The reasons behind these weak sales trends vary according to sector. In the apparel segment, discounter sellers such as Primark are taking share from traditional department stores and other high-street shops. DIY retailers are being impacted by a structural shift away from do-it-yourself towards do-it-for-me as well as sharp declines in UK home values. Among electricals retailers, DSG international plc (DSG) and Kesa Electricals are contending with a secular shift in the electricals market from brick and mortar stores to the internet and a slowdown in the digital product cycle.
Retailers are responding in various ways, including adding lower-priced items to their merchandise offerings, introducing new services, and improving store appearances and layouts. However, with operating cash flow constrained by the recession and, potentially, a weaker pound, it is difficult for retailers to quickly transform and adapt their businesses. Investments to re-model stores will not yield much return until consumer spending recovers, though these investments position retailers for an eventual turnaround, perhaps in 2010. Finally, the real estate downturn, combined with long lease terms in retail parks, makes it difficult for big box retailers to close less profitable locations.
In general, these retailers are retrenching by cutting costs, disposing of non-core assets and preserving cash. Kingfisher recently completed the sale of its Italian business, strengthening its balance sheet and providing a boost to its liquidity. DSG continues to explore strategic alternatives for its weaker European businesses, as it focuses on turning around its struggling UK operation. Fitch's January 2009 downgrade of DSG to 'B' with a Negative Outlook reflects the expectation for substantially weaker credit metrics and the potential for covenant compliance issues in 2009.
The credit outlook for the UK non-food retail sector remains negative, as reflected by Negative Outlooks on Marks and Spencer Group plc (M&S; 'BBB'), Kingfisher ('BBB-' (BBB minus)) and DSG ('B'). Next ('BBB') has a Stable Outlook, albeit with limited headroom. The preponderance of Negative Outlooks reflects the uncertainties brought on by the current downturn, the longer-term competitive concerns outlined above, and previous actions such as share repurchases (at Next, M&S and DSG) that have reduced the headroom in these companies' existing ratings.
Looking ahead, weak sales trends in 2008 will make for easier comparisons in 2009, suggesting LFL sales will, at a minimum, be less negative in the coming holiday season. However, even should sales trends begin to stabilize over the next year, the volatility in the pound present new challenges for the sector, raising the cost of imported goods. This will be felt over the course of 2009 as currency hedges expire, and will lead to a combination of higher prices and gross margin contraction should the pound continue its downward trend. As such, earnings will continue to suffer even should top-line sales begin to recover.
