Theft Is A Top Risk

S&P Global Ratings has been monitoring the rise in U.S. retail theft over the past year, and we believe it is now among the top risks to the sector.   At least a dozen companies cited inventory loss or "shrink", which includes theft, as eroding profits in quarterly earnings this summer, including Target Corp., Lowe's Cos. Inc., and Dick's Sporting Goods Inc.

In our view, the numbers in the financial statements don't fully illustrate the problem this poses to American brick-and-mortar players. Some estimates have pinned shrink's impact as 2% of net sales or below and that remains the case this year. We observed the gross margin hit was also mostly only between 10 basis points (bps) and 100 basis points through the latest quarter of 2023 for our rated issuers, translating to just 0.1x of S&P Global Ratings lease-adjusted leverage at most. For larger investment-grade credits, that debt to EBITDA hit was even less than 0.1x. That type of credit metric impact would not in itself drive a negative outlook or a rating action.

That said, we believe that over time, theft undermines the most important driver of retailers' profits: customer traffic. Customers need to feel safe shopping in stores for the sector to operate profitably and grow long term. E-commerce, while obviously a high-growth category, remains only about 15%-20% of total retail sales in the U.S. and is often unprofitable upfront for brick-and-mortar players. As a result, opening physical stores and successfully drawing customers into them remain the bread-and-butter underpinning U.S. retailers' ability to support debt repayment.

It has been a challenge in recent years to bring shoppers back into stores after the COVID-19 pandemic and theft is becoming another material set back.   Customers stayed home in the pandemic and became increasingly savvy at shopping online. Retailers lost market share permanently to Amazon.com Inc. and other e-commerce players, especially in categories like grocery and apparel. Off-mall and urban stores, where it appears more theft is occurring, were seen as important sources of new store growth.

Now theft, which is a $100 billion problem for the U.S. retail industry, according to a National Retail Federation 2022 survey (up from $94.5 billion in 2021 and $90.8 billion in 2020), could continue to keep customers away. The biggest portion of 2021 inventory shrink was from external theft including organized crime (37%), then employee and internal theft at 28.5%, according to the survey.

This year, many retailers we rate are depending on the benefits of the holiday season more so than in previous years. That's because many need to offset weak first-half results in 2023 that arose from a persistently inflationary environment that decreased consumer demand for discretionary goods.

Top executives at the retail companies we rate agree that employee safety is a top priority, especially in this ESG focused world. But since markdowns, excess inventory, and supply chain challenges have already taken a material bite out of margins in the past year, many report they do not have sufficient dollars to invest in further labor to beef up in-store security. Instead, we believe labor shortages and efforts to limit costs have helped drive increased self-checkout, which is also contributing to the issue.

Our understanding is theft below $1,000 has become more common, given it is the value for a misdemeanor of the first degree in many states, versus a felony. We are told federal and state law enforcement partnerships and potential congressional legislation could be crucial to fill this security gap.

We believe some retail companies could be overstating the contribution of theft this year.   Instead, it could be their own poor merchandise execution or inventory management that is the issue. That said, we do believe these big picture, long-term concerns about theft are likely part of what are driving big market hits. Dick's Sporting Goods stock, for instance, fell more than 25% in August amid mention of theft and other challenges as part of earnings.

On the credit side, S&P Global Ratings believes theft will contribute to negative rating actions in the next six to twelve months.   Lower-rated issuers or those that already have a negative outlook could be most vulnerable in coming months. Theft could also more materially impact companies with already-thin margins or immediate refinancing needs. About 70% of our rated companies are in the speculative-grade category of 'BB+' or lower and have seen their interest burden skyrocket amid higher rates over the past year. Notably so far this year, we have seen 23 downgrades versus 19 upgrades. Almost 30% of our credits have a negative outlook or are on CreditWatch Negative.

A sampling of comments on shrink from top retailers is below. Data below also illustrates pressured profitability and elevated leverage relative to expectations for almost all the companies cited. These trends in addition to declining adjusted EBITDA margins for many over the past year speak to how important it will be for the industry to stabilize these theft trends going forward.

Comments From Top Retailers

Target Corp.

Target Corp. said in the first quarter of 2023 that shrink would reduce profitability by more than $500 million compared with a year ago. In the second quarter of 2023 the company continued to cite the issue as well as potential impairment of long-lived assets. Target said it saw a 120% rise in violent theft incidents or those involving threats of violence in the first five months of this year and that it drove a full point of profit pressure versus last year. We note the company's latest twelve months through the second quarter ended July 29, 2023, declined to 2.4x from a peak of 2.7x in the first quarter, and we believe it will continue to deleverage amid less markdowns and other benefits including some abatement of shrink in coming quarters.

Chart 1

Chart 2

Lowe's Cos. Inc.

Marvin Ellison, the chief executive of Lowe's Cos. Inc., said in the company's August 2023 earnings call that it is "the most difficult retail environment for shrink in my 35 years in this space." Loss or theft of inventory (as Lowe's defines shrink) hit gross margins 20 bps in 2022 and required higher inventory reserves. Shrink has been growing steadily at the company as a percentage of net sales over recent years.

Chart 3

Chart 4

Dick's Sporting Goods Inc.

Dick's Sporting Goods Inc. said in August that shrink (which includes damage, theft, and other causes) contributed to a reduction in full-year guidance. Higher-than-expected shrink represented one-third of its merchandise margin decline and the CEO said, "the impact of theft on our shrink was meaningful to both our second quarter results and our go-forward expectations for the balance of the year." It is expecting inventory shrink to be about 50 bps higher than fiscal 2022 on a full-year basis, as a percentage of net sales, according to its latest earnings. We note the company saw an 84 bps increase in inventory shrink due to increased theft, but also saw merchandise margins fall 254 bps in the quarter, highlighting this is not the only issue weighing on the retailer.

Chart 5

Chart 6

Macy's Inc.

In the first quarter, Macy's Inc. said it adjusted its annual gross margin rate to include an estimate for increased shrink. We believe the issue is less impactful in terms of absolute dollars at mall-based retailers, more in the 0.2%-0.5% of net sales range. However, these risks, coupled with emerging ones related to credit card revenue declines, are among those we continue to monitor for the back half of 2023.

Chart 7

Chart 8

Kohl's Corp.

Kohl's Corp. said gross margin declined 61 bps in the second quarter of 2023 compared to the prior year from product cost inflation and higher shrink, partly offset by lower freight expense and digital-related cost of shipping. The CFO noted in the latest earnings call that it is something the company has "called out in the last two quarters that has weighed in on our margins" and remains a headwind in the second half.

Chart 9

Chart 10