Key Rating Factors - Business and Financial Risks in The Retail Industry

ARCHIVE | Criteria | Corporates | Industrials:
Key Credit Factors: Business And

Financial Risks In The Retail Industry
Primary Credit Analysts:
Jerry A Hirschberg, New York (1) 212-438-1000; jerry_hirschberg@standardandpoors.com
Stella Kapur, New York (1) 212-438-1262; stella_kapur@standardandpoors.com
Nicolas Baudouin, Paris (33) 1-4420-6672; nicolas_baudouin@standardandpoors.com
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
THIS WAS PREPARED EXCLUSIVELY FOR USER BARBORA MATOUSKOVA.
NOT FOR REDISTRIBUTION UNLESS OTHERWISE PERMITTED.
SEPTEMBER 18, 2008 1

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

In 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(Editor's Note: This criteria article is no longer current. It has been superseded by the article titled, "Key Credit Factors For The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 Previously, this article was partially superseded.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describing liquidity/short-term factors was partially superseded by the article titled, "Methodology And Assumptions: Liquidity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superseded by "Methodology: Management And Governance Credit Factors For Corporate Entities And Insurers," published on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 Tables 1, 2, and 3were superseded by the business risk and financial risk matrix found in "Methodology: Business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.

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ARCHIVE | Criteria | Corporates | Industrials: Key Credit Factors: Business And Financial Risks In The Retail
Industry
Table 1
Chart 1 summarizes the rating process.

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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
Satisfactory
BBB
Weak
BB
Vulnerable
B/CCC

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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).

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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;

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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

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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;

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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

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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;

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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
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

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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;

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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

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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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ARCHIVE | Criteria | Corporates | Industrials:

Key Credit Factors: Business And

SEPTEMBER 18, 2008 1

ARCHIVE | Criteria | Corporates | Industrials:

Key Credit Factors: Business And Financial Risks

Relationship Between Business And Financial Risks

SEPTEMBER 18, 2008 2

Chart 1 summarizes the rating process.

SEPTEMBER 18, 2008 3

Part 1--Business Risk Analysis

Business Risk Measures

SEPTEMBER 18, 2008 4

2. Industry business and credit risk characteristics

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Intense price competition in many subsectors in the developed world;

Keys To Competitive Success

Size; strong relative market share and position;

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3. Company competitive position

Market position and share;

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Marketing and brand management;

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Labor relations and employee training;

Part 2--Financial Risk Analysis

Financial Risk Measures

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Analytical adjustments and areas of potential concern;

2. Financial governance/policies and risk tolerance

3. Cash flow adequacy

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Free operating cash flow + interest/interest;

4. Capital structure/asset protection

Total debt + present value of operating leases/EBITDAR;

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