A Strong Brand, Astute Management and a Robust Balance Sheet: the Three Keys to High Street Survival

Introduction

This is the third of a series of weekly notes analysing the state of the UK retail market in the light of the COVID-19 pandemic. This note explores four key themes:

- Tesco: the view from the “essential” frontline

- “Non essential” online demand – is there really a spike?

- Further occupier fall-out

- Retailers’ attempts to shore up the balance sheet

Please do not hesitate to contact myself or any of my retail colleagues if you require any further information.

Key Messages

• Tesco lays bare the challenges facing even “essential” retailers

• Expects to incur additional costs of between £650m and £925m this year

• Business rate holiday will result in a saving of ca. £585m

• Transparency on the vast sums UK retailers pay the Treasury each year

• Implied ceiling of online grocery capacity of 10%-15%

• Online clothing pureplay ASOS sees sales slump -20%-25% during March

• Fashion demand exceptionally soft in both instore and online channels

• Debenhams’ “light touch” administration unlikely to be its last

• Cath Kidston’s administration a reflection of private-equity ownership

• Retailers increasingly looking to shore up the balance sheets in absence of cashflow 

• Expect further refinancings, cash raising and property disposals / sale & leasebacks

1. Tesco: the view from the “essential” frontline

Tesco’s annual results presentation laid bare many of the realities and challenges of being an “essential” frontline retail operator. Clearly, foodstores and other “essential” retailers have a competitive advantage over retailers that are currently under enforced closure, but the current crisis is patently anything but plain sailing for those involved.

That the UK’s largest retailer’s full-year trading figures were something of a sideshow to recent narrative speaks volumes as to the scale of the crisis. For what they were worth, Tesco’s FY performance metrics were generally strong. Sales were a little disappointing (UK and Ireland +0.2% at constant currency to £44.9bn, against market growth of growth +2.6%), but all the other figures were impressive, not least that group operating profits grew +13.5% to £2.9bn and the business therefore surpassed its golden target of a margin of 4.0% (4.2%) that many scoffed at when it was announced five or so years ago.

But these results pre-dated the COVID-19 crisis (Tesco’s financial year-end was 29 Feb) and current trading has changed dramatically since then. In early March, sales surged +30% as some consumers took to stockpiling and this resulted in major availability issues in some product categories. But when the UK actually moved into lockdown, CEO Dave Lewis revealed that grocery sales “began to tail off” and return to more normal levels – and warned that sales could slip into negative territory year-on-year during the summer and beyond. Unexpected spikes in demand are clearly not helpful in the longer term.

Responding to this demand spike and rising to the challenges of the crisis generally have come at considerable cost. Tesco mapped out three scenarios based on three different timeframes, which assume that the UK will “return to normal” at the end of July, August or September. Under those scenarios, the retailer’s cost base will swell between £650m and £925m as a result of increases in payroll, distribution and store expenses. Either way, this will severely depress annual group profit.

The business rates holiday will only partially soften the blow. Tesco estimates it will save ca.£585m this year (an absolutely staggering figure, to my mind), significantly less than the additional costs that it is incurring. An important reflection here for the wider retail market, even more so for those retailers deemed “non-essential” and current with very limited / zero cashflow. The business rate holiday is helpful and very welcome – but it will not provide salvation in isolation.

Tesco also provided transparency on the capacity constraints of online grocery that I outlined in last week’s Retail Note. When the crisis hit, increased online basket size and higher instore footfall put pressure on in-store pickers and reduced capacity to below 600,000 deliveries a week as a result. But the business has added 145,000 new online delivery slots in the last two weeks alone, taking its overall capacity to 805,000 home deliveries every week.

Tesco’s statement that “between 85% and 90% of all food bought will require a visit to a store” gives a broad inverse indication of capacity constraints of online grocery. And there is no indication that this will prompt a permanent upscaling of online capacity – Mr Lewis was tellingly tight-lipped in making any statement as to long-term changes in shopping behaviours in the wake of the pandemic.

Tesco’s very revealing picture should firmly put to bed any lingering cynicism that the grocers are in any way profiteering from the current crisis. Yes, they are still able to open for business and have seen a temporary spike in demand. But this has come at significant cost and no small measure of hard graft. Serving customers as best they can in impossibly trying circumstances, rather than putting profits first. NHS frontline staff are quite rightly earning huge public plaudits for their ongoing dedication. In my opinion, frontline retailers, big and small, are likewise owed a deep debt of public gratitude.

2. "Non essential" online demand - is there really a spike?

I covered the nuances of the online grocery demand in last week’s Retail Note. What of non-food, or “non essential” online demand? The picture is very mixed and certainly not one of universal, unbridled growth as many believe.

ASOS’ half-year results this week were a case in point. Like Tesco, the reporting period ran to 29 February and the metrics were very strong. The online pureplay achieved a ‘record’ uplift in interim pre-tax profit to £30.1m from £4m the previous year, while group revenues jumped 21% to £1.6bn. Total order numbers rose 19% year on year to 41.1 million. But sales in March plummeted by -20%-25% and the business has undertaken refinancing to mitigate on the impact of COVID-19 (more on that below).

The recent slump in demand at ASOS is very telling. As an online pureplay, it is not directly affected by the enforced lockdown. Indeed, conventional wisdom would suggest that online pureplays should be major beneficiaries of the high street shutdown and this should be boom time for them. Clearly, this is not the case.

ASOS’ experience is consistent with many other multi-channel fashion retailers we have spoken to. Online is simply not picking up the slack of lost store-based sales. For many, online remains their sole source of cashflow during lockdown, but some are reporting that even online sales growth is “not at a level we would otherwise expect”.

Of course, this experience will vary by sub-sector and by operator. In contrast to fashion, electricals have definitely seen a spike in consumer demand online, on the basis of narrative from both pureplay operator AO World and multi-channel Dixons Carphone.

For all intents and purposes, the fashion sector generally appears to be at the very sharpest end of this crisis. Even with the benefit of increased footfall, Tesco reported that clothing sales had slumped by -70% in the past few weeks. And Tesco is a bigger player in this market than most appreciate, with F&F now being a £1bn+ brand.

Two absolute fundamentals of online retailing have been totally reinforced by recent events:

1. Our old mantra of online and stores working in collaboration rather than conflict. Take away either channel and the other will suffer. Multi-channel retailers are seeing online falter without the stores as allies.

2. Retail is retail. Online is just a channel within retail and is not a defense against wider retailing forces. If people aren’t buying clothing, they’re not buying it from anywhere. Not even the a great pureplay such as ASOS can thrive if no one is buying the product it sells.

3. Further occupier fall-out

As outlined last week, the COVID-19 pandemic will inevitably prompt considerable occupier failure. Two major retailers filed for administration this week – Debenhams and Cath Kidston.

Debenhams came as little surprise, the business having launched a CVA last year and with negotiations with landlords and suppliers ongoing. It described the latest process as a "light touch" administration to protect it from legal action from creditors while its department stores are closed. The business did not state how many of its 142 stores would reopen after the lockdown. 

As I’ve argued before, Debenhams’ long term salvation will only come if it is able to re-establish sustainable topline growth through a well-formulated and –executed product-led consumer-focused strategy. Store closures, general cost-cutting and refinancing won’t achieve this, they will only buy it time. In my view, this “light touch” administration won’t be the last.

Cath Kidston is set to call in administrators Alvarez & Marsal, putting 950 jobs at risk. The business said that the administration was part of an ongoing turnaround plan embarked upon before COVID-19 hit the UK. A brand revered by some as a quintessential British cottage industry has actually been private equity-owned since 2010, when the eponymous founder sold a majority stake to T A Associates, who subsequently sold the business to Baring Private Equity Asia in 2016.

The last filed accounts for Cath Kidston Limited were for 2017/2018 and showed the business reported a pre-tax loss of £18.2m. The business currently has over 200 stores globally, of which around 60 are in the UK. I suspect the company will survive, but this again serves to highlight the limitations and pitfalls of private equity ownership of UK retailers. Where there is pain, private equity is seldom far away.

4. Retailers seek to shore up balance sheets

With many retailers inevitably fighting for survival in the current crises, a strong balance sheet is a crucial safety net. Unsurprisingly, an increasing number of retailers are looking to shore up their balance sheet in one way or another, either by refinancing or raising cash by other means. Various examples to emerge this week include ASOS, WH Smith and Next.

ASOS launched an equity share raise and extended its revolving credit facility to deal with the impact coronavirus on its business. It expects to raise up to 18.8% of its existing share capital, or more than £200m. It also plans to extend it existing revolving credit facility by £60-80m and apply to access the Bank of England’s COVID-19 corporate finance facility set up to lend money to larger companies in a bid to mitigate coronavirus-induced business disruption.

WH Smith successfully raised almost £166m from investors after launching an emergency cash call to shore up its balance sheet. The business placed 15.8m shares at 1050p per share, representing a discount of 4p on the previous day’s closing share price, and equivalent to 13.7% of the company’s share capital. A day earlier, the company said it had secured a new lending facility of £120m, conditional on completing the equity raise. WH Smith issued a profits warning in March as travel restrictions triggered by pandemic led to a significant drop in shoppers at its airport outlets, initially in the Asia Pacific region, which accounts for 5% of its travel division’s revenues. The company stated that its annual profits would be half the £80m previously forecast.

Next has put its headquarters in Enderby (Leicestershire) and three of its warehouses in Yorkshire up for sale, in a bid to raise up to £100m. CEO Lord Wolfson said this would "secure the cash resources of the business" for the future. "We have modelled the effects of differing levels of sales declines along with all the measures we can take to ensure that the company remains within its bond and bank facilities," Lord Wolfson added.

We expect that this be a major direction of travel for many retailers in the coming weeks and months. But retailers will have varying means to fall back on. ASOS, WH Smith and Next are all well-regarded PLCs, with good credit history and access to capital markets. Many others do not have (or have not earned) that luxury.

The scope of retailers’ property ownerships also varies dramatically. Very few are owner-occupiers of the stores they trade in (the supermarket operators being the main exceptions), but some may own at least a few freeholds, be they stores, warehouses or offices. Property may now provide a vital source of cash. Again, this is probably not an avenue available to many private equity-owned retailers.

While there will definitely be considerable fall out in the coming months, many operators will survive and ultimately thrive. Likely common denominators of those that do weather the storm - a strong brand, astute management and a robust balance sheet.