June Retail Update: Sales Rose In The Retail Sector As The Downside Risk Diminished For Some Companies

Primary Credit Analysts: Diya G Iyer, New York (1) 212-438-4001; [email protected] Robert E Schulz, CFA, New York (1) 212-438-7808; [email protected] Secondary Contacts: Ana Lai, CFA, New York (1) 212-438-6895; [email protected] David M Kuntz, New York (1) 212-438-5022; [email protected]

Table Of Contents
June 2013 Subsector Comments Summary Related Criteria And Research

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June Retail Update: Sales Rose In The Retail Sector As The Downside Risk Diminished For Some Companies
Retail and restaurant-related industry data released through mid-June still supports our view that the retail sector is benefiting--albeit unevenly--from a continued, broader economic recovery. Accordingly, the vast majority of our rating outlooks are stable. Grocery, clothing, furniture, and sporting goods retailers all posted gains for the first five months of 2013. Overall, U.S. retail sales rose 0.6% in May after rising 0.1% in April, declining a revised 0.5% in March and rising a revised 1.1% in February. We expected the increase in May, as the improved stock market and higher house values amid increased demand have offset lingering headwinds (due to the payroll tax increase earlier this year and fluctuating gas prices) for some households. The rise among the types of companies that we rate in the retail sector (excluding the impact of fuel, auto sales, and building supplies) was 0.3% in May (up from a revised 0.2% in April versus a revised unchanged rate in March). The latest available First Data SpendTrend retail dollar volume, an indicator of consumer spending using credit, debit, and check, was up 5.5% year-over-year in May, following a 4.3% increase in April. Supporting our cautiously positive view is year-to-date consumer spending in 2013, which has been slightly up. Consumer confidence was also up in May, reaching its highest level in almost six years. Meanwhile, there has been no further notable progress after the Senate passed a bill that would permit states to collect sales tax on out-of-state internet sales purchases. Overview The economic recovery is continuing and we assume many retail and restaurant issuers will report flat to positive same-store sales growth in 2013, with first quarter results tracking this assumption. Improved stock market and home price values are offsetting persistent high unemployment and higher taxes and contributing to steadily improved consumer spending, which we believe will continue for the remainder of the year. We anticipate continued strong results from discounters and home improvement stores, with flatter spending at department stores and restaurants.

Table 1

Insights From Recent Rating Actions

Company SUPERVALU Inc. Date 5/16/2013 Rating action 'B+' corporate credit rating (CCR) affirmed, stable outlook, 'B-' rating on senior unsecured notes 'B' CCR affirmed, outlook revised to negative from stable 'BB-' CCR affirmed, stable outlook, 'BB-' rating on new notes 'B' CCR assigned, outlook stable Comment U.S. food retailer and wholesaler refinancing a portion of its $1 billion 8% senior unsecured notes due 2016 and amending and restating the existing $1.5 billion term loan due 2019. Outlook revision due to performance below our expectations amid weak family dining demand. Company proposed a $700 million notes issuance to refinance its existing senior notes. New specialty apparel retailer with thin credit protection metrics but potential for continued operational enhancements under new management.

P.F. Changs China Bistro Inc. Ingles Markets Inc. Hot Topic Inc.

5/21/2013 5/29/2013 5/31/2013

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June Retail Update: Sales Rose In The Retail Sector As The Downside Risk Diminished For Some Companies

The majority of our rating outlooks on retailer and restaurant companies remain stable, taking economic headwinds and, in several cases, dividend recapitalizations and share repurchases into account. With a very limited number of companies reporting, comparable-store sales growth in the past month has been in the low- to upper-single-digit percentage for several, with low-single-digit declines for others. Federal and company data tracking activity released through mid-June generally aligned with Standard & Poor's Ratings Services' current full-year 2013 assumptions for consumer sentiment and consumer spending (see table 2). As a result, we expect continued monthly sales volatility to result in flat-to-slightly positive profit growth in 2013 for many retailers and restaurants.
Table 2

Recent Data Versus Standard & Poor's Economic Outlook

2013 (% change) Real GDP(1) Consumer sentiment(2) Consumer spending Core CPI (Levels) Unemployment rate S&P 500 Index Crude oil ($/bbl, WTI) Housing starts (mil.) Unit sales of light vehicles (mil.) 7.8 7.8 7.7 7.5 7.1 7.9 1,498 97.65 0.89 15.4 7.7 1,514 92.03 0.92 15.3 7.6 1,569 97.24 1.04 15.2 7.5 1,598 93.22 0.85 14.9 7.4 1,588 92.04 1 15.6 6.7 1,672 89.33 1.29 16.2 1.8 1.7 2.9 2.2 3 1.6 4.7 2.1 3.9 2.2 Q4 2012 0.4 Q1e 3.3 Q2e 1.8 Q3e 5.0 Actual Q4e 13-Jan 13-Feb 13-Mar 13-Apr 2013e 2014e 5.2 73.8 0.2 0.3 77.6 0.7 0.2 78.6 0.2 0.1 76.4 (0.20) 0.1 2.5 85.8 2.6 1.9 3.2 87.6 3 2.2

1,418 1,515 1,575 1,585 1,600 88.17 94.35 90.57 88.78 89.65 0.9 15 0.91 15.1 0.98 15.1 1.07 15.7 1.14 16.2

(1)Figures released quarterly. (2)Annual forecasts only. e--Estimate.

In our base-case, the difficult economic and political environments in both the U.S. and Europe support low but positive same-store sales increases for most rated issuers. However, there are exceptions, including some casual dining operators due to pressure from value-seeking customers. A recent modest uptick in gas prices in recent weeks (see chart 1) could remind the consumer to remain cautious and in our view remains a greater challenge for the retail sector than for the auto or housing sectors. However, we note that stock market indices have approached all-time highs recently, which could help support luxury retailers' sales.

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June Retail Update: Sales Rose In The Retail Sector As The Downside Risk Diminished For Some Companies

Chart 1

Demand (as measured by the U.S. Census Bureau's advance monthly sales data) remains fairly weak (see chart 2). Generally, advance monthly sales have not grown more than about 1% month-over-month since 2009; recent expansion has generally been less than 1%.

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June Retail Update: Sales Rose In The Retail Sector As The Downside Risk Diminished For Some Companies

Chart 2

We see no changes to competition for the consumer dollar across discretionary goods, supermarkets, casual dining, and transportation. Many discounters continue to focus on and expand their grocery segment to drive traffic. The consumer's sharper focus on value, which developed during the great recession, does not seem to be abating. The back to school season is one of the next upcoming key seasonal selling periods in 2013. Recent shopper traffic trends are shown in chart 3.

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June Retail Update: Sales Rose In The Retail Sector As The Downside Risk Diminished For Some Companies

Chart 3

June 2013 Subsector Comments

Apparel/Department Stores/Discounters
Apparel: Many companies could post positive same-store sales, supported by on-trend product offerings and improved consumer sentiment. In addition, more favorable commodity prices (especially for cotton) are helping sales compared with the second half of 2012. As a result, margins improved meaningfully for those companies that were most affected by the 2011 commodity price hike. We believe that operating performance and credit protection measures for specialty apparel retailers will likely be stable to somewhat positive in 2013. Department Stores: Moderate department stores demonstrated fair performance over the past year, and we expect results will continue to be positive, though diminished, over the next 12 months. This is due to the weak economic recovery coupled with persistently high unemployment and a higher tax burden. Most moderate department stores demonstrated either stable or slightly positive performance in part due to good merchandising and improved execution. We believe this translated to positive same-store sales, strong omnichannel revenue growth, and modest margin expansion. Still, a cautious consumer and increased competitive pressure from peers and off-price retailers could hamper a recovery. Upscale retailers tended to outperform their mid-tier peers over the past year as luxury consumers opened their wallets based on the solid performance of the capital markets. We expect some further growth over the next year, but we do not expect results to be as strong as they were in 2012.

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June Retail Update: Sales Rose In The Retail Sector As The Downside Risk Diminished For Some Companies Discounters: The performance of the U.S. discount retailing sector depends on the cautious consumer. Based on the slow pace of the economic recovery, we expect sales growth to moderate in 2013 compared with 2012. Even big box discounters could report slower same-store sales growth in the 1% range. The consumables and food categories led sales growth as their core customers focus more on necessities and less on discretionary items. Demand for discretionary items remains weak and highly promotional, but tight inventory management and positive sales leverage contributed to a relatively stable level of profitability. Dollar stores remain the fastest growing segment of the retail industry.

Nonapparel
Automotive Aftermarket: Despite increased new car sales, scrap rates are still relatively low and there are many older cars still in use. Moreover, all of the larger auto parts retailers are growing their store bases and are likely taking share from smaller independent competitors. Our ratings on the auto parts retailers assume that these companies manage stock buy backs around target leverage metrics. We expect overall ratings stability among these three competitors in 2013. Consumer Electronics: Last year was a very challenging year for consumer electronics retailers and we do not expect that dynamic to change. Consumers are purchasing smaller products such as smartphones, tablets, and e-readers and fewer larger ticket items. These smaller items are lower priced and have worse gross margins. Additionally, consumers purchase most audio and visual content online and through discounters, while warehouse clubs have increased their consumer electronic offerings. Due to these factors, we believe specialty consumer electronics retailers will continue to face headwinds in 2013. We also believe they have too much square footage in terms of selling space and are not ideal to meet consumers' tastes and shopping behaviors. Footwear: We expect footwear retailers to post low-single-digit comparable-store sales and flat margins in 2013. Athletic sneaker categories including basketball and running remain among the most popular, while men's and women's dress shoes and apparel, including fitted baseball caps, could deliver weaker results. We continue to see footwear companies move away from lower-margin wholesale lines to focus on profitable licensed brands, while expanding store bases modestly based on the attractiveness of lease terms in malls and strip centers nationwide. We also expect less merger and acquisition activity following the wave of transactions in 2012 in this sector. Home Improvement: We expect positive sales trends in the next several quarters on signs that the recovery in the housing market is holding up and repair and remodeling activities will rise further this year.

Restaurants
We foresee 2013 to be similar to 2012, in that there were rather mixed results from restaurant operators. Generally, restaurants with compelling value offerings fared better. Many consumers strained by prolonged economic weakness have looked for relative values in both the casual dining and quick service sectors of the industry. While we expect a moderate increase in consumer spending in 2013, we do not expect a change in consumer behavior. Therefore, a restaurant operator's success will hinge on its ability to create appealing menu items at relatively low price points, while maintaining reasonable gross margins. In the near term, we expect overall food inflation to be moderate and manageable, but protein inflation, particularly beef, should outpace overall food inflation. Restaurants with a high concentration of protein costs could experience margin erosion and credit quality deterioration.

Supermarkets/Drug Stores/Convenience Stores

Supermarkets: Over the past year, the pace at which discounters and nontraditional food retailers took share from supermarkets seemingly intensified. Many traditional supermarkets made price investments to combat the competition. This led to profit declines and underperformance for some when compared with peers. On the other hand, supermarkets with competitive pricing and strong merchandise assortments that include good private-label

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June Retail Update: Sales Rose In The Retail Sector As The Downside Risk Diminished For Some Companies

programs, solid prepared food offerings, and quality perishables, have performed well and driven higher sales, leading to profit growth. Drug Stores: The increased penetration of generics should result in higher profitability, but lower sales volumes. Still, there is constant reimbursement rate pressure that drug chains are looking to mitigate with cost efficiencies. Convenience Stores: Persistently rising oil prices are a risk to our forecast. Increased oil prices could pressure fuel margins, squeeze consumers' discretionary income, and would likely hurt same-store merchandise sales. In such a scenario, we think convenience store operators have some cushion in financial metrics for their current rating categories to withstand temporary market weakness.

Summary
We expect a further rebound in the U.S. economy. However, some retail segments, including niche non-apparel, restaurants, and certain mid-tier department stores still face greater challenges than others in their abilities to draw in the consumer. We currently assume companies that can benefit from the housing recovery or those that provide a strong perceived value to consumers will have the best fundamentals. The majority of our ratings are in the 'BB' or 'B' category as of mid-May 2013 and credit quality is vulnerable to weak due to lackluster consumer traffic or new product introductions. Several rated companies remain in the 'CCC' category. However, the vast majority of our retail and restaurant outlooks are stable and we assume most speculative-grade issuers will be able to sustain their current credit profiles during 2013 under our base-case.

Related Criteria And Research

May U.S. Auto Sales Growth Remains Consistent With Standard & Poor's Full-Year Estimate For 2013, June 7, 2013 U.S. Economic Forecast: Mother, May I?, May 16, 2013 Industry Report Card: Performance Will Remain Uneven For The U.S. Retail Sector In 2013 As Consumers Remain Cautious, May 14, 2013

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