Retailers need to think policy not just experiences

More 'experiences' won’t help them overcome the macro headwinds.    

It is tough out there …

It is no secret that conditions are tough on the UK high street. High profile restructurings and profit warnings have dominated the headlines and EY’s recent report showed that the profit warnings from consumer services FTSE sectors hit a seven-year high in the first quarter of 2018.

… with less money to go round …

But, as is often the case, the headlines only tell part of the story. There are significant differences in performance between retail sub-sectors. Despite the overall doom and gloom, FTSE food & drug retailers issued their lowest level of profit warnings in a decade in 2017. Supermarkets in particular benefited from higher inflation and the ability to pass on these price increases.

However, with real incomes shrinking, the increase in supermarket prices increased the squeeze on other retail spending. The FTSE travel & leisure sector issued its highest number of profit warnings since the financial crisis in 2017 and this continued into 2018 while several of the general retail sub-sectors also came under pressure – the slowdown in the housing market hit the home improvement sector hard for example.

Source: EY UK Profit Warnings, Q1 2018

… but this is more than a cyclical slowdown …

The argument that this peak in retail profit warnings is cyclical is supported by the fact that there was a similar surge in warnings in 2011, when inflation was also running well ahead of wages and disposable income showed the biggest year-on-year fall since 1981. But, even then, the increased focus of supermarkets on non-food product lines, the rapid growth of online shopping and new digital technologies arguably had the most profound impact, initiating long-term transformation of the sector and the continuing impact of the drivers of structural change can be seen when we dig into the latest data.

The continuing impact of the drivers of structural change can be seen when we dig into the latest data. In 2017, most profit warning activity focused around restaurants and bars, who face an almost perfect storm of economic and structural headwinds. According to the EY ITEM Club, consumer spending only grew by just 1.4% last year and this together with increasing costs in food and labour put pressure on the sector. But the problems in this sub-sector run much deeper. We have seen increased pressure on margins from the growth of home delivery services, which, together with a period of over-expansion as a result of a flow of investment into the sub-sector, has increased supply dramatically, while at the same time putting pressure on the labour market – shortages of chefs are increasingly common. This sub-sector, like others in retail, has also become accustomed to relying on a seemingly never-ending supply of cheap, low-skilled labour. With potential restrictions on migration after Brexit and moves to change labour market regulation, business models are under real stress. This is a structural problem not a short-term cyclical dip.

… we are seeing a retail revolution …

My retail sector colleagues have been talking about the grip of a 'margin vice' for some time now, with retailers squeezed between lacklustre consumer spending growth and rising costs in a highly competitive market. Spending and cost pressures wax and wane, but structural changes brought about by advances in technology and interlinked changes in consumer behaviour are unrelenting and the “margin vice” keeps tightening.

Since 2011, the amount spent online has doubled to almost 20p in every pound. Retailers who built up their business in bricks and mortar have been building their online presence, however, this has typically been done by running the two businesses in parallel. In a shifting market and faced with nimbler, asset-light online rivals it has proven very difficult to compete effectively when operating two platforms.

… led by the shift to 'experiences' …

Retailers are now talking increasingly about re-inventing the high street experience to create new reasons for customers to visit stores. Examples include more and newer in-store restaurant concepts, leisure attractions and opportunities to try new activities. The share of retail floor space allocated to selling goods is falling as a share of the overall footprint.

There is a real risk that the drivers of change are so significant that the shift to experiences adds cost but doesn’t create value. Technology is going to continue to strengthen its grip and many more experiences will be available virtually rather than tied to a specific location. Offering more experiences will potentially increase costs while reducing selling space and also divert customer time from consuming.

… but the solution may be targeting the wrong problem …

Even more significant in terms of impact could be the changes in the consumer market. Much is made of changing consumer preferences and how these can drive future retail activity and hence the need to change the nature of a trip to the high street. However, while this micro-level analysis is relevant, some of the changes are macroeconomic and it is these that potentially pose a more significant threat to retail profits over time.

The labour market has changed dramatically in recent years and wages have not increased at the rate expected given the fall in unemployment. Although the national minimum wage has improved pay at lower income levels, the middle of the income distribution has seen pay growth stall. It seems likely young people will therefore have less disposable income at all ages compared to the previous generation and with labour markets more flexible and many people having student loans to pay off, spending may struggle to grow at rates previously seen.

We are also seeing geographic differences in economic performance. The UK’s larger cities are tending to grow faster than the UK’s smaller cities, towns and remote areas. In smaller towns and cities, retail is often the largest employer and a major source of local economic activity. As retailers restructure and reshape their businesses, it is demand due to a fall in retail employment putting further pressure on retailers and this sets the smaller cities and the towns that bear the brunt and this sets off a vicious cycle with reduced demand due to a fall in retail employment putting further pressure on retailers.

… suggesting more radical thinking is needed …

In the environment described above, it may well become the case that investing in increasing the appeal of stores alone may not pay off and more needs to be done to boost economic activity overall and especially on the high street. From a macro perspective, retailers should be thinking more widely about their strategies and engaging with policy-makers to ensure policy is supportive of strategy. These should include:

• Working through how technology might impact labour markets and hence consumer demand and so what the implications might be for policies to help manage the change such as a basic income model.
• Assessing how Brexit may impact supply chains and labour markets and developing an approach to respond.
• Engaging with policy-makers on economic development at a local and regional level. More experiences alone will not attract sufficient numbers of people into town and city centres. People travel to work as well as to shop and to have experiences, and so retailers need to engage around policy more widely. In addition to driving commercial activity, retailers should also consider how to support more people living on or near high streets, maybe using vacated retail space. Again retailers should be willing to help drive initiatives to increase overall activity.
• Developing approaches to business rates and the taxation of retail generally, both physical and online, that are based upon a wider economic analysis of costs and benefits.

… time for a policy strategy.

The 'experience' concept is clearly an important part of the approach to responding to change in retail markets. But is, at best, a partial solution to a dynamic set of challenges. Retailers need to be more strategic and think about a wider and more sophisticated response to support their long-term transformations.

@MarkGregoryEY

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