On Aug. 23, the Trump administration announced 15% tariffs (up from previously announced 10%) on $300 billion worth of Chinese imports, targeting a wide array of products including apparel, footwear, electronics, and appliances. The first tranche of tariffs (designated by the U.S. government as List 4A tariffs) went into effect Sept. 1, while the second tranche (List 4B) is scheduled to be implemented on Dec. 15.
While the extra costs on goods imported from China are clearly bad news for retailers in general, we think that if all these tariffs are imposed as scheduled, the fallout for domestic retailers won't be the same in all cases. Yes, the U.S. domestic economy is still healthy, with unemployment at less than 4%, projected 2019 GDP growth of 2.3%, and consumer confidence at a high level. But in particular, smaller retailers, those that sell more price-sensitive goods, those without adequate negotiating power over vendors or supply chains that can circumvent Chinese production, and those that are cash-strapped and already under operating pressure, will be the ones thrown off course. And their plight could even deepen if the economy also worsens—we put the odds of a recession over the next year at 30% to 35%.
We think that the tariffs will create uncertainty throughout all of U.S. retailing—especially as the retail landscape is continuing to undergo secular shifts in how and where consumers do their shopping. Moreover, higher tariffs will also widen the gap between retail winners and losers, as some companies will be better able to adjust to the higher costs and potentially even expand shares while others struggle.
Tariffs Will Raise Costs For Everyone
Overall, these tariff increases are bad news for retailers. Almost all of them will face potential margin erosion or at least shrinking consumer wallets, if higher prices are passed on only at other retailers. Moreover, S&P Global Ratings had already expected declining sales at many retailers this year as consumers grow increasingly accustomed to waiting for sales or promotions before buying, as well as forsaking brick-and-mortar purchases in favor of online shopping.
With the added impact of tariffs, we believe margins will be squeezed even more as retailers and their vendors will likely share the burden of the higher cost. We also expect potentially greater sales and earnings pressure in 2020 if List 4B takes into effect as scheduled in December. Although not a preferred path by most retailers because of consumers' continued sharp focus on "value", we think some retailers may ultimately resort to selectively and strategically increase prices in 2020, depending on their ability to negotiate with vendors and their analytics of consumer price sensitivity. This will likely amplify sales volatility as the level of customer response to specific price actions remains uncertain. Moreover, any sharp sales decline due to an unfavorable pricing action will likely further dampen profitability. Nevertheless, not all retailers will fare the same. In fact, we believe tariffs will magnify the divergence in performance and ratings trends amongst retail companies.
Well established larger players will fare better
We expect big retailers will respond better to the tariff-related challenges. First of all, they typically have more extensive vendor networks and stronger negotiating power due to their scale. Moreover, they tend to be more operationally savvy and better at training their buyers in terms of negotiating with vendors, equipping them with up-to-date industry data and technology support. And finally, in the event that retailers take a bigger bite of the tariff burden and profitability shrinks, larger players have more financial power to ride out the earnings and cash flow volatility. For example, they might be able to offset some losses with other operating initiatives, such as cost-cutting. Direct sourcing also gives the companies an extra edge in terms of managing the cost and speed along the supply chain. Companies such as Abercrombie & Fitch Co., which has increased direct sourcing over the years, are better positioned to respond more quickly and directly to the changes needed in the supply chain because of tariffs.
Today's shopper remains sharply focused on price and value. Depending on the ease of price comparability, purchase frequency, and nature of the product, customers will react differently to a potential price hike. We anticipate companies will deploy data-driven analytics when considering merchandise price architecture and potential price actions. We also believe there will be limited tariff impact to the U.S. luxury retailers. Given their higher margins and limited Chinese imports, the expectation is for these companies to offset the impact of tariffs mostly with greater operating efficiency. For example, Capri Holdings Ltd. (holding company of the Michael Kors, Versace, and Jimmy Choo brands) commented on its most recent earnings call that it expects to maintain price and profitability despite the uncertainty around tariffs—including goods on List 4.
Companies' product categories with substantial exposure in China will be more heavily affected
Among the rated U.S. retailers, exposure to China ranges widely from less than 10% (i.e. at Dollar General Corp., which is mostly U.S. sourced) to up to 60% (footwear retailers such as Caleres Inc.) depending on the product category concentrations. Yes, moving manufacturing facilities out of China could offer a medium- to longer-term mitigation, and many companies have already started on this path. However, we expect moving certain production will be more challenging, depending on manufacturing and labor requirements, and the supporting infrastructure that is needed. One example is footwear retailers, which generally have substantial exposure to production in China. This makes it difficult to move out of China quickly. Moreover, maintaining product consistency and quality requires skilled labor, which may not be easily or quickly available.
The Effect Of Tariffs On U.S. Retail Companies By Segment
|The Effect Of Tariffs On Department Stores And Specialty Apparel|
|Less Affected||Watch List|
TJX Cos. Inc. (A+/Stable/A-1)
J.C. Penney Co. Inc. (CCC+/Negative/--)
|We believe TJX is relatively better positioned compared to department store and full-price peers, based on its long-track record of maintaining deep relationships with a vast network of vendors. The company is less reliant on Chinese imports and has more flexibility to adjust where products are sourced.||Despite some mitigation efforts with respect to list 3 tariffs, we believe the company's lower margin profile makes it increasingly vulnerable to potential future impact from list 4. An increasingly difficult macroeconomic environment and increase in competition are key risks to J.C. Penney's operating performance.|
Nordstrom Inc. (BBB+/Negative/A-2)
|Relative to other department store retailers under our coverage, we believe Nordstrom is less exposed to China-based import tariffs (the company’s private label merchandise penetration is lower compared to peers). However, as tariffs are implemented and consumers face higher prices at other retailers, dampened consumer confidence or diminished purchasing power could negatively impact sales at companies that are less directly exposed to tariff pressures.|
Foot Locker Inc. (BB+/Stable/--)
Caleres Inc. (BB/Stable/--)
|Foot Locker maintains important relationships with key vendors which provides it an advantage over competitors. We believe Foot Locker will be able to pass on most of the tariff burden through either higher prices or efficient vendor negotiations.||Caleres has made progress diversifying its sourcing however we note that in fiscal 2018, it still sourced about 60% of its merchandise from China. We believe the company will be able to share some of the burden with consumers through price increases but remain cautious given uncertainty surrounding consumer confidence and response towards the price actions. If list four tariffs take full effect, we believe margins at the company could thin materially.|
The Gap Inc. (BB+/Watch Neg/--)
Tailored Brands Inc. (B+/Negative/--)
|Across its portfolio of brands, the company sourced 21% of its products (16% of apparel) from China, as of February 2, 2019. We expect Gap will employ a similar playbook to other retailers exposed to tariffs by negotiating with vendors, diversifying the countries its sources from, and selective pricing actions. In our view, Gap should be able to weather the tariff pressure better than most given its scale and the steps the company has previously taken to reduce exposure to China.||Tailored has responded to tariffs by diversifying sourcing away from China. It currently sources about 20% of product directly from China (down from 30% in 2017). However, as tariffs are enacted and consumers face higher prices across the retail space, we expect the menswear industry will become increasingly price competitive while consumers will shift spending towards more value-oriented purchases. We see this as a major risk to Tailored's already stressed topline and margins.|
|The Effect Of Tariffs On Electronics And Home Goods|
|Less Affected||Watch List|
Eyemart Express Holdings LLC (B/Stable/--)
Harbor Freight Tools USA Inc. (BB-/Negative/--)
|The company is meaningfully penetrated in higher margin private-label, maintains good profit margins, and has relatively recession-resistant operations because of the value-oriented and medical necessity nature of its products. As such we believe company will be able to absorb tariffs without major impact to its bottom line.||Harbor Freight sources about 80% of its private label tool and equipment products from China. We believe the company may face performance pressures from the recent tariff actions as it would be hard to move sourcing of its private label products outside of China in the near-term. We expect the company to opportunistically take price increases when feasible, although we believe it may choose to absorb most of the tariff burden in the short term as the company focus is on price value.|
Best Buy Co. Inc. (BBB/Stable/--)
The Michaels Cos. Inc. (BB-/Negative/--)
|List 4 tariffs cover a significant portion of Best Buy’s merchandise and with approximately 60% of Best Buy’s COGS being sourced from China today, we expect gross margins will experience pressure. However, through mitigation actions, Best Buy estimates it can reduce its exposure closer to 40% in 2020. We expect the company will leverage its market leading position and its strategic importance to its vendors to offset some of the cost pressures. Additionally, the company’s recently announced five-year $1 billion cost-savings plan has the potential to absorb some of the tariff-related cost pressures.||We believe incremental shifting of vendors outside of China will become more challenging while an increasingly competitive arts and crafts environment will limit Michaels' ability to mitigate tariff costs by increasing prices. We expect some success with vendor negotiations, allowing Michaels to share the burden with its suppliers, to a limited extent. With full implementation of list four tariffs, we expect about 30% of the company’s COGS to be impacted.|
Jo-Ann Stores Holdings Inc. (B-/Negative/--)
|List three impact has been significant, with little success from pricing and sourcing efforts so far. The company sources a significant portion of its COGS in China, and has meaningful exposure to products in both list 3 and list 4. Based on the discretionary nature of its products as well as the increasingly competitive environment, we believe passing on the tariff cost to customers through price increases will remain challenging.|
Floor & Decor Holdings Inc. (BB-/Stable/--)
At Home Group Inc. (B+/Negative/--)
|FND has successfully reduced sourcing from China with COGS declining to the mid 30% range by the end of 2019 (from 50% last year). We believe the company has greater pricing ability than other retailers given their position as a low cost leader in the hard surface flooring industry.||At Home absorbed the initial wave of tariffs (list 3 at 10%) largely through negotiations with suppliers and select strategic price increases. The company avoided increasing price as list 3 tariffs rose to 25%, leading to moderate margin pressures. In Q2 the company began slowly raising prices in line with competition mitigating further impacts to profitability. We do not anticipate any impact from list 4 (largely seasonal merchandise that has already been purchased) in fiscal 2020. However, absent mitigation efforts we believe the company could be impacted by list 4 tariffs in fiscal 2021.|
|The Effect Of Tariffs On Luxury Goods And Discounters|
|Less Affected||Watch List|
Capri Holdings Ltd. (BBB-/Stable/--)
|Capri has effectively mitigated list 3 tariffs and we do not expect list 4 to have a major impact given higher margin profile than other retailers. We expect the company will be able to successfully mitigate impact through initiatives to improve operating efficiency rather than price increases.|
Tiffany & Co. (BBB+/Stable/A-2)
|Tiffany manufactures most products in the U.S. limiting tariff exposure. As a luxury retailer, pricing power could offset some of the tariff impact.|
Walmart Inc. (AA/Stable/A-1+)
Big Lots Inc. (BBB-/Negative/--)
|The company sources 1/3 of its products outside the U.S, including China. It has acknowledged it will be more broadly impacted by List 4 and will have to partially offset what it can’t re-source or re-merchandise through price increases to customers, although this is considered a last resort to manage margins. We do not expect EBITDA margin impact at this time given the company's scale and benefit from grocery and other sales that can offset this pressure.||Big Lots purchased 21% of its merchandise from China-based vendors in 2018. As a discount retailer, we believe Big Lot’s ability to fully pass on higher costs to customers is limited. We expect gross margins will compress modestly this year and remain pressured as the company partially absorbs higher tariff-based costs.|
Dollar Tree Inc. (BBB-/Stable/--)
|DLTR announced in August that without mitigation, List 4A and the additional 5% tariffs on List 1, 2 and 3 would cost the company about $26 million. Prior to the recent announcements on List 4 as well as the additional 5% tariff increase on all lists, Dollar Tree had mitigated most of the adverse effects of list 3 tariffs with negotiated price concessions, cancelled orders, modified specifications, evolved product mix, and diversified vendors.|
Amplifying The Gap Between The Weak And The Strong
Over the past several years, the traditional retail world has gone through significant transformations with fewer stores (and square footage), higher e-commerce penetration, enhanced market data-driven merchandising, and faster inventory turnover. This has resulted in generally thinner margins and increasingly uneven sales performance in the industry. While we anticipate these factors will continue affecting all retailers, we note a growing divergence in terms of performance trends and credit quality between the stronger and weaker players.
In 2017 and 2018 we took rating actions on 44% and 50% of investment-grade rated entities, respectively, as the initial secular change hit the entire industry. At the same time, we also saw certain larger retailers adapting a more aggressive financial policy, which contributed to the negative trend. This number has come down significantly to 17% so far in 2019, including only one negative rating action, as larger players have started to stabilize performance and translate their initiatives into operating results. On the other hand, smaller players, mainly rated in speculative grade, continue to experience very high volatility. We took rating actions on about 65% of the speculative-grade entities in each of the past two years. The number remains above 60% so far in 2019, and we anticipate it will remain at a very high level similar to previous years.
In recent years, many larger, well-positioned brick-and-mortar retailers with solid cash flow have been able to invest in various initiatives and accelerate critical omni-channel capabilities. This has enabled them to adapt to today's retail landscape and narrow the gap to e-tailers such as Amazon.com Inc. These retailers have also used consistent free operating cash flow to manage their balance sheets and reduce funded debt, building extra headroom for potential operating underperformance or earnings volatility down the road. Examples include Kohl's Corp. and Macy's Inc., which we had downgraded and/or placed on negative outlook in previous years. Earlier this year, we raised our ratings on Kohl's to 'BBB' from 'BBB-' and revised the outlook on Macy's to stable from negative, reflecting these companies' improved operating performance and sizable voluntary debt reduction. Similarly, we revised the outlook on Walmart Inc. to stable from negative, reflecting the company's revenue gains as its digital brand expands and international performance strengthens.
On the other hand, cash-strapped weaker players have experienced ongoing operating pressure and deteriorating credit metrics, ultimately pressuring their liquidity and capital structure. This is partially due to the companies' lack of financial and operating resources (i.e. cash generation and stable management teams) to invest and execute on key initiatives to adequately address the rapid industry transformation, especially in ecommerce. As a result, we are seeing a larger gap in terms of online penetration and capabilities. For example, online sales now represent over 30% of the total revenue at Nordstrom Inc., up from 18% in 2014, although online sales remain a less significant share at certain smaller regional department stores. Moreover, in addition to shrinking sales and earnings, many of the weaker retailers have to deal with a burdensome debt load and anemic cash flow, leading to unsustainable capital structures. We lowered the ratings on Ascena Retail Group Inc., Belk Inc., and J.C. Penney Co. Inc. into the 'CCC' category this year, reflecting a high risk of default in the near term. Currently about 16% of rated retail issuers are in the 'CCC' category, and six have defaulted so far in 2019. We expect this elevated pace of negative rating actions to continue for the balance of the year.
More Retailer Ratings In Distressed Territory
The rapid and continuing secular change over the past years has already pushed many e-tailers into distressed territory (a 'CCC+' or lower rating) and some into selective default or bankruptcy. Ratings in CCC/CC categories jumped to 23% in 2017 from 8% in 2016, and remained elevated at around 20% in 2018. At the same time, defaults (including selective default) have also picked up pace, rising to 10 in 2017 from 4 in 2016, remaining at 8 in 2018.
We expect the distressed rating level to remain elevated in the second half of 2019 and into 2020, especially as the full impact of tariffs start to take effect in December. Some of the smaller players, which have limited ability to bargain with vendors, opted to take advantage of the tariff effective timing by pre-buying inventory. However, this window will close completely before the end of the year. Moreover, the strategy could result in excessive inventory for the next couple of quarters and potentially lead to much higher than planned promotional activities following the holiday season, further weighing down profitability and cash flow. Overall, we believe 2020 will present a greater challenge for retailers. As the overall economic environment decelerates from the current peak level and recession becomes more likely, refinancing terms for small retailers will be increasingly unfavorable. Ultimately, with List 4 tariffs taking a full swing, we anticipate the weaker retailers to face narrower margins, dwindling cash flow, and greater difficulty in refinancing their maturing debt.
Of course tariffs are not the entire story. Vendor and inventory issues have already contributed to the recent spate of retail bankruptcies. When a retailer's operating performance significantly deteriorates and it appears to be cash-strapped, vendors become increasingly anxious about being paid and typically demand stiffer payment terms. In some cases, they cut out shipments all together. For example, in September 2017, vendors tightened screws and cut shipments to Toys "R" Us Inc. before the holiday season, afraid that the company wouldn't be able to refinance its $5 billion debt. This, in turn, accelerated the company's filing for bankruptcy shortly after. Because of the rising cost from tariffs, we anticipate that increased negotiation between retailers and vendors could lead to more onerous payment terms for the struggling, weaker retailers. Ultimately, this could leave little room to execute a turnaround strategy, leading only to the edge of the cliff, and tumbling into debt restructuring or bankruptcy.
- Credit Conditions North America: Rising Recession Risk Adds To Trade, Rate Uncertainty, Sept. 30, 2019
- Economic Research: Will Trade Be The Fumble That Ends The U.S.'s Record Run?, Sept. 27, 2019
- Jo-Ann Stores Holdings Inc. Downgraded To 'B-' On Lower Projections From Tariff Pressure; Outlook Negative, Sept. 19, 2019
- The Michaels Cos. Inc. Outlook Revised To Negative On Tariffs And Risk Of Soft Consumer Spending; 'BB-' Rating Affirmed, Sept. 11, 2019
- Harbor Freight Tools USA Inc. 'BB-' Rating Outlook Revised To Negative On The Pressure It Will Face From Tariffs, Oct. 11, 2018
This report does not constitute a rating action.
|Primary Credit Analyst:||Helena H Song, CFA, New York (1) 212-438-2477;|
|Secondary Contacts:||Lori Shapiro, New York + 1 (212) 438 0424;|
|Sarah E Wyeth, New York (1) 212-438-5658;|
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