Chart 1

The Pandemic Has Fragmented Retail Into Essential And Discretionary Segments

For the COVID-19 lockdowns, government decrees about what goods and services were essential divided the retail sector into two very broad and basic categories: Other than food retailers and grocers, most fell into the category of non-essential and had to close their stores. The dividing lines weren't always uniform. For instance, in some countries or regions, the general and home improvement retailers were considered essential. In the U.S., a craft supplies retailer successfully argued that it was essential in many jurisdictions because it provided materials for protective face coverings. In addition, what governments considered essential did not necessarily correspond to consumers' views on the matter. Several retailers had to close at least some of their stores or to restrict their assortment to focus on core and essential offerings.

Overall, lockdowns have been quite favorable for grocers and supermarkets due to the essential nature of food retail, especially when many are forced to stay at home. While they have benefited from significant surges in sales and a shift from out of home to in home consumption, most of them have struggled to cater to the spike in demand. At the same time, increased operating costs associated with wages, distribution, cleaning, and sanitization procedures will limit the positive effect of the topline growth on margins. While we expect higher wages to be phased out gradually, we believe the costs associated with protecting employees and customers are here to stay for the foreseeable future.

If the pandemic continues, we could see some nonfood retailers aiming to diversify into some basic level of food retail operations to hedge their bets on several fronts: to remain open during any future lockdowns, benefiting from footfall in the stores, tide over the decline in demand for discretionary products and remain connected to their customers. Nevertheless, we expect this transition to be of limited scale and mostly around long-life and ambient food products, because full-scale food retail requires expertise around handling fresh foods and is associated with higher costs and lower profitability.

As the restrictions are lifted only gradually, in our view, some discretionary retail segments could take longer to bounce back in advanced economies, if consumers perceive them to be less necessary. The course and pace of recovery will also depend on the extent the social distancing measures continue. In jurisdictions already emerging from lockdown, we observe restrictions on maximum customers per store, for instance.

If these restrictions are not substantially relaxed or are reinstated due to subsequent outbreaks, consumer spending on discretionary goods and services will be depressed for longer, especially in the backdrop of the recession and weaker employment levels. The economic downturn will lead to a fall in disposable incomes and further accelerate the tendency for customers to seek value and gravitate toward discounters, as they did in the previous recession. Chinese customers could defy this trend, however, because we believe discretionary and luxury retail will continue to grow, albeit more slowly.

Segments like duty free and travel retail could take even longer to recover because global travel is set to be subdued for the foreseeable future. We also see the risk that both leisure and business travel volume might not return in full after the pandemic, with airlines having reduced their capacity. In a sharp turn of fortunes, before the pandemic, travel retail was one of the segments least affected from structural issues. This sector, particularly duty free retail, also benefited from a higher share of turnover-based rent, which we expect will be more prevalent as retailers seek to maintain flexible cost structures given uncertain consumer demand.

Ecommerce Will Accelerate And Omnichannel Will Become More Crucial

For many nonfood retailers, especially the apparel, specialty, and general retail segments, ecommerce has emerged as a lifeline during the lockdowns. For many retailers, it was the only way to generate revenue and stay connected to customers while storefronts were closed. Retailers without strong e-commerce capability have struggled to keep pace with surging demand and provide a customer experience that can compete with the speed and efficiency of a well-developed e-commerce platform. Delivery time with less robust transport and delivery infrastructure has been a major constraint in the growth of e-commerce in some developing countries of Asia and Latin America, especially outside the major cities.

The pandemic will also lead to enduring change in shopping habits. Even before this, consumers expected the ability to shop in store, online, and on mobile devices, accompanied with a range of home delivery, click, and collect options. Retailers' capability to operate omnichannel platforms will become an essential component of their competitive advantage.

Even food retail will see a growth in ecommerce, and we expect companies to focus more on reducing the cost of the last mile deliveries to customer homes. Home consumption will remain strong, so we expect grocers to benefit from larger orders sizes, as operational efficiency of distribution network improves faster.

Successful Phygital Operations Will Become A Vital Differentiator

Retailers will have to integrate their supply chains, warehousing, distribution, and stores into a cohesive unit to offer a seamless "phygital" (physical-digital) experience (see chart 2). In our view, many retailers are predominantly in the early phase of this long journey. This will also require many retailers to invest more in technology platforms to present an omnichannel view to the customer. This will include customer-facing systems; and substantial investment in supply chain, logistics, and distribution. In addition, we expect greater customer profiling and analytics, digital targeting, interaction, and information sharing with customers through a variety of online and mobile platforms, including significant increase in customer reward and loyalty programs. This will also be facilitated by greater acceptance, flexibility and integration of e-payment apps.

Chart 2

At the same time, retailers need to rethink their strategies aimed at differentiated shopping experiences at stores, given physical restrictions. In the past several years, many brick and mortar retailers tried holding out against e-commerce by providing experience-based value-added, which will be substantially constrained by the "new normal," including physical distancing measures.

Retailers Will Radically Optimize Their Store Portfolio And Push Landlords For Flexible Lease Terms

While the brick and mortar store will retain its importance, we expect retailers to become more selective in the nature and number of store sites and be less tolerant of loss-making locations.

Following the lockdowns and stores closures, many retailers in a bid to conserve cash, have not paid their rent or have approached their landlords to cancel, defer or renegotiate their rental commitments. Many retailers will use this to push for more flexible and less onerous rental terms and lease contracts. We would likely see retailers ask landlords for shorter and less rigid lease terms. We will also see more revenue-share-based rental contracts as retailers try to de-risk their cost structures and share some of the pain with real estate companies. The high lease rentals for the desirable and previously higher customer traffic locations close to major transport hubs, in particular, will come under greater scrutiny. These sites will see significant profitability pressures, with reduced travel and lower pedestrian traffic.

Retailers Will Have To Drastically Reduce Their Cost Base

Historically, the retail sector has suffered under the burden of high fixed costs and increasing the topline was key to higher profitability. This pandemic will lead many operators to reevaluate their cost structures, which will need to become a lot more flexible.

To that end, we anticipate an increase in part-time, flexible, or temporary working arrangements for customer serving staff in retail, restaurants, and food service sectors. This could arise from the rationalization of stores and a lower number of staff per site due to reduced capacity and limits to the amount of personal interaction between staff and customers. We also expect greater automation around order picking and fulfillment processes, to enable higher volumes and reduce labor costs.

However, some operating costs will also increase considerably. This pandemic will lead to higher costs and investments in cleaning, hygiene, and health and safety measures to protect employees and customers. This, coupled with physical distancing, will weigh on profitability in the near term. However, we expect these costs will gradually blend into the industry's cost structure.

Restaurants, Cafes, Bars, And Pubs Face Far-Reaching Transformation, And Delivery And Takeaway Will Become More Central To Operations

Even as some countries look to open restaurants and bars selectively, many restrictions remain. We expect the process of easing restrictions to be gradual. In our view, the casual dining, bars, and pubs sectors will be most severely affected by the pandemic and resulting social distancing measures.

When these businesses eventually reopen, they will have to make extensive operating changes and adjustments to how they are configured and serve customers. The food preparation, cooking, and dining areas will have to be redesigned, with tables and customers spread out to ensure appropriate physical distancing. This will have significant implications: When restaurants open, their capacity will be sharply reduced. These businesses will have to materially lower their breakeven costs and rework their margin structures to operate at reduced capacity. In practical terms, this means that many of them will have to get favorable lease terms from their landlords to remain economically viable.

Some segments, like cafes and U.K. wet led pubs (which primarily rely on beer sales), have to broaden their offerings and appeal to more customers. We expect many of these pubs to look to operate in open outdoor spaces, such as the beer garden format. We anticipate that out-of-home consumption will take a long time to recover, and for many businesses, food delivery and takeaway will have to occupy a central place in their business model. Still, we don't expect the growth in these segments to fully cover the lost sales on premises.

We expect quick service restaurants (QSRs) to recover more quickly than dine-in restaurants, especially in the U.S. QSRs' strong off-premise operations offer a convenient, inexpensive alternative to home-cooking. Those with drive-thru lanes and strong digital platforms have benefited even more, as consumers seek to minimize human contact. We expect this subsegment of restaurants to bounce back from the shutdown and be well-positioned in the subsequent recovery. With greater menu choices and more healthy alternatives, the low cost food-away-from-home option will continue to be attractive in an environment of high unemployment and low consumer confidence.

Retailers Will Strive For Greater Control And Visibility Over Their Supply Chains

The pandemic has brought home a stark realization that supply chains for both food and nonfood products, have become very complex and interdependent. With the huge demand surge, the priority for grocers is to have a reliable supply of food and household essentials on their shelves. In the near term, many grocers will be forced to reduce their ranges and focus on fewer stock-keeping units (SKUs) to improve availability of staples and essential products. In many developed economies, we also expect greater emphasis on more local, socially responsible, and sustainable sourcing and packaging, which also matches greater customer expectation around fresh, organic, and healthier food products. As part of this, food safety aspects around the food supply chain become even more critical for customers following high numbers of COVID-19 cases in food processing factories in the U.S. and Europe.

In nonfood segments, many retailers have been hurt severely by the store closures. In the near term, they will have to focus on cash by liquidating their inventories, both through e-commerce and promotions when they are allowed to reopen. The focus will have to be more on working capital management and ensuring their stock levels, orders, and payment terms match demand cycles. To that end, they will have to pay more attention to their merchandising and coordinate more closely with suppliers to manage inventories and payables. Following the lockdown, we expect the stock levels in seasonal categories such as apparel to take several quarters to wind down, resulting in increased levels of markdowns, pack-and-hold storage, and write-offs. Some nonfood retailers with weaker credit quality and without adequate credit insurance will see their suppliers demand upfront cash or advance payments. Over the medium term, the focus for many retailers will be to diversify their supplier base and reduce reliance on a few countries. Some larger retailers will also consolidate and bring their supply chain closer with a view to limiting the reliance on imports that could get disrupted by outbreaks. Financially stronger retailers will see opportunities to acquire attractive brands and smaller rivals, as it is inevitable that some leveraged companies will suffer financial distress.

A Focus On Cash And Rapidly Adapting Business Models Are Key To Preserving Credit Quality

In the near term, many retailers have to focus on liquidity to be able to weather the pandemic. When the lockdowns and restrictions ease, many businesses have to make significant changes to their operating models, as well as their capital structure and financial policy.

Aside from operating transformation, many retailers will have significant changes to their capital structure, because many of them have issued debt to shore up their liquidity during the shutdowns. These debt issuances have taken the form of bonds or in a few cases also government-backed commercial paper programs (primarily in the investment-grade space), additional bank debt in form of loans, drawings under the revolving credit facilities or other loan guarantee schemes or forms of government funding.

For many retailers, aside from improving liquidity coverage, the additional financing will mean higher leverage and the need to take tough financial policy decisions in form of discontinuing share buybacks and even suspending dividends. Many of the more challenged retailers are aiming to significantly cut capex, restricting it to bare maintenance levels. We see this as a major challenge as retailers will also need to fund this transformation at a time when the health of these companies has been already damaged not only by the economic fallout from this pandemic, but the digital disruption most of the sector had to endure over the past few years.

The weak topline recovery will affect margins and cash flow, diminishing the already-low headroom for the ratings on many of these issuers. With more than half of the ratings in the 'B' category or below, and with outlooks weighted toward negative, the pandemic increases the vulnerability of retailers and restaurants to further downside risks. Because it is difficult for them to fill the void in their topline, the success of cost-management and cash-preservation initiatives, which almost all retailers are pursuing, will be key to maintaining credit quality.

Related Research

• Coronavirus Dramatically Increases Risk For Already Stressed Retail And Restaurant Sectors, March 20, 2020
• Spotlight On European Retail Real Estate, March 3, 2020
• Inside Credit: The Health Of Branded European Consumer Goods Companies Isn't Immune To The New Coronavirus, Feb. 3, 2020