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Credit FAQ: Hot Retail And Restaurant Topics In A Cooling Economy

The post-pandemic operating environment poses risks and opportunities in the retail and restaurant sector. To date, consumers have been relatively resilient: Retail sales are still well above levels before the COVID-19 pandemic, even adjusted for inflation. However, high prices at the grocery store and elsewhere are eating into household budgets, forcing consumers to reduce discretionary spending and trade down.

S&P Global Ratings expects a mild recession in the first and second quarters of 2023. Consumer confidence has deteriorated again in recent months as inflation, the U.S. debt ceiling standoff, and fear of a deep economic downturn more than offset support from the still strong labor market.

Chart 1


Our rating actions reflect the headwinds the sector faces. Negative rating actions have outnumbered positive by two-thirds this year, and this trend is likely to continue. Negative outlooks outnumber positive outlooks by three. Distressed retailers, especially those in discretionary categories, no longer have the buoying support of consumers looking for ways to spend excess cash. Six defaults already this year are three times the defaults in 2022 and 2021 each.

Still, pockets of the sector have benefitted from recent dynamics. Here, we discuss recent questions from investors.

Frequently Asked Questions

Do Home Depot and Lowe's have room for the housing market recession at the current ratings?

There is always room for potential unexpected downside from our base case. But at this time, a continued challenging macroeconomic environment, including recessionary trends and slower housing spending (both discretionary and non-discretionary) are baked into our forecasts for fiscal 2023.

It's our view that Home Depot Inc. (A/Stable/A-1) will maintain S&P Global Ratings-lease-adjusted leverage below 2x this year, even with the low-single-digit percent decline in its top line and EBITDA margin compression we expect compared to 2022. We believe the company would adjust its capital allocation in the vent of long-term, persistent performance pressure. Lowe's Cos. Inc. (BBB+/Stable/A-2) should also stay below its 3x S&P Global Ratings-lease-adjusted leverage downside for 2023, even factoring in its lowered full-year guidance released with first quarter 2023 earnings.

Sporting goods retailers were big beneficiaries of COVID-19-related spending as homebound consumers looked for activities. Why hasn't there been a sharp reversal now that the pandemic is largely behind us?

We believe resilience in this category reflects shifts in consumer demand before the pandemic, particularly consumers' increasing interest in health and wellness, and demand for experiences. Sporting goods benefits from being at the intersection of these two trends. The pandemic turbo-charged demand for products that support healthy lifestyles and could be used safely outside or in the home. Sales increased in the mid- to high-single-digit percents for Dick's Sporting Goods Inc. (BBB/Stable) in 2020 and 2021, rose significantly each of those years for Great Outdoors Group LLC (BB/Stable), and more than 17% for Academy Sports and Outdoor Inc. (BB/Positive). Moreover, in 2022, Dick's increased sales another 28% and S&P Global Ratings-adjusted EBITDA margins over 800 basis points (bps) compared to 2019. Academy similarly improved profitability, with margins increasing over 800 bps, while S&P Global Ratings-adjusted margins also expanded meaningfully for Great Outdoors in 2022. Homebound consumer pursuing outdoor activities along with an increased focus on an active lifestyle, casualization of workplace attire, and more people working from home were trends that help propel sales and profitability for sporting goods and outdoors retailers. Moreover, there has been no shortage of data reflecting an evolving consumer appetite that favors services and activities to goods. Sporting goods facilitate many activities and experiences that consumers seek. The resilience of this evolution was apparent in the fourth quarter at Dick's, where higher transactions were partially offset by lower tickets. Academy realized this in a different manner, higher ticket sizes more than offset by lower transactions. A more active consumer base with still-robust--although narrowing--savings should provide for a more gradual normalization in buying habits over the foreseeable future.

How will auto parts retailers fare in a recession, and looking out further, how is S&P Global Ratings incorporating the shift to electric vehicles into ratings?

Under our base-case forecast for a shallow recession this year, we project low- to mid-single-digit percent revenue growth across aftermarket auto parts retailers that we rate. We expect modest growth in vehicle miles traveled and suppressed new vehicle sales to spark higher automotive maintenance and repair spending this year. Consumers tend to defer new vehicle purchases and keep their automobiles during economic weakness. In previous downturns, operating results for large aftermarket auto parts retailers were relatively resilient. During the Great Recession, Advance Auto Parts Inc., AutoZone Inc., and O'Reilly Automotive Inc. generated positive comparable-store sales. Risks to our forecast include a deeper economic recession, including a spike in unemployment, which could cause consumers to delay repairs and defer maintenance on their vehicles.

The transition to electric vehicles (EV) in the U.S. is accelerating, spurred by incentives, regulations, and increasing consumer demand. Sales of EVs and plug-in hybrid vehicles accounted for 7% of new light vehicle sales in 2022, up from 4% in 2021 and 2% in 2020. Our forecast assumes the share of EVs sold will increase to 18%-23% by 2025 (see "Despite Higher Volumes, U.S. Auto Sector Ratings Upside Remains Limited Due To Macro Uncertainty, Pricing Pressure, And High Interest Rates", published April 24, 2023). Despite this secular risk, our ratings outlook for the national aftermarket auto part retailers is stable for now. Even as EV adoption expands, most vehicles on the road will continue to be powered by internal combustion engines for years to come. Approximately 99% of the roughly 285 million vehicles in operation in the U.S. are non-EVs. Additionally, EV affordability concerns and underdeveloped charging infrastructure is limiting widespread adoption in the U.S. Nevertheless, aftermarket auto part retailers face risks related to the evolution of the car parc--the number of cars or other vehicles in a market--and how EVs are serviced. To the extent EVs displace internal combustion engine vehicles faster than we anticipate and parts retailers cannot adapt, we would reassess our views on the sector.

While most quick-service restaurants (QSR) are resilient in weak economic periods because of their value offering, Taco Bell appears to be outperforming its peers. How would you rank the three Taco Bell franchisees: Tacala, MIC Glen, and Pacific Bells?

Taco Bell is the dominant leader in the Mexican QSR sector, with more than 8,000 restaurants worldwide that generated over $14.6 billion in 2022 systemwide sales. While fast-casual Chipotle finished 2022 with more than 3,000 units and over $8.6 billion in sales, it is not a true Taco Bell peer as its higher prices suggests a slightly different consumer that does not consider both Taco Bell and Chipotle when making a buying decision (value vs. absolute price). In addition to frequent menu innovation, Taco Bell has over 10x the units of the No. 3 player, providing it with a discernable moat in Mexican QSR, compared to the much more competitive, ubiquitous array of hamburger QSRs.

Some of Taco Bell's largest franchisees include Tacala LLC (B-/Stable; 347 Taco Bells in seven states at the end of 2022), MIC Glen LLC (B-/Stable; over 300 in 10 states), and Pacific Bells LLC (B-/Stable; 277 in nine states). The identical ratings and outlooks point to high S&P Global Ratings-adjusted debt-to-EBITDA leverage of 6x-6.5x, financial sponsor ownership, and exposure to fluctuating commodity prices as franchisees. MIC Glen, with 320 stores, is the most diverse of the three, having franchise operations of Seven Brew and Whataburger, compared to only one non-Taco Bell unit (KFC) each franchised by the other two peers. However, Tacala is the largest with 347 units and had the highest S&P Global Ratings-adjusted EBITDA margin of the three as of the fiscal year ended December 2022. However, Tacala had the highest leverage of the three at year-end 2022. Tacala also has the nearest-term maturities (cash flow revolver due in 2025 and term loan due in 2027), which we believe it should refinance well in advance. Pacific Bells, with 278 units, has a meaningful presence in California, where wage pressure can be particularly high, which likely contributes to its relatively low margins.

High freight costs have come down significantly, which should provide a tailwind for The Michaels' Cos. What is required to revise the outlook on Michaels to stable from negative?

Key factors that could lead us to revise our rating outlook on Michaels include improving profitability, liquidity, and leverage. Our base-case forecast assumes easing supply chain costs, led by lower international freight rates, which will relieve margin pressure in fiscal 2023. Less certain, however, is if consumer demand for the company's highly discretionary products will rebound this year. Sales within Michaels' core arts and crafts product category, which accounts for about 60% of its sales, declined roughly 10% last year. Overall sales are trending slightly below pre-pandemic levels. In our view, high albeit moderating inflation will pressure consumer spending this year, particularly in discretionary categories. Michaels' ability to stabilize sales, expand margins, and generate free operating cash flow approaching $200 million while maintaining S&P Global Ratings-adjusted leverage below 6x would support an outlook revision.

Can department stores return to investment grade when the economic forecast improves or are the challenges more fundamental?

All of our ratings on department stores are speculative grade ('BB+' or lower). We downgraded Macy's Inc. out of investment grade in early 2020 before the forced store closures from the pandemic, Nordstrom Inc. later that year, and Kohl's Corp. in late 2022. We believe the underlying business risks are higher than for typical investment-grade issuers. Recent performance has been volatile due in part to the pandemic, but department stores' relevance has been waning for years. Industry sales have declined 2.5% annually on a compound annual growth rate basis from 2010-2022, compared to annual growth of 5.6% in other retail trade sales (excluding department stores, food service, auto, and gas) during the same period, according to U.S. Census Bureau data. We believe the pandemic provided a temporary reprieve as consumers sought spending outlets while they had excess cash and were homebound. As consumers settle into a new normal, we expect the secular competitive pressures to return. These include the evolution of shopping behaviors to more costly digital formats and away from poor performing malls; value players pressuring prices; and competition from experiences, health care, autos, and services for share of wallet.

Chart 2


We believe each of the three largest rated department stores have unique advantages that could provide a foundation for a sustainable turnaround. Kohl's partnership with Sephora cosmetics should draw new customers to stores, and its value offering could retain them, especially in weak economic times. Its largely off-mall locations also appeal to consumers' need for convenience. Macy's operational acumen enabled it to avoid the dramatic inventory misses that most of the industry endured. Its smaller footprint should provide a lower-fixed-cost basis and position it for margin improvement. Nordstrom's higher-income consumers have been less affected by inflation to date. These consumers' discretionary spending should be more resilient.

If these advantages contribute to long-term, sustainable, and profitable growth, we could reevaluate our view of each department store's competitive position. Until then, an investment-grade rating is unlikely because we believe the risks and pressures in the underlying businesses will produce volatile results.

This report does not constitute a rating action.

Primary Credit Analyst:Sarah E Wyeth, New York + 1 (212) 438 5658;
Secondary Contacts:Diogenes Mejia, New York + 1 (212) 438 0145;
Pablo A Garces, Dallas + 1 (214) 765 5884;
Declan Gargan, CFA, San Francisco + 1 (415) 371 5062;
Frederico Carvalho, San Francisco (1) 415-371-5071;
Mathew Christy, CFA, Columbia + 1 (212) 438 7786;
Diya G Iyer, New York + 1 (212) 438 4001;

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