic downturn, the ability to increase market share, find more locations and to consolidate will allow the strong to survive and the weak to perish.

Stronger capital and equity markets and lower valuations will permit such opportunities to occur. We must remain optimistic that the “new world” is still being defined and that those that persevere will emerge stronger than ever.

For now, the focus must be on how to capitalise on these positive initiatives and there will be significant benefits to the merchandising industry.