The Great Retailer Squeeze: margins under pressure as costs soar and demand softens

High inflation and rising interest rates will keep retail sales depressed in the first half of the year and weigh on retailers’ margins, as headwinds multiply across the UK retail sector in the New Year. Squeezed margins could trigger a fresh wave of insolvencies by the spring, as retailers absorb upward pressure on the cost of goods in the first half of the year while cost of living forces weaken consumer sentiment. However, in the second half of the year, cost inflation is expected to ease as the outlook for retailers brightens somewhat. Retailers’ focus for the year is to optimise operations, costs, and inventory.

UK retail sales were weaker than expected in December, falling by 1% in the month and by 1.3% in Q4, according to Office for National Statistics (ONS) data. December’s drop took sales volumes to 1.7% below the pre-Covid level of February 2020. The weak retail sales data follows a further fall in consumer confidence in January, as indicated by GfK’s Consumer Confidence Index, which dropped three points in January to -45 as pessimism prevails over the outlook for the economy.

In the broader context, the UK economy is enduring the highest inflation and the most widespread industrial action since the 1980s. In addition, retailers must also contend with a very tight labour market, energy and food price inflation exacerbated by the war in Ukraine, and unresolved supply chain disruptions. While annual UK CPI inflation eased for the second consecutive month to 10.5% in December, price pressure remained in double figures since October’s 41-year peak at 11.1%, according to the ONS. Core inflation – which excludes food, energy, alcohol and tobacco prices – remained unchanged at 6.3%. Economists expect the Bank of England to stay on its hawkish footing and keep the base rate “higher for longer”. Tighter financial conditions have markedly increased retailers’ debt servicing costs, many of which exited the pandemic with much higher balance sheet leverage through forced Covid loans to ensure corporate survival.

The great retailer squeeze is compounded by labour market shortages and ongoing industrial action, increasing wage inflation and causing operational disruption. Ironically, retailers reported that postal strikes provided a fillip for the crucial Christmas sales window, as consumers rushed to stores as they were unable to rely on online deliveries. However, this tailwind was uneven as rail disruption and wintery conditions also prevented shoppers from accessing certain retail locations in the last week before Christmas. The threat of ongoing industrial action may also impact retail sales throughout the first quarter.

Across the retail sector, financial resilience runs a broad spectrum. Fast-fashion retailer Asos said delivery market disruption “resulted in earlier cut-off dates for Christmas and New Year deliveries”, which reduced December sales. Asos warned full-year sales for 2023 would be between a £100m loss and flat, with significantly improved profitability and cash generation in H2. However, profitability pressures remain. To turn around its fortunes, the online retailer plans to “renew its commercial model, improve inventory management, simplify and reduce its costs profile, and maintain a robust and flexible balance sheet”. Rival online retailer Boohoo suffered from the Christmas return to physical shops and postal strikes, reporting a 13% decline in revenues to £637.7m in the four months to 31 December. Boohoo forecast revenues will decline by about 12% for 2023, with “cost inflation expected to begin to moderate in the second half of the year”.

Weaker retailers are typically over-encumbered by leverage after the pandemic forced many to take on Covid-era loans to survive the lockdown-imposed demand collapse. In mid-January, Matalan, the discount clothing and homeware retailer, struggling under almost £600m of debt, completed a debt for equity swap with lenders Invesco, Man GLG, Napier Park and Tresidor. The lenders will also inject up to £100m in fresh capital to support the business. However, the Financial Times reports the finalised deal did not have the complete support of Matalan’s founder John Hargreaves who reportedly felt the agreed debt reduction terms remained inadequate. It is a reminder of how highly leveraged some retailers were when heading into the pandemic, and how their debt burden became even greater as they tried to survive. Many more retailers are struggling to return to self-sustainability since the expiry of the Covid loan schemes, as well as loose insolvency rules and the moratorium on tenancy eviction for rental arrears.

Elsewhere, Tesco, Sainsbury’s and Marks & Spencer reported better than expected Christmas sales as people confronted the deepening cost of living crisis by celebrating the holiday season at home. But the momentum has already faded as households focus on repaying credit card bills. Retail activity weakened across the UK after Christmas but remained well above the levels seen a year earlier, according to the ONS. Retail sales are predicted to have contracted in 2022, and further weakness is expected in the year ahead as households absorb the sharpest real earnings contraction since 2009 while higher interest rates and energy and food prices will continue to restrict discretionary spending. Data from Barclays reveals that rising living costs caused an uptick in households to cancel subscription services. Elsewhere, e-commerce giant Amazon announced plans to close three UK warehouses.

The near-term outlook for retailers will be shaped by the confluence of these multiplying headwinds: inflation, borrowing costs, consumer demand, as well as unresolved supply chain disruptions and industrial strikes. Retailer casualties are likely as we head into the spring. For retailers, the message may sound familiar: the sooner you engage advisers to review your business, the greater the resolution options at your disposal.

BTG Advisory is well placed to advise on refinancing, restructuring, a trade sale and insolvency options. Over the first half of 2023, distress in the UK retail sector will present investment opportunities for larger, more resilient retailers, and private equity and hedge funds keen to grow market share as the industry consolidates. Do not hesitate to get in touch with our team today to improve your chances of survival, or if you want to capitalise on the opportunities ahead.