Retail:The finance flowWill money start moving in 2011?

2 Retail

Although the high street has been struggling for some time, the news keeps getting worse, with many retailers recently reporting their worst months on record. The pressures being created by high inflation - particularly in relation to commodity prices - and the rise in VAT and National Insurance contributions have really come through with full force during the spring of 2011, and have materially impacted upon consumer spending, with retailers suffering as a result. According to the latest figures from the British Retail Consortium, UK retail sales values for May 2011 were 2.1% down on a like-for-like basis compared with the same month a year earlier. In particular, food sales slowed dramatically, though other areas such as clothing, footwear and homewares also suffered.

Furthermore, it looks unlikely that conditions will improve quickly: the continuing low interest rates and relative support from the banking sector are still masking a lot of the fundamental structural issues retailers are facing, primarily the significant over-capacity on the high street. As a result, banks will continue to be cautious when it comes to providing funding, especially where new facilities and new relationships are concerned.

But it is not all doom and gloom. Certain strategies, especially those focusing on the online space and those where there are elements of technological innovation, are working well, and the banks and specialised retail lenders, though cautious, will back the businesses with the most robust propositions. There is also significant private equity money available for investment in the sector.

Although there are certainly stormy times ahead for many in the retail space, strong support from the advisory community and sensible strategic planning should help retail businesses plot a course through the turbulence until calmer conditions prevail.

Barry KnightHead of RetailGrant Thornton UK LLP

The retail industry is central to the UK’s economy: it employs in the region of 2.9 million people – 11% of the total UK workforce – and in 2010 UK retail sales stood at over £293 billion. Yet it is clearly facing severe challenges at the moment.

Foreword

Retail 3

During the first quarter of 2011, Remark, the research and publications arm of the Mergermarket Group, carried out a third major survey of mid-market opinion on behalf of Grant Thornton. On this occasion, 200 CEOs and CFOs of UK businesses with turnovers in the £25-250 million range were surveyed. All answers were treated confidentially and have been reported in aggregate. The statistics relating to the retail sector are drawn from a meaningful proportion of this national sample.

About the survey

Foreword 2

Business outlook

Economic conditions hamper recovery 4

Some optimism 6

Funding and strategy

Poor access to capital 8

Specialist lending issues 10

Few big failures 12

Strategies to counter the downturn 14

Closing remarks

In it for the long haul 16

Contact us 17

Contents

4 Retail

Overall, almost a quarter of the survey’s retail respondents believe that the financing environment will deteriorate over the coming year, while a further 30% see no likely improvement (see chart 1). What’s more, a full 50% of those that rated the market as static or declining are not predicting an improvement in conditions until 2013 or beyond, by far the most pessimistic forecast among all the sectors (see chart 2).

Among those retail areas feeling the worst of the effects are businesses focusing on the sales of higher value items such as cars, furniture and carpets, and certain electrical goods. In contrast, the retailers of essentials – ie supermarkets – have fared better, as have DIY chains.

In many respects this is understandable. To begin with, immediately prior to the survey being carried out the worst winter

Of all the respondents to the national survey of mid-market businesses carried out during the first quarter of 2011, those active in the retail sector clearly shared the most gloomy outlook on the UK economy and the prevailing financing environment.

Economic conditions hamper recovery

Business outlook

in generations had severely impacted upon trading during the sector’s most important period of the year, and this contributed to the surprise contraction in the overall economic growth figures for the fourth quarter. If one adds to this the cumulative effects of the VAT rise and inflationary pressure brought about by the rising cost of fuel and many key foodstuffs, it is understandable that retailers might not be as sanguine as those in other industrial areas. The most recent consumer confidence figures certainly back up this bleak outlook, with a sharp decline in the latest figures published at the end of May 2011 by the Nielsen Company and the British Retail Consortium (BRC).

50%

31%

19%

0%

Retail 5

Improving

Deteriorating

Static

Chart 1 – How do you see the financing environment developing in the next 12 months?

2013 or later

H2 2011

H2 2012

H1 2012

Chart 2 – If you selected Static or Deteriorating, when do you believe the environment will become more favourable?

30%23%

47%

6 Retail

Business outlook

Expert comment:

Stephen RobertsonDirector General British Retail ConsortiumHouseholds’ disposable incomes continue to be squeezed by uncomfortably high inflation and low wage growth, while uncertainty over the effects of government cuts is hitting consumers’ sentiment about future finances.

The VAT rise since last year is flattering the sales figures for most non-food goods, while renewed weakness in the housing market made life particularly difficult for retailers selling furniture and household goods. This new evidence of weak spending shows how important it is to support this soft patch in the recovery by keeping interest rates low.

Case study:

kiddicare.comToday, Peterborough-based kiddicare.com is the UK’s leading specialist online retailer of baby products, though its origins are firmly in traditional retail, having been founded in 1974 by Neville and Marilyn Wright. In 2000 the company began its move to online by developing a proprietary technology platform from which to grow its business. This strategy has led to major growth in recent years – the business has grown by 75% in the past three years alone – and kiddicare.com now generates over 80% of its £37.5 million turnover online.

In late 2010, when kiddicare.com’s founders decided to seek a succession solution for the business, Grant Thornton’s Corporate Finance team was mandated to run what became a highly successful and fiercely competitive sale process. In February 2011, the company and the rights to its highly regarded technology platform were sold to Wm Morrison Supermarkets plc for £70 million, representing a first step for Morrisons in developing its online business.

According to Tim Hansell, Corporate Finance Director at Grant Thornton: “kiddicare.com is a high quality business which attracted significant interest from a broad range of strategic trade and private equity buyers, with around 20 indicative bids being received for the business.” Mike Hughes, Corporate Finance Director at Grant Thornton, adds: “This process has provided further evidence that strategic trade buyers are very definitely back in the retail M&A market. Businesses such as kiddicare.com, with a strong buyers’ brand name, a scalable technology platform and significant operating capacity, can expect to continue to be top of buyers shopping lists in the months ahead.

Retail 7

In addition, there was some relief for the sector during April 2011, when fine weather combined with multiple public holidays and the ‘feel good factor’ created by events such as the Royal wedding combined to drive retail sales upward. However, as the BRC has warned, this is unlikely to be representative of retail growth trends in the short-term, which are more likely to be driven by the negative reactions of consumers and retailers to developments in the wider economy.

47% of respondents believe that the funding environment will improve over the next 12 months, while 50% of those that rate the short-term prospects as static or deteriorating expect some improvement in conditions at some point during 2012.

Certainly anecdotal reports suggest that a number of areas within the retail landscape are faring better than others. Online sales in particular are forecast to grow more significantly than those in the high street. According to recent figures from the BRC, while online, mail-order and phone sales slowed in May of this year, growth was still running 10.4% above the same month in 2010. Similarly, there have been some notable success stories among retail businesses with a high IT element or other areas of innovation.

The statistics coming out of the survey do also show some cause for optimism.

Some optimismCreated in 1997 lookfantastic.com specialises in the sale of salon hair and high-end beauty products for both men and women, stocking over 12,000 lines in total. However, the Sussex-based business is no ordinary e-commerce operation: it emerged out of the Crown’s Salon Group, a family-owned chain of franchised hair salons, which since 1992 has also operated a programme to train hairdressers to NVQ Levels 1–3. The programme has trained over 2,000 hair stylists to date.

And these origins have played an important part in fuelling the company’s strong growth in the online space. The network of salons across London, Sussex and Kent – as well as the training programme with its strong social responsibility angle – had proved attractive to many high-end salon and beauty brands and enabled the business to build up the highly-successful online side.

In late 2010 the founders of lookfantastic.com, advised by Grant Thornton, sold the business to the rapidly growing retail company The Hut Group in a deal backed by its existing private equity investor Balderton. For the founders, the move represented an important opportunity to take lookfantastic.com into a new phase of growth along as part of an ambitious and rapidly expanding retail group. For The Hut Group, the acquisition dovetailed well with its aim of penetrating the luxury goods and health and beauty markets in general, as well as consolidating its position in the online retail space.

Case study:

Lookfantastic.com

8 Retail

Funding and strategy

Poor access to capital

In total, 60% of retail respondents rate the banks as being more conservative now than they have been over the past 12-18 months, and a further 13% see no change. By comparison, if all sectors are taken into account, less than 40% of respondents rate the banks as more conservative. In contrast, only 27% of respondents are seeing any improvement in banks’ appetite to lend (versus 38% of the whole sample).

One issue that came through clearly from the survey is that compared to their peers in other sectors, mid-market retail businesses are facing especially tough conditions when it comes to accessing bank funding.

Banks are more conservative

No change

Banks are less conservative

Chart 3 – Compared with the last 12-18 months how would you describe banks’ current appetite for UK mid-market lending?

27%

13%

60%

The extent to which lenders will place high demands on retail businesses seeking funding is graphically demonstrated by Chart 4. Questioned about the main focus of banks’ attention, cash flow remained the key measure, as it had across all sectors. However, for retail respondents it is cited in almost every single instance, compared with 66% of responses across the whole sample. What is more, the differential between the whole sample and retail respondents is uniformly higher across the various key metrics, from cash flow to business plans and historical earnings, suggesting that retail businesses looking to raise capital are much more likely to have to tick all the boxes for banks to take notice.

Chart 4 – Based on your experience over the past 12 months, what are banks looking for in mid-market businesses?

Retail

Overall

90%

57%60%

43%

66%

39% 38% 37%

Retail 9

Strong cash flows Clear business plans Historical earnings quality

Sector conditions

Expert comment:

Charles LamplughLead Relationship Director – Retail Lloyds Banking GroupLife as a lending banker is not easy at the moment. Trading is very challenging and many retailers are behind budget. The key for both the banker and the retailer is communication and, to use the trust that has been built up through the relationship. We know that businesses will be behind plan but together we need to work on a revised plan which, if it takes a few weeks to put together so be it. We want it to be workable as we are all in this for the long-term.

10 Retail

This is further reflected by the results of the survey, which show that over 50% of retail respondents have banked with the same lender for over five years (and almost 90% for three years or more).

Funding and strategy

Chart 5 – For how long has your current debt provider been providing you with debt finance?

Retail

Overall

At one level, this indicates that it has been difficult for retail businesses to form new banking relationships for a number of years. But it is also a reflection of the often highly specialised nature of the

Specialist lending issuesThe fact that retail groups are finding the lending environment difficult is not a new phenomenon – the banks have treated the retail sector with considerable caution for some time now.

0%

<1 year

7%

1 to 3 years 3 to 5 years >5 years

12%

28%35%

31%

54%

33%

financing tools that are employed within the retail sector. To a significant extent this complexity centres around the fact that much of the capital needed by retail borrowers is held off balance sheet because of the nature of leasehold arrangements. In addition, there are other areas of lending tailored to the sector such as foreign exchange facilities and trade insurance.Expert comment:

Tim HansellDirector, Corporate Finance Grant Thornton UK LLPNotwithstanding the current weakness in consumer confidence, investor appetite still remains high to provide equity funding to support growth in certain niche fast-growing segments of the UK retail sector, such as online retail.

With the ongoing channel shift from the high street to online continuing to build momentum, this is underpinning future growth potential for a number of niche online retailers, notwithstanding the current economic backdrop.

However, lenders are still cautious about providing leverage to ‘new to bank’ retail customers, and leverage multiples in retail/online transactions continue to be conservative, particularly where the off balance sheet rent roll is significant.

Funding for retail deals continues to be challenging, and presenting well-thought-through business plans that will stand up to the rigours of lender credit committees is more important than ever.

Retail 11

Among the handful of high-profile groups to have ceased trading in recent years are music retailer Zavvi, Whittard of Chelsea, the Officers Club, Woolworths and MFI. But of course there are other potential candidates out there: despite battling hard to fight the conditions, retail groups such as HMV are still facing real challenges to survive intact as high street sales of CDs, DVDs and games have lost ground to online competitors.

Expert comment:

Barry KnightHead of Retail Grant Thornton UK LLPConditions for many retail businesses have undoubtedly been tough in recent years and look likely to remain so for some time. However, there are several tools that, with the correct advice, can be employed to ease the pressure. To begin with, working capital constraints can be improved by the better management of creditor payments, employing ‘creditor stretch’ tactics, while Time To Pay (TTP) arrangements can be tailored by HMRC to suit the ability of the retailer to pay its tax bills. Developments in asset-based lending also mean that there may be a viable alternative to traditional cash-flow-based lending for some retail companies. Meanwhile, for businesses already in difficulties, Company Voluntary Agreement (CVAs) and debt for equity swaps can both be brought into play as part of a rescue plan.

Few big failuresDespite the obvious problems retailers are having securing funding, as well as the deteriorating consumer confidence and pressure on disposable incomes, there have actually been relatively few major failures.

12 Retail

Funding and strategy

One noticeable difference, though, is in the responses surrounding cost cutting strategies: as it is across the whole sample, cost cutting is the third most important strategy for retail respondents. However, it is interesting to note that it was flagged by a significantly smaller percentage of retail respondents (33%) than overall (49%). Underlying this is the fact that, for many retail businesses, cost cutting is not a realistic strategy: rent, rates and staffing costs are typically the most significant outlays, and retailers are restricted in the ways they can reduce their spending in these areas (minimum wage regulations, long-term lease contracts, etc). Furthermore, given that

the conditions for retail companies have been sub-optimal for some time now, many of the ‘firefighting’ measures have already been put in place and firms are already likely to be following sophisticated best practice models in areas such as supply chain management.

Chart 6 – Do you expect to complete any significant transactions over the next 12 months?

Retail

Overall

Yes

No

40%

60%

59%

41%

Strategies to counter the downturnAccording to the survey, the main strategic priorities for retail respondents are largely in line with those of their peers across other sectors, with a strong focus on building earnings and growing market share.

Retail 13

Expert comment:

Stephen BakerPartner, Corporate Finance Grant Thornton UK LLPGiven that many retailers have already worked through cost cutting actions, more dynamic strategies may be required to counter the continuing downturn and drive growth. As well as driving online capability, options to widen product offer or add selective contribution enhancing locations, whether organically or via acquisition, should be considered, albeit financing such actions will need compelling arguments and creative solutions.

The survey also provided little evidence to suggest that retail businesses are likely to try and acquire their way out of the downturn, with M&A ranking low on the list of priorities. In total, only 15% of retail respondents cited consolidation and M&A as being a high priority, compared with 22% of the overall sample. Nevertheless, some 40% of retail respondents expect to complete a significant transaction over the next year, suggesting that M&A activity might come onto the radar on an opportunistic basis for well-funded businesses.

Expert comment:

Mike HughesDirector, Corporate Finance Grant Thornton UK LLPIn the last six months we have seen one or two ‘stand-out’ M&A transactions, such as Wm Morrison Supermarkets plc’s £70 million acquisition of kiddicare.com. This opportunity attracted a significant number of trade offers from both the UK and overseas, and also a high level of interest from the private equity community. The final price and deal multiple was driven by the quality of the opportunity and the strong strategic rationale for the buyer. Overall, in terms of M&A the online space with its ability to scale quickly and capture market share from the high street appears to have fared better than traditional retail businesses.

14 Retail

Interestingly, out of the survey sample, retail sector companies are among the least likely to have explored the potential for raising capital from alternative funding providers to support their growth strategies. But opportunities do exist, especially from within the ranks of private equity backers both in the UK and further afield. Among this type of institution there is a long track record of supporting the retail sector, particularly in niche areas of the industry or where there is the potential to generate scale in an otherwise fragmented market. It is therefore likely that a good proportion of the M&A activity within the UK retail area will be linked to or funded by private equity backed businesses.

66%

0%

No, but under certain circumstances we would

Yes, and we now use alternative sources of finance

Yes, but we decided against it

Chart 6 – Have you explored alternative sources of finance?

34%

Funding and strategy

Retail 15

Expert comment:

Mo MeraliHead of Private Equity, Grant Thornton UK LLPPrivate equity has been a consistent supporter of the retail sector and has reaped huge rewards from backing high quality businesses in the past. More recently, however, the record has been somewhat mixed, with the double-whammy of the consumer recession and over-leveraged businesses leading to some high-profile failures. Notwithstanding this, we have seen significant private equity interest in the sector-focused on businesses with robust propositions – typically those in a unique market position such as HobbyCraft. The winners – both investors and businesses will emerge from those who are willing to embrace innovation and technology in their business model as well as their approach to the consumer.

Case study:

HobbyCraftHobbyCraft, the UK’s leading art and craft retailer, was established in 1995 by Warren Haskins, who had recognised the potential for launching an art and craft superstore in the UK after having investigated the well established hobbies and crafts market in the US. By 2010 the company had built up a network of 47 out-of-town stores throughout the UK, each of which carries over 35,000 products and caters for more than 250 different art and craft activities.

When the time came for the group’s management team to look at options to realise their investments in the business, the potential upsides of a sale to private equity backers were clear: a well-funded financial backer with strong international reach would offer not just the funding, but also the strategic expertise and contact network necessary to take the company into its next phase of growth.

Grant Thornton worked closely with HobbyCraft throughout the disposal process, which was concluded in April 2010 when funds advised by pan-European mid-cap specialist Bridgepoint Capital acquired the firm in a deal worth over £100 million. Importantly, the founder and management team were given the opportunity to reinvest in the company going forward.

Commenting on the deal, Paul Stout of Grant Thornton said: “HobbyCraft is a unique business which has gone from strength to strength and has defined the market for arts and crafts in the UK. The success and size of the deal with Bridgepoint Capital is testament to the entrepreneurship and drive of Warren Haskins and the management team, and we have thoroughly enjoyed working with them throughout the process.”

16 Retail

But many will not make it: the latest figures from the Insolvency Service on the administration of wholesale and retail companies in Q1 2011 show a 70% increase over the previous quarter and an 11% rise over the same quarter of 2010. However, there are options out there, both in terms of strategy and funding, and it is more important than ever that retail businesses seek the best advice

In it for the long haulWhile there may be some bright spots in the retail market – most notably in the online, non-store space – all the signs suggest that most British retailers will have to dig in for a long haul out of the current slump.

Closing remarks

available on how to put the necessary procedures in place, and how to access the alternative sources of capital, be it bank funding, asset-based lending or private equity.

Barry KnightHead of RetailGrant Thornton UK LLP

Retail 17

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Barry Knight T 020 7865 2150 E barry.s.knight@uk.gt.com

Chantal Goodman T 020 7728 3299 E chantal.goodman@uk.gt.com

18 Retail

Notes

© 2011 Grant Thornton UK LLP. All rights reserved.

‘Grant Thornton’ means Grant Thornton UK LLP, a limited liability partnership.

Grant Thornton UK LLP is a member firm within Grant Thornton International Ltd (‘Grant Thornton International’). Grant Thornton International and the member firms are not a worldwide partnership. Services are delivered by the member firms independently.

This publication has been prepared only as a guide. No responsibility can be accepted by us for loss occasioned to any person acting or refraining from acting as a result of any material in this publication.

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