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Retail and the DBCFT: Projections of a Gloomy Outcome

Retail industry trade associations have been vocal in their opposition to the DBCFT. The imposition of border adjustment would impact virtually all rated retailers adversely, albeit to varying degrees, given the import-intensive nature of the goods they sell. All else equal, a border adjustment would be hitting an industry that has several struggling subsectors - especially department stores and specialty apparel -already dealing with revenue declines and margin erosion.

Retail is viewed by many analysts as one of the key sectors that would be most unfavorably impacted by the DBCFT. Many companies are already under pressure from online retailing, stagnant wages in the U.S., and a preference for buying autos rather than going to the mall. Even segments of the industry that are performing better than some national chains, like off-price retailers, would be impacted by these changes given their supply chains. And the big question is the pace of discretionary spending consumers facing prices made higher by a border adjustment tax, if adjustments in the value of the dollar don’t compensate for that levy.

We believe the industry would still react to border adjustment by trying to pass on any impact to its margins in the form of higher prices. But such a move would come against that challenging backdrop.

The U.S. retail industry is very much a part of—and often the end destination—of a global supply chain. The supply lines that would be impacted by the DBCFT are many. While all countries would be affected, the broader discussion has been particularly focused on Mexico; that country is a top 10 exporter to the U.S. for auto parts, computers, televisions and electronic parts. China, and the rest of Asia of course, are major apparel exporters. Supermarkets source a good amount of fresh produce from Mexico and South America. While food deflation has been a recent feature of the market, that would reverse quickly if higher prices needed to be passed through.

The benefits of corporate tax reduction that some other industries anticipate would not have as widespread a favorable impact on the retail industry. The reduction to a top rate of 20% would benefit the larger and profitable retailers, but they represent a minority of the S&P Global Ratings universe (about 56% of our rated universe is in the ‘B+’ category, where you don’t find the more successful stores). Even if a company found itself with a lower tax burden as a result of corporate tax reform, given the challenges in retail, we would not expect to see a big expansion push if companies found they had more cash flow from a lower rate. Depending on the issuer, we would expect to see capital allocation flow instead to shareholders and/or debt reduction. However, if there was increased investment spending as a result of the tax changes, we would expect to see it in the form of increased investment into ecommerce capabilities. (That area of spending might also benefit from the full first-year expensing of capital expenditures).

The loss of interest rate deductibility is not likely to have a unique impact on retail issuers compared to other corporate borrowers. Cost of capital calculations and strategies will need to be adjusted of course for both investment grade and speculative grade issuers. Some investment grade retail companies borrow and buy back shares to keep leverage flat if their leverage would otherwise decline from rising EBITDA. This behavior might moderate if interest payments were no longer deductible, but perhaps not if the allocation of capital to shareholders remains a priority use for cash.

Few retailers carry significant cash reserves offshore. But for those that do, repatriation would be expected to be use like any additional cash flow derived from lower tax rates: more capital in the hands of shareholders through buybacks or dividends rather than further investment in growth in the face of a challenging environment.