The strong economic rebound in Europe has created several pressures on retail and consumer goods companies. They face higher wages, price rises, shortages of raw materials, and increased costs for freight, packaging, logistics, and energy. While we do expect some squeeze on margins for the sector as a whole, most market leaders and large companies will be able to benefit from higher demand and offset higher input costs from a combination of internal cost-saving measures and selective price rises. A diverse supplier base, bigger order capacity, and superior supply chains and logistics will enable larger companies to gain more competitive advantage based on better product range and availability.

At the other end of the spectrum, highly leveraged companies with weak business risk profiles (35% of rated consumer product companies and 22% of rated retailers) typically have less bargaining power with respect to suppliers and services such as freight. While some regional players holding niche product leadership positions or those with an efficient local supply chains and low overheads will be less impacted, many smaller companies remain vulnerable to significant volatility in operating performance, strong competition, and tough execution amid persistent cost inflation. Many of these companies, still early in the process of recovery from pandemic-related shocks, will struggle to provide a customer experience that can compete with the reach, range, speed, and efficiency of larger players' well-developed global diversified supply chain capability. For these retail and consumer product companies, supply chain and logistical challenges and persistent inflationary headwinds, which we expect will continue into the second half of 2022, will result in margin pressure, slower deleveraging, and lower rating headroom.

Retailers Have Delivered Robust Sales Despite Several Operating Bottlenecks

Europe's economy has responded strongly to the reopening, leading us to revise upward our 2021 GDP growth forecasts. We expect the eurozone economy to expand 5.1% this year and 4.5% in 2022 (after a 6.5% contraction in 2020) largely due to better-than-expected second-quarter GDP growth, underpinned by strong household spending as restrictions were lifted, a strong rebound in investment, and job creation.

High household savings and strong consumer confidence has fuelled the recovery in retail sales (see chart 1). The retail sales growth that started in the second half of last year has continued into this year, with the overall retail sales value index remaining higher than before the pandemic. Buoyant e-commerce and the reopening of stores have boosted retail sales on the back of higher volumes.

Chart 1

However, customer demand and spending continue to shift with the reopening of the economy, and we expect to see variability in sales across subsectors. For instance, apparel retail sales are still around 20% below pre-pandemic levels for the industry while a few market leading brands have shown a strong rebound in their topline. In addition, COVID-19 outbreaks, and restrictions in countries like Vietnam has also affected production capacity. Together with product availability constraints (also reflecting freight and transport delays and uncertainties from China and Asian manufacturing hubs), this puts great pressure on companies to preempt demand patterns. This is a particular issue for retailers that are more reliant on seasonal and Christmas-related merchandise.

While material labor and logistical challenges have had a global impact across several industries, U.K.-based agribusiness, food products, retailers, and restaurants have been hit the most severely due to lack of workers. These industries have historically sourced the bulk of their workforce from continental Europe, and have therefore suffered from Brexit-induced labor shortages in general and specific issues such as scarcity of heavy goods vehicle drivers and additional documentation and checks when moving goods between borders.

Although price increases are evident in food and also consumer goods and services, higher inflation still predominantly arises from higher energy and fuel prices. In October, the highest contribution to the annual euro area inflation rate of 4.1% came from higher energy prices at 2.21%, followed by services at 0.86%, non-energy industrial goods at 0.55%, and food, alcohol, and tobacco at 0.43% (see chart 2). In the U.K., the CPI index also rose by 4.2% in the 12 months to October 2021. Again, the largest increases came from higher transport costs (1.35%) on back of higher motor fuels and household energy costs (0.95%).

Chart 2

Cost Savings And Efficiencies Will Help Absorb Some Of The Inflationary Pressures

Almost all the companies we rate intend to continue to focus on cost efficiencies to offset some of the cost increases. Many companies continue to follow through on the defensive steps that they took to lower their cost base during the peak of the pandemic. For much of the sector, these actions were critical in limiting the damage of the pandemic, in addition to government support in the form of furlough schemes and business rate and payment holidays. The focus on reducing costs continues as many of these support schemes have been phased out. As such, many retailers and consumer goods companies have entered the recovery phase, with leaner cost structures and higher focus on operating and cost efficiencies through greater use of technology and automation.

But, We Expect That Most Companies Will Raise Prices To An Extent

Most of the retailers and consumer product companies that we rate have several tools at their disposal to cope with the inflationary pressures. Many companies, especially in the consumer products sector, are able to selectively modify, rationalize, and reconfigure products to match new price points (see chart 3).

These include reducing quantities, pack sizes, and packaging to manage the price perception at the consumer end while maintaining broadly similar product-level margins after factoring in higher input costs.

Chart 3

Consumer goods companies in particular will be able to use premiumization and product innovation to launch new products at premium price points. Retailers will also look to adopt differentiated pricing on certain private label products with premium and discount ranges to suit a wider range of consumers. However, in our view, branded consumer goods companies are likely to be more successful in increasing and maintaining higher prices compared with private label products. Concerns on higher input prices and the need to manage margins has also curtailed promotional activity in the sector to a large extent and will narrow the price gap between discounters and mainstream retailers.

In our view, branded consumer product companies have a moderate to high ability to pass costs on to consumers (see chart 4). However, the highly competitive retail landscape and wide range of competing brands and products often mean that consumer-facing price increases are typically undertaken after a time lag and only after consideration of several alternatives. Price increases are done thoughtfully and take into account a variety of factors such as competitive conditions, the nature of the product, and its demand elasticity. Furthermore, many consumer goods companies and retailers have invested significantly in IT systems to gather and analyze customer data. They have good visibility on what their consumers are buying and their reaction to price modifications. We expect many companies will be making small and periodic price adjustments rather than one-off large price increases.

Chart 4

Securing A Timely Supply Of Goods Will Be A Higher Priority Than Working Capital Management

As long as the supply-side and shipping disruptions continue, companies will pay less attention to working capital and trade terms as their main priority will be to secure supplies on time to prevent stock-outs. Faced with supply disruptions, companies are more focused on maintaining amicable relationships with their suppliers and avoiding unnecessary tensions around pricing.

This will have a knock-on impact on working capital, which we expect will deteriorate over 2021 and into the second half of 2022. In 2020, by contrast, working capital was a surprise positive factor for many rated companies. Both consumer and retail companies had significant payback from their efforts to carefully manage order flow, inventories, and payment terms. In fact, working capital played a large part in the reduction of S&P Global Ratings-adjusted debt, which fell in 2020 compared to 2019 at investment- and speculative-grade food retailers and at investment-grade nonfood retailers.

Credit Quality Should Hold, But Cost Pressures Will Dampen Margins And Impede The Full Benefits Of Post-Pandemic Recovery

Over the last four quarters, rating actions across both the European retailers and consumer product companies have been mainly positive. This has reflected the higher-than-anticipated resilience of these companies to the extremely tough operating conditions during the pandemic. While we expect strong topline in the key golden quarter, which includes Black Friday and Christmas trading on back of strong consumer demand, this sales growth is unlikely to feed into higher profitability for many companies across the sector.

The ability to pass on input-cost increases to customers varies because of the uneven recovery across the many sub-segments. Larger and more-diversified consumer goods companies and retailers have greater pricing flexibility thanks to more nimble and well-established supply chains. For others, especially smaller and highly leveraged retailers, their ability to absorb higher input and labor costs remains largely limited. Highly leveraged companies with weaker business risks have typically lower bargaining power with respect to suppliers and services such as freight. They also remain vulnerable to significant volatility in operating performance, strong competition, and tough execution amid ongoing cost inflation. If the supply chain issues and inflation remain more persistent, some of these companies will struggle to reach their pre-pandemic margins despite strong consumer demand. That said, in our base case we expect many components of higher inflation for consumer goods and retail companies to likely ease significantly from the end of next year, setting the scene for a stronger recovery in 2023.

Editor: Sam Foster. Digital Designer: Joe Carrick-Varty.

Related Research

• Supply Chain Strains and Rising Costs Will Pressure Profitability in 2022, Nov. 18, 2021
• Industry Top Trends Update: Retail and Restaurants EMEA, July 15, 2021
• Industry Top Trends Update: Consumer Products EMEA, July 15, 2021
• European Retailers Seek To Reopen Their Doors To Usher In The Post-Pandemic Recovery June 29, 2021
• U.K. Pubs, Shaken And Stirred, Look To Recover After A Cocktail Of Headwinds, April 8, 2021