Many U.S. retail companies, already beset by high levels of debt they are struggling to service, face a further squeeze in coming months from rising interest rates.
Retail companies typically operate on low-profit margins after competing on price and paying high labor costs, forcing them to borrow to invest in their businesses. Those investments are all the more critical now as traditional retailers ramp up their spending for store improvements and e-commerce operations to better compete with Amazon.com Inc. and other online retailers, analysts say.
Retailers have racked up their debt loads over the past decade, taking advantage of cheap rates for borrowing, David Berliner, BDO Global retail restructuring partner, said in an interview. The effective federal fund rate fell from 4.2% to 0.2% in 2008. On June 13, the U.S. Federal Reserve raised its benchmark interest rate to a range of 1.75% to 2%, its second rate hike of the year.
As the Federal Reserve hikes the benchmark federal funds rate several more times this year and next, as it has signaled, it will make interest payments for variable-rate loans that much more expensive and strain the ability of retailers to refinance their debt or borrow more.
"It's going to take the margin of error away from some of those retailers that were operating on a tightrope," Berliner said. "It's that much more difficult for them to execute when they have such a small range of available cash before they fall off the cliff."
Retailers already highly levered
Leverage is high compared to past years in the U.S. retail sector, according to an S&P Global Market Intelligence analysis.
One key measure of leverage — net debt over EBITDA — hit 1.9x at the end of 2017 and 2016 for publicly traded retailers.

That is the highest that ratio has been since the end of 2013 when it reached 2.1x. The net debt over EBITDA figure has otherwise stayed below 2x since the Fed dropped the effective federal funds rate at year-end to 0.2% in 2008.
Another measure of leverage — the median total debt to capital ratio — peaked at 42% at the end of 2017 for publicly traded retailers. That is the highest the ratio has been at year-end since 2000, the beginning of S&P Global Market Intelligence's analysis.
High leverage can be more troublesome for retailers than other companies because of "sizable but necessary" investments in inventory, employee wages and store improvements, said Perry Mandarino, head of restructuring at B. Riley & Co., in an interview. Even if retailers already have a lot of debt and face higher interest rates, many will still need to borrow just to continue operating.
"Retail is a low-margin business but it's a business with a lot of capital needs" he said. "Generally for retailers, they need to be nimble and have a good balance sheet since it's so low margin, so if you're funding working capital, competitive low prices and investments into your business through debt, it's going to catch up with you at some point."
Retailers may struggle to cover that high leverage. The interest coverage ratio — an indicator of how comfortably a company or industry can service its debt — for the publicly traded U.S. retail industry has fallen since 2012.
The median ratio for publicly traded retailers dropped to 11.6x at the end of 2017, down from a peak of 26.1x in 2012.
Vulnerability of retail sector has 'spooked' investors
The decline of the interest coverage ratio is worrisome for the industry, said Edward Jones retail analyst Brian Yarbrough in an interview.
It could signal that lenders will not cut retail companies much slack or grant favorable terms when companies in the sector come to refinance or take out more debt and a time when investors are already uneasy about overall malaise in the industry, he said.
"They're spooked," he said. "There's not a long line of people ready to lend retailers a lot of money right now."
Not only did U.S. retail bankruptcies hit a six-year high in 2017, the sector also has a relatively high average one-year probability of default, according to S&P Global's Fundamental Probability of Default Model. This model provides a fundamentals-based view of credit risk for corporations by assessing business and financial risk to calculate a one-year probability of default. Business risk includes country risk, industry risk, macroeconomic risk, company competitiveness and company management. Financial risk includes liquidity, profitability, efficiency, debt service capacity and leverage.

The consumer discretionary sector has an 8.13% average one-year probability of default. Only the energy and information technology industries outpace consumer discretionary.
Some subsectors within the retail industry are faring worse than others.
Apparel retail and specialty stores have the highest one-year probability of default within the U.S. retail sector. Apparel retail's one-year probability of default score came in at 14.52%, while specialty retail's one-year probability of default score is 14.10%. Apparel and specialty retail debt maturities are set to swell in 2019.
Investors' pessimism about the sector is worsened by the familiar names that are finding themselves with high levels of debt and an inability to meet interest payments, Yarbrough said.
"It adds another element of anxiety for lenders when these companies are things they can see disappearing around them," he said.

Stein Mart Inc., Rent-A-Center Inc. and Lands' End Inc. are among the highest-levered publicly traded retailers in 2017. All three have an interest coverage ratio below 2.5%, which is largely considered a warning sign for an individual company's ability to pay its interest.
Sears Holdings Corp., once one of the country's largest department store operators, is now one of the sector's most vulnerable retailers with a one-year probability default score of 25.93%. Wayfair Inc., which Yarbrough called a former "darling" of the e-commerce business, has a one-year probability of default score of 17.78%.
"If these companies — and some of them had big, powerful brands at one point — are in trouble now, that isn't a great sign for how the industry is going to be doing once interest rates go up," he said. "Investors know that."
For further information on retailer credit levels levels, try watching S&P Global's recent webinar: Keeping Pace with Disruption: Retail and Real Estate in the Digital Age. |

