UK Retail sector: Trading in 2017 - EY - United States

1 UK Retail sector : Trading in 2017 Are you ready for a perfect storm?A perfect storm is brewing in Retail as rising external pressures meet deepening structural challenges What risks and opportunities lie ahead and what should retailers be doing, not only to weather the storm but to also shape the future? An EY panel with a wealth of Retail expertise held a webcast to discuss their views and ask participants for their Retail sector : Trading in 2017 Are you ready for a perfect storm?1 Impact of a falling pound and unrelenting cost pressures further tightens the margin vice2 Apparel and DIY regarded as the most vulnerable to the squeeze3 Going beyond optimising the core requires a new level of risk taking 4 The biggest innovation challenge can be one of mindset rather than cash5M&A activity continues; but investors have become more cautious and selectiveHeadlines6 Source: EY Item Club420-2 Per yearHousehold incomeHousehold creditYear on year increase in unsecured debt to November 2016 (Bank of England) spendingDecember 2016 increase in spending on foreign payment cards (Worldpay)2UK Retail sector : Trading in 2017 Are you ready for a perfect storm?

2 The margin vice tightens We started 2017 with retailers facing a perfect storm of continuing structural challenges and an increasingly difficult economic backdrop that looks set to turn further against the consumer. Growing external pressures Our survey of webcast participants showed external margin concerns increasing with good reason. The latest EY ITEM Club Report sets out two fundamental changes that will make this a watershed moment for consumers and retailers in 2017 . The first is the rise in sterling and the end of the long-running inflation holiday, which will hit both input prices and disposable income. Inflation is forecast to peak over 3% in 2017 , which will in turn hit consumer spending power. Secondly, EY ITEM Club expect employment to increase by just in 2017 , compared to last year. Wage rises also remain subdued, despite the introduction of the National Living Wage. This leaves disposable incomes falling by in 2017 and only growing by in 2018.

3 The drop in consumer spending growth is delayed somewhat by consumers using their savings and lower interest rates to maintain borrowing and spending falling from in 2016 to in 2017 and in 2018. Although unsecured borrowing is already running at levels close to the 2008-peak and has started to Retail sector : Trading in 2017 Are you ready for a perfect storm?Continued price pressures As currency hedges run out, the impact of the weak pound on import prices will increase with the effect compounded by higher commodity prices including energy and fuel. Retailers are working with suppliers but - given the scale of price rises they will have to try pass some of this on. Some retailers will be able to off-set this with increased sales to overseas visitors or online buyers. The pound s weakness is also helping to end the long-running deflationary environment in food Retail which outperformed non-food this Christmas.

4 But although the big four supermarkets are showing signs of recovery and resilience, the discounters continue to grow sales faster and increase their market share across the sector . The price war isn t over and the pressure to keep prices low will only increase as disposable income falls. This pressure is already intense. A brief look backwards; Black Friday 2016 was not so much a day as a season. Promotional activity started high and rose steadily up to Christmas, reflecting the need to clear inventory before the start of the Boxing Day sales. Companies who did not participate in Black Friday tended to perform better, although it may be that these retailers did not need to take part. This is just one reason why we are cautious with regard to using like-for-like data or Retail surveys to assess Christmas Trading . Given that nearly half of retailers reporting had less than 3% growth and the ongoing pressures on margins - companies final results may give us a much less upbeat view than these like-for-like note on like-for-likes We treat like-for-like sales data with caution.

5 There is not an industry standard for reporting like-for-like sales, whilst private companies are not obliged to report their figures and will often only do so if they are positive. Hence Retail surveys can be much more downbeat that reported sales. Moreover, these figures only look at the top line with very little discussion about profitability or cash. 4UK Retail sector : Trading in 2017 Are you ready for a perfect storm?New structural challenges Meanwhile, internal cost and structural pressures are not letting up and neither are consumers expectations. Many retailers are still struggling to create a profitable omni-channel model. Online sales growth, once again, contrasted with flat in-store sales and effectively rescued Christmas. However, sales channels are becoming increasingly blurred - beyond Click & Collect - as online and offline become symbiotic. It is less easy to draw the line between physical and digital when the consumer is permanently connected through smart devices and often checking prices/buying online whilst in-store.

6 Nevertheless, many retailers are still running legacy assets and online in parallel, rather than creating an integrated model. Retailers are also contending with the unpredictable impact of BREXIT on supply and distribution channels. There is a changing regulatory landscape, including a further increase in the national living wage and a new apprenticeship levy. Rising business rates add to rising cost pressures. Yet, of course, consumers are not reducing their expectations in terms of value, convenience and fulfilment or service. Apparel in the cross-hairs Even with relatively fair economic winds, profit warnings from quoted retailers were the highest for five years in 2016. With surveys showing sales falling further in January and the margin vice tightening this will clearly put additional pressure on cash and working capital. An overwhelming majority two-third of our webcast participants named apparel Retail as the sector most likely to be under pressure in 2017 .

7 It has been challenged for some time by overcapacity and certainly the falling pound adds another dimension. It will also be interesting to see how the housing market and consequently DIY and big ticket retailers - hold up if consumer confidence falls. 5UK Retail sector : Trading in 2017 Are you ready for a perfect storm?How can retailers weather and ride the storm?Efficiency gains Retailers have picked most of the low hanging fruit in efficiency improvements. There are still opportunities in supply negotiations - especially where factories have extra capacity. Some are exploring newer low cost countries, such as Cambodia, whilst others are bringing more supply closer to home to reduce lead times or changing detail to move products up or down price bands. Technology and advanced data analytics probably offer the greatest opportunities to improve efficiency. Reducing the amount of discounted stock using more scientific methods to optimise merchandising and mark down effectiveness is the biggest opportunity to protect gross margin.

8 Retailers can also make use of technology to improve labour efficiencies and even look at Radio Frequency ID (RFID) to improve and streamline management and handling of the futureRetailers also need to look at how they can shape the future. The sector is undergoing a high level of technological disruption and to remain competitive, many retailers will need a level of risk taking that was not necessary in the past. Companies need to play to win rather than not to lose. This is a difficult mental shift to make especially when companies are under pressure elsewhere. Retailers can be less confident in making changes in the areas of agile supply chain, driving actionable insights from data, understanding profitability and keeping pace with new technology. But it is in innovation that is often the toughest area to to playHow to winCreate new markets, target new customer needsDisruptive Developing breakthroughs and inventing things for markets that do not yet existAdjacent Expanding from existing business into new to the company businessCore Optimising existing products for existing customersEnter adjacent markets, serve adjacent customersServe existing markets and customersUse existing products and assetsAdd incredmental products and assetsDevelop new products and assets6UK Retail sector : Trading in 2017 Are you ready for a perfect storm?

9 To get into this yellow zone of finding adjacent and disruptive growth, companies need to make innovation integral to their business strategy. Some retailers are starting their own start-ups - either within a traditional business or by creating a secret competitor to the parent which means being unafraid to cannibalise the core business. Indeed, mind-set rather than cash can be the biggest challenge. Companies can start by experimenting with advanced technologies relatively cheaply or can begin collaborating with start-ups and providing time and space for their own people to try-out new ideas. In this arena, retailers will need to think about talent not just in terms of digital savvy engineers but also the people who can understand the customer and apply technology. How would you assess confidence in the Retail sector for the year ahead?Positive: good growth prospectCautious: but willing to invest Reluctant: unless an exception27%73%0%7UK Retail sector : Trading in 2017 Are you ready for a perfect storm?

10 How will the investor community respond?Investors are clearly approaching the sector with an increasing degree of caution. This has not stymied deal activity completely but the sector can clearly expect a more selective investor stalls IPOsThis caution is most apparent in IPOs, where there were just four retailers coming to market in 2015 and two in 2016. This partly reflects a fall in activity in the broader IPO market, which hasn t really picked up since the 2015 General Election, due to BREXIT uncertainty and related valuation issues following the fall in sterling. Recent IPOs have performed better than the somewhat troubled class of 2014; but since BREXIT, UK Retail indices have underperformed the wider market. Activity will remain subdued whilst this uncertain and unsupportive backdrop M&A continuesIn contrast, the volume of Retail M&A transactions has been remarkably consistent in the last three years including transformative domestic deals and interest from overseas.