Key Rating Factors - Business and Financial Risks in the Retail Industry (1)

ARCHIVE | Criteria | Corporates | Industrials:

Key Credit Factors: Business AndFinancial Risks In The Retail Industry

Primary Credit Analysts:

Jerry A Hirschberg, New York (1) 212-438-1000; [email protected]

Stella Kapur, New York (1) 212-438-1262; [email protected]

Nicolas Baudouin, Paris (33) 1-4420-6672; [email protected]

Table Of Contents

Relationship Between Business And Financial Risks

Part 1--Business Risk Analysis

Keys To Competitive Success

Part 2--Financial Risk Analysis

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT SEPTEMBER 18, 2008 1

THIS WAS PREPARED EXCLUSIVELY FOR USER BARBORA MATOUSKOVA.

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ARCHIVE | Criteria | Corporates | Industrials:

Key Credit Factors: Business And Financial RisksIn The Retail Industry(Editor's Note: This criteria article is no longer current. It has been superseded by the article titled, "Key Credit Factors For The

Retail And Restaurants Industry," published on Nov. 19, 2013. Previously, this article was partially superseded. The section

describing liquidity/short-term factors was partially superseded by the article titled, "Methodology And Assumptions: Liquidity

Descriptors For Global Corporate Issuers," published on Sept. 28, 2011. The section describing management evaluation was

superseded by "Methodology: Management And Governance Credit Factors For Corporate Entities And Insurers," published on

Nov. 13, 2012. Tables 1, 2, and 3were superseded by the business risk and financial risk matrix found in "Methodology: Business

Risk/Financial Risk Matrix Expanded," published Sept. 18, 2012.)

Standard & Poor's Ratings Services' analytic methodology evaluates the qualitative and quantitative factors of an issuer

to determine a credit rating opinion on that issuer. The analytic framework for industrial companies in all sectors,

including retailers, is divided into two major segments: The first part is fundamental business risk analysis. This step

forms the basis and provides the industry and business context for the second segment of the analysis, an in-depth

financial risk analysis of the company.

Our rating analysis of retailers begins with the industry, business, management, and competitive positions of the entity

before we consider the financial risk profile. The company's business risk profile determines the financial risk it can

bear at a given rating level.

Relationship Between Business And Financial Risks

Before discussing the specific factors we analyze in our methodological framework, it is important to understand how

we view the relationship between business and financial risks. Table 1 displays this relationship and its implications for

a company's rating.




Table 1

Chart 1 summarizes the rating process.




ARCHIVE | Criteria | Corporates | Industrials: Key Credit Factors: Business And Financial Risks In The RetailIndustry

Chart 1

Part 1--Business Risk Analysis

Business risk is analyzed in four categories: country risk, industry risk, competitive position, and profitability. We

determine a score for the overall business risk based on the scale shown in table 2.

Table 2

Business Risk Measures

Description Rating equivalent

Excellent AAA/AA

Strong A

Satisfactory BBB

Weak BB

Vulnerable B/CCC





Analysis of business risk factors is supported by factual data, including statistics, but ultimately involves a fair amount

of subjective judgment. Understanding business risk provides a context in which to judge financial risk, which covers

analysis of cash flow generation, capitalization, and liquidity. In all cases, the analysis uses historical experience to

make estimates of future performance and risk.

1. Country risk and macroeconomic factors (economic, political, and social environments)

Country risk plays a critical role in determining all ratings on companies in a given national domicile. Sovereign-related

stress can have an overwhelming effect on company creditworthiness, both directly and indirectly.

Sovereign credit ratings are suggestive of the general risk that local entities face, but the ratings may not fully capture

the risk applicable to the private sector. As a result, when rating corporate companies, we look beyond the sovereign

rating to evaluate the specific economic or country risks that may affect the entity's creditworthiness. Such risks

pertain to the effect of government policies and other country risk factors on the obligor's business and financial

environments, and an entity's ability to insulate itself from these risks.

2. Industry business and credit risk characteristics

In establishing a view of the degree of credit risk in a given industry for rating purposes, it is useful to consider how its

risk profile compares to that of other industries. Although the industry risk characteristic categories are broadly similar

across industries, the effect of these factors on credit risk can vary markedly among industries. Chart 2 below

illustrates how the effects of these credit-risk factors vary among some major industries. The key industry factors are

scored as follows: High risk (H), medium/high risk (M/H), medium risk (M), low/medium risk (L/M), and low risk (L).





Chart 2

We believe the retail industry in many developed countries has an elevated level of business risk because of the

confluence of higher risk industry factors including:

Susceptibility to demand volatility driven by economic and product cycles;

Intensity of competition in many developed markets;

Slim operating margins and the increasingly commoditized nature of many retail product offerings;





Capital intensity;

Operating leverage;

Retail overcapacity or oversupply; and

Reliance on growth in consumer credit purchases, which has been a major spur to sales in recent years. However,

growth in consumer spending may become increasingly constrained by record levels of household debt.

The retail industry in developed countries is also being pressured by economic and demographic maturation, which is

slowing growth and driving consolidation. While consolidation reduces the number of competitors and often improves

operating efficiency, it only tends to reduce pricing competition once an industry subsector has become highly

concentrated. In earlier stages of consolidation, price competition is often exacerbated by the development of a

two-tiered industry structure, where larger consolidators benefit from economies of scale. Their improved operating

efficiency allows them to compete on price against smaller second-tier survivors (that are forced to compete by

discounting). While these competitive dynamics are often very positive for consumers as it drives prices down, it is

negative from the perspective of bond and equity holders as it erodes profitability and debt coverage. Internationally,

exceptions to this higher risk industry profile can sometimes occur in certain developed country markets--particularly

those with small or mid-sized populations, where the domestic industry is highly consolidated--and market size may

not be attractive to large foreign operators. This is true, for example of the Australian and New Zealand supermarket

industries, which have among the most favorable operating environments in the world.

In rapidly industrializing developing countries, the retail industry's growth prospects are significantly stronger than in

the developed world, driven by higher economic and demographic growth. These dynamics create rising disposable

incomes and the expansion/penetration of Western style consumerism into traditional sectors of the economy.

Companies operating in the retail sector have a fairly wide dispersion in their business risk profiles dependent on:

The industry subsector in which they operate;

Their competitive positions within a subsector; and

The price segment served.

Industry subsectors

The retail industry is composed of various subsectors, with many similarities in their profiles, but also some significant

differences. Subsectors types that have similar traits, and compete directly with each other for the consumer wallet,

can be grouped together for purposes of industry risk analysis. In North America, we group the following subsectors

together for analytic purposes:

Supermarkets, pharmacies, and convenience stores;

Department stores, general merchandise discounters, and apparel stores; and

Nonapparel retailers (including electronics and appliances, home improvement/hardware, furniture and

housewares, books, music, hobbies, sporting goods, and other specialty goods and services).

The effect of cyclicality is the main risk differentiator between subsectors. Retailers selling staples, such as

supermarkets and pharmacies, are less susceptible to economic downturns than are retailers in home improvement,

appliances and apparel, where consumer purchases can be postponed when economic times become tougher.

In all subsectors, sales growth and volume are critical to profitability, because of the high fixed cost base and property





intensity of these businesses (i.e., high operating leverage). The need to invest in new stores, undertake costly

renovations of existing properties to maintain existing sales, and expand geographically to drive sales growth makes

the business capital- and borrowing-intensive. Outdated and/or poorly maintained stores are susceptible to material

sales erosions.

Industry strengths:

Pivotal role of the retailing sector and consumerism in the economy;

Rapid industrialization of China, India, Eastern Asia, and the old Soviet Block countries spurring global retail

demand, and overseas growth opportunities;

Development of much-improved operating supply & inventory management capabilities, which has lowered costs,

inventory, and working-capital risk;

Availability of consumer finance in developed markets, spurring demand;

Advent of low-cost, high-quality goods from emerging industrial countries has stretched the consumer dollar in

developed countries, helping spur consumer demand;

Consolidation in various subsectors (e.g., home improvement, electronics, and books) has created significant

leverage over suppliers, economies of scale, and strong national retail name brand recognition; and

Internet shopping provides a new high-growth distribution channel for traditional retailers.

Industry challenges/risks:

Intense price competition in many subsectors in the developed world;

Maturing population means slowing demand growth in many developed countries;

Cyclicality of demand tied to economic, consumer, and housing cycles;

Overbuilt retail space in many developed markets;

Seasonality and fashion risk;

High consumer leverage in a growing number of major developed countries will likely crimp credit-driven growth

for the foreseeable future--credit expansion/low interest rates have been a mainstay of retail sector growth in many

developed markets in recent years; and

Rapid growth of on-line shopping may erode traditional store sales demand, exacerbating retail space overcapacity,

and undermine competitive position of traditional retailers that have not develop profitable on-line capabilities.

Keys To Competitive Success

As part of our industry analysis, we identify the keys to success that are typical for a company in a given industry. We

consider the following factors to be primary drivers of business success in the retail industry:

Size; strong relative market share and position;

Geographic diversity of earnings, regionally and/or internationally;

Presence in higher-growth segments, markets, or regions;

Store sizes and appeal (efficient square footage, locations, layouts, and merchandizing);

Well-established franchise, with strong retail brand loyalty;

Operating efficiency, with effective management information systems, logistics/supply management, inventory

controls, and efficient buying programs;

Portfolio of profitable private-label products;

Development of strong on-line shopping capabilities and distribution channels;

Effective marketing programs;





History of successful repositioning to deal with competitive, demographic, fashion, product, and technology

changes;

Proven track record in profitably executing acquisitions; and

Financial strength.

3. Company competitive position

In analyzing a company's competitive position, we consider the following:

Market position and share;

Actual and target client demographics;

Brand and customer value proposition;

Store locations, appeal, layout, and merchandizing;

Competition;

Operating strategy, capability, performance, and efficiency;

Distribution and marketing;

Extent of diversification and concentrations;

Management evaluation;

Business risk appetite and record of growth strategy;

Governance and other corporate culture and organizational considerations; and

Earnings and profitability, volatility of earnings and cash flows.

Market share. Size alone does not ensure profitability and growth. However, in retailing, high market shares allow

companies to spread out costs and enjoy more economies of scale than their competitors. It influences a company's

ability to purchase goods and reorder fast-moving lines cost effectively. It can provide economies of scale in

distribution, advertising, overhead, and information systems. Market share leadership creates clout with suppliers. Size

is often closely correlated with, and is an outgrowth of, diversification. To achieve greater size, companies usually need

to operate across multiple geographies. Smaller and medium sized operators will usually be precluded from reaching

the highest ratings levels despite having strong profitability and solid financials characteristics because of lack of

product, segment, and geographic diversification. International operators usually have stronger diversification and

economies of scale.

Diversification. We view diversification in terms of geography: Retailers generally are not diversified across

subsegments. Rather, their concentration in one subsector tends to create a concentration of risk to cyclicality and

competition in that sector.

Regions may be in different stages of the business cycle, and experience different severity of cyclicality, with

downdrafts in some areas offset by upswings in others. A company's ability to tailor strategies to the needs of local

markets and to manage foreign exchange risks also is important. Diversification across different national markets is

also critical because there are different levels of market maturity and growth opportunities; there are risks associated

with a given national jurisdictions (particularly in the emerging markets); and there are differing levels of

competitiveness and profitability in different national markets.

Operating efficiency and flexibility. Retail companies must accommodate a high level of fixed and semi-fixed costs

(including payrolls). For example, stores face ongoing costs such as property taxes, insurance, depreciation and

amortization, interest, rent, and equipment leases. In addition, for a store to be operational, a minimum level of labor is

necessary. Thus, a portion of a facility's labor costs can be viewed as fixed (of course, incremental labor may be added

as business activity grows). Once revenues pass the breakeven point, however, a substantial percentage of incremental





revenues typically become profit. This is operating leverage. Putting pressure on vendors for better terms can be an

effective way to hold down operating costs. The percentage of inventory that is "vendor financed" can be a good

measure of cost efficiency. This metric is calculated by dividing accounts payable by inventory. Other traditional

measures of operating efficiency include inventory days-on-hand and the size and frequency of inventory write-downs.

Reducing in-store labor, damaged merchandise, and workers' compensation costs are key to lowering overall costs.

Effective management information systems with up-to-date technology help ensure better control over daily

operations, including labor scheduling. These systems improve the relationship between vendor and retailer by

enabling electronic data interchange, and reducing inventories. This helps speed orders and reorders for most basic

goods by quickly pinpointing which merchandise is selling well and needs restocking. It also identifies slow-moving

inventory that needs to be marked down, making space available for fresh merchandise.

In merchandising and buying, we believe there is no single best way to maximize efficiency. There are a variety of

approaches, from centralized buying to team buying to autonomous purchasing. The key is to use the chosen approach

successfully, be nimble enough to mix approaches when necessary, and recognize when a change needs to be made.

On-going systems investments continue to be a priority for all retailers. To remain competitive, it is critical for retailers

to invest in inventory management and point-of-sale systems to improve the flow of merchandise into stores (i.e.,

inventory replenishment), to better match product mix and brands with consumer tastes and preferences in local

markets, and give customers broader payment options.

Managing capital. Retail companies must regularly re-invest in their properties, or build new properties to continue to

attract customers, so the industry is capital intensive. Investment beyond normal maintenance spending is required to

periodically reinvigorate a property, especially in more competitive markets.

Capital intensity is a limiting ratings factor for retailers. This issue gives rise to a substantial amount of credit risk

because management teams must plan capacity additions well in advance of new facility availability. When coupled

with demand that is often linked to economic growth and therefore inherently difficult to forecast, retail companies can

report wide variations in operating performance during the business cycle.

Property development and refurbishment expertise. We view a company's renovation and development experience as a

key competitive competency and advantage, considering the property risk and capital intensity inherent in the sector

and the need to maintain an updated property portfolio.

Inventory selection and merchandising. Selecting products that appeal to consumers' taste is key to attracting high

consumer traffic, as is promoting product by developing strategies for effective display and publicity. Introduction of

new items and moving into new categories and price points can reinvigorate sales and image. However, stocking

merchandise and assortments that differ from customers' expectations or image of the store can bring problems.

Management. Management is assessed for its ability to run and expand the business efficiently, while mitigating

inherent business and financial risks. Retailing is a highly competitive business requiring experienced and successful

management teams with a strong mix of the following disciplines:

Marketing and brand management;

Maximization of property cash flow;

Operating efficiency and cost control;

Customer service quality;





Labor relations and employee training;

Asset, property, and project management;

Value creation, and appealing prices, quality, and shopping experiences;

Experience in successfully identifying, executing, and integrating acquisitions;

Local government, zoning board, and regulatory relations management; and

Capital access necessary to create and maintain property portfolios, and successfully manage leverage levels.

4. Profitability

Profitability is critical for retailers because of the need to fund investment in the business, and in making acquisitions.

Profit potential is a critical determinant of credit protection. A company that generates higher operating margins and

returns on capital also has a greater ability to fund growth internally, attract capital externally, and withstand business

adversity. Earnings power ultimately attests to the value of the company's assets, as well. In fact, a company's profit

performance offers a litmus test of its fundamental health and competitive position. Accordingly, the conclusions about

profitability should confirm the assessment of business risk. Profitability measures include the following ratios, which

need to be compared with both those of other participants and of rated entities in other industries:

Pretax, pre-interest return on capital;

Operating income plus D&A as a percentage of sales; and

Earnings on business segment assets.

Return on capital measures the underlying efficiency of invested assets and can be a leading indicator of long-term

survival. This profitability ratio is indifferent to the mix of debt and equity in a company's capital structure, facilitating

the comparison of one company to another.

Part 2--Financial Risk Analysis

Having evaluated a company's business risk, the analysis proceeds to several financial categories. The company's

business risk profile determines the financial risk appropriate for any rating category. Financial risk is portrayed largely

through quantitative means, particularly by using financial ratios.

We analyze five risk categories: accounting characteristics; financial governance/policies and risk tolerance; cash flow

adequacy; capital structure and leverage; and liquidity/short-term factors. We then determine a score for overall

financial risk using the following scale:

Table 3

Financial Risk Measures

Description Rating equivalent

Minimal AAA/AA

Modest A

Intermediate BBB

Aggressive BB

Highly leveraged B

A major goal of financial risk analysis is to determine the quality of a company's cash flow, which influences its





continued access to capital. An integral part of this analysis is also to evaluate the debt structure, including the mix of

senior versus subordinated, fixed versus floating debt, as well as its maturity schedule. It is also important to analyze

and form an opinion of management's financial policy, accounting elections, and risk tolerance. Using cash flow

analysis as a building block, the analyst can then evaluate a company's liquidity profile. While often closely related, the

analysis of a company's liquidity differs from that of its cash flow, as it also incorporates the evaluation of other

sources and uses of funds, such as committed undrawn bank facilities, as well as contingent liabilities (e.g., guarantees,

triggers, regulatory and legal settlements).

1. Accounting characteristics

A critical first step in evaluating a company's risk profile is to form an understanding of, and an opinion about, a

company's accounting consistency, strategies and policiesand related implementation processes. Financial

statements and related notes are the primary source of information about the financial condition and performance of a

company. We also focus on the following areas:

Analytical adjustments and areas of potential concern;

Significant transactions and notable events that have accounting implications;

Significant accounting and financial reporting policies and the underlying assumptions; and

History of nonoperating results and extraordinary changes or adjustments and underlying accounting treatments,

disclosures, and explanations.

2. Financial governance/policies and risk tolerance

The robustness of management's financial and accounting strategies is a key element in credit risk evaluation. We

attach great importance to management's philosophies and policies involving financial risk. Transactions involving

high debt levels may place a heavy burden on the company's cash flow and liquidity. Therefore, an evaluation of

management's ability and commitment to managing debt leverage in line with a rating is an important consideration.

Companies' financial accounting strategies and track records are critical to understanding the intent and risk appetite

and profile of management, and can be a material negative rating factor in instances where over-aggressiveness and

imprudence are evident. Understanding management's strategy for raising its share price, including its financial

performance objectives, e.g., return on equity, can provide invaluable insights toward its financial and business risk

appetite.

3. Cash flow adequacy

Cash-flow analysis is the single most critical element of all credit rating decisions. Although there usually is a strong

relationship between cash flow and profitability, many transactions and accounting entries affect one and not the

other. Analysis of cash-flow patterns can reveal a level of debt-servicing capability that is either stronger or weaker

than might be apparent from earnings.

Cash flow ratios. Ratios show the relationship of cash flow to debt and debt service, and also to the company's other

financing needs. Because there are calls on cash other than repaying debt, it is important to know the extent to which

those requirements will allow cash to be used for debt service or, alternatively, lead to greater need for borrowing:

Funds from operations/total debt (adjusted for off-balance-sheet liabilities);

Debt/EBITDA;

EBITDA/interest;





Free operating cash flow + interest/interest;

Free operating cash flow + interest/interest + annual principal repayment obligation (debt-service coverage);

Total debt/discretionary cash flow (debt payback period);

Funds from operations/capital spending requirements; and

Capital expenditures/capital maintenance.

Careful assessment of free cash flow and debt service burden is particularly important for speculative-grade

acquisitions, because of the near-term vulnerabilities arising from either aggressive leverage and/or weaker

competitive positions. The results of these ratio calculations should not be viewed exclusively on a standalone basis.

For example, retailers with mature portfolios, with static or falling profit margins, may generate what appear to be

healthy levels of net cash because of the lack of growth opportunities that might otherwise require cash to be utilized

in working capital or fixed asset investment. However, the sustainability of such cash flow generation capacity may be

suspect if profit margins are eroding, or are likely to decline over the short or medium term. Conversely, companies

operating in growth markets may generate weak cash flow because of the need to fund growing working and fixed

capital needs, yet be underpinned by improving profit margins and healthy business risk dynamics.

4. Capital structure/asset protection

The following are useful indicators of leverage:

Total debt + present value of operating leases/EBITDAR;

Total debt/total debt + equity;

Total debt + off-balance-sheet liabilities/total debt + off-balance-sheet liabilities + equity; and

Total debt/total debt + market value of equity.

A company's assets and related cash flow mix are a critical determinant of the appropriate leverage for a given rating

level. Assets and brands producing greater cash flow with clear marketability justify a higher level of debt than assets

with weaker cash generation and market value characteristics.

5. Liquidity/short-term factors

The analysis of liquidity and short-term factors are a critical component of all corporate credit analyses. We try to

determine the likelihood that a company might run out of cash and be unable to service its debt. We focus on

assessing a company's ability to meet its financial obligations on an ongoing basis, given the challenges the company

faces in its industry, its competitive position, its earnings and cash flow-generating ability, and its debt-service

requirements. Gradual erosion in a company's fundamentals can ultimately lead to liquidity problems. Yet, even a

company with a solid business position and moderate debt use can, when faced with sudden adversity, experience an

actual or potential liquidity crisis, or an inability to access public debt markets. In considering liquidity, the analytical

context is focused on the downside: the concern is whether the company can meet its obligations on a rainy day,

rather than just under the expected circumstances. Speculative-grade issuers are more susceptible to liquidity crises,

therefore necessitating even tighter scrutiny regarding upcoming interest and principal payments, financial covenants,

and availability on revolving credit facilities. In analyzing liquidity, we review cash and components, debt maturities,

internal and external sources of liquidity, and management strategy for ensuring adequate liquidity.

The starting point of any liquidity analysis is looking at how much cash is on the balance sheet relative to the

company's needs. This includes cash in the bank, cash equivalents, and short- and long-term marketable securities. It is





also important to identify the company's maturity schedule for debt and other long-term obligations. Near-term

maturities include commercial paper; sinking fund payments and final maturity payments of long-term debt;

borrowings under bank credit facilities with approaching expiration dates; and mandatory redemptions of preferred

stock. Other significant financial obligations may also need to be considered--for example, lease obligations,

contingent obligations such as letters of credit, required pension fund contributions, postretirement employment

payments, and tax payments. Even when analyzing highly creditworthy companies, it is necessary to be aware of the

overall maturity structure and potential for refinancing risk.

External sources of funding. In terms of the need for external financing, some retail subsectors are more working

capital intensive than others. Inventory is the major consideration in a retailer's working capital cycle and short term

financing needs. For example, department stores, general merchandisers, and consumer electronics are very

working-capital-intensive, with the most important seasonal peak representing the inventory buildup for the year-end

holiday season in many countries. Because most operators have sold their proprietary credit card operations in recent

years, accounts receivable financing no longer represents an important call on funds as it had for many years. In

cyclical downturns, reduced financing requirements for working capital and capital expenditures temper deterioration

of debt leverage and cash flow protection measures.





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Research:Relationship Between Business And Financial RisksPart 1--Business Risk Analysis1. Country risk and macroeconomic factors (economic, political, and social environments) 2. Industry business and credit risk characteristics Industry subsectorsIndustry strengths:Industry challenges/risks:

Keys To Competitive Success3. Company competitive position4. Profitability

Part 2--Financial Risk Analysis1. Accounting characteristics2. Financial governance/policies and risk tolerance3. Cash flow adequacy4. Capital structure/asset protection5. Liquidity/short-term factors

Key Rating Factors - Business and Financial Risks in the Retail Industry (1)

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