Employment Slump Pressures Consumer Companies

(This is the first of two parts.) With the U.S. unemployment rate at its highest in more than a quarter-century and likely to rise further, industries that depend on discretionary consumer spending may not rebound soon. In October, the jobless rate jumped to 10.2%, a 26-year high. Standard & Poor's Chief Economist David Wyss predicts that unemployment will continue to climb, reaching 10.6% in mid-2010. Even with Congress' extension of jobless benefits and the pace of job losses having slowed since the recession's trough, Americans will probably value frugality until there's a verifiable and significant reduction in unemployment, which could take years to happen. In addition, a still-unstable housing market and concerns that the economy could again falter continue to outweigh any so-called wealth effect that the recent rebound in stock markets may have created. It's no surprise, then, that Americans prefer to save than to spend: The U.S. personal savings rate reached 3.3% in September, almost double the low of 1.7% we saw in 2007, but still below its historical average. Retailers—particularly luxury chains—have suffered most in this environment. Gaming and lodging companies have also taken a hit because they depend on discretionary spending (and, in the case of hotel operators, on business travel). Manufacturers have suffered as well. Apparel companies are generally struggling, and automakers are looking at annual sales that are more than one-third below their peak. After a temporary boost from the government's cash-for-clunkers car rebate program, consumer spending fell 0.5% in September. Subsequently, consumer confidence dropped to 47.7 in October, from 53.4 a month earlier, suggesting that Americans are tightening purse strings as they head into the end-of-year holiday season. And while October retail sales rose 1.4%, this came as the Commerce Dept. revised September sales data to show a 2.3% decline. Retailers And Restaurants: Quiet Cash Registers While even some upscale retailers have enjoyed a bump as sales at U.S. chains increased for the second consecutive month in October, Standard & Poor's Ratings Services believes this is only an early sign of stabilization, rather than the start of a sustainable surge. The main problem facing retailers is high unemployment. "Consumers can come to terms with many things: rising gasoline prices, stock market volatility, etc.," says Standard & Poor's Senior Director Gerald A. Hirschberg. "But you can never get accustomed to being out of a job." Adding to the overall pain in the retail sector is the fact that even wealthy consumers have curtailed spending. Luxury retailers such as Neiman Marcus (S&P credit rating: B) and Saks (SKS) (B-/Negative/—) have taken a somewhat surprising beating, given that their core customer base still has plenty of buying power. Simply put, psychological forces that counterbalance the wealth effect seem to have changed even affluent consumers' spending mentality. Fortunately, many retailers have prepared for a prolonged slump. Heading into the holiday season, they have slashed inventories, which may help them bolster prices. It seems unlikely that shoppers will enjoy the 70% and 80% discounts they saw last year. That isn't to say that promotions, with attractive discounts, are a thing of the past, but merely that stores are prepared for what will surely be yet another very competitive season. All told, while sales may be down for the holidays, merchandise margins stand a good chance to be up from last year. At any rate, Standard & Poor's believes that retailers can expect more traffic this holiday season than in 2008, even if consumers remain wary because they have less discretionary income. "Many shopping malls are full of people now but consumers are being very careful about what they buy," Mr. Hirschberg said. "So yes, it's going to be difficult to find a parking spot at the mall, but shoppers are still being frugal." As customers look to economize, discount retailers have tended to benefit. Dollar stores have done remarkably well in this recession, and customers trading down have been a boon to Wal-Mart Stores (WMT) (AA), a perennial sales leader. Target (TGT) (A+), the country's No. 2 discounter, hasn't fared as well because of its higher-price image, inventory of more discretionary items, and much smaller mix of groceries in its sales. In this vein, auto parts retailers have also fared reasonably well because consumers are doing more repairs themselves, rather than paying mechanics. Meanwhile, retailers in big cities such as New York have fared comparatively well as tourists—especially Europeans benefitting from the euro's strength against the dollar—have helped to bolster sales to a limited degree. Supermarkets have proved to be largely resistant to recessions, despite some struggling seen among high-end companies such as Whole Foods Market (WFMI) (BB-). Restaurants have fared variously, depending on their clientele. Casual dining chains such as Chili's Grill & Bar and T.G.I. Friday's (both unrated) have been hurt, with traffic and sales down substantially. We don't expect much of a turnaround until the U.S. job market starts to improve. Much of the business at upscale restaurants, meanwhile, depends heavily on corporate accounts. Until companies start to loosen up on expenses, we expect sales at fine-dining establishments to remain well below those of prior years. The eateries that have done best, relatively speaking, are so-called quick-service restaurants (QSRs) such as McDonald's (MCD) (A), which has the world's highest restaurant sales. Clearly consumers are looking to McDonald's and such rivals as Burger King (BKC) (BB-/Stable/—) to save money on meals they purchase and eat outside the home. With regard to our corporate credit ratings, much of the news has been bad in the restaurant and retail sectors. Through the end of October, we had taken 62 rating actions—43 of them to the downside. That followed our 71 downgrades (compared with just 18 upgrades) for all of 2008—the worst year for these sectors in recent memory. Things were especially gloomy in the fourth quarter of last year, when 22 of our 25 rating actions were downgrades, including selective defaults. While we expect ratings to stabilize, with the worst of the U.S. economic slump presumably behind us, the environment for retailers is hardly favorable. Even after unemployment peaks, a drop back down to 10%, for example, isn't likely to spur consumer confidence as much as retailers wish. For 2010, we expect to see a mild recovery in sales, assuming there is no double-dip recession. All things considered, however, U.S. restaurants and retailers are bracing for a prolonged struggle. Apparel Makers, Personal-Care Products: Feeling The Pinch Moving back up the supply chain to apparel makers, it's no surprise that many are suffering badly. Sales are slumping and stores are carrying less inventory—a one-two punch that many apparel makers are struggling to absorb. While shoppers will buy if they are offered better value for their money, we expect purchasing of luxury apparel and accessories to be far from robust. "Consumers' behavior has clearly changed," said Standard & Poor's Ratings Services Director Jayne Ross. "Unless people see an offer they can't refuse, they are simply not going to buy." Some companies in the apparel sector have struggled more than others in an increasingly competitive market—one that carries significant risk associated with changing fashions, even in the best of times. Liz Claiborne (LIZ) (B), for example, has in recent years added higher-margin contemporary brands such as Juicy Couture, Lucky, and Kate Spade while selling, exiting, or discontinuing noncore businesses, including many of its moderate-margin brands. In this difficult and more promotional retail environment, the company's revenues and margins have suffered as more value-oriented consumers eschew higher-end goods. Meanwhile, clothing companies that can rely more on classics and basics are poised to fare comparatively well. For example, Jones Apparel Group (JNY) (BB-), with its strategy of offering multiple brands over various price points and distribution channels, looks as if it may have righted itself. While the company's sales dropped 8.9% in the first quarter, the decline was far less than it originally expected. Jones Apparel's well-recognized brands in the women's apparel and footwear segments—including Anne Klein, Gloria Vanderbilt, and Nine West—will likely help. Moves down the pricing scale to "value" products have also occurred in household and personal care items. Consumers are also waiting longer to repurchase necessities, rather than maintaining a stockpile as in the past. Companies that have anticipated these trends stand to fare better than their competitors. Procter & Gamble (PG) (AA-), for instance, built its product portfolio on the premise of developing and selling more premium products through pricing, packaging, and innovation. But as consumers trade down to lower-cost alternatives and private labels in several of the company's segments—particularly grooming, health care, and beauty—or curtail discretionary spending, Procter & Gamble is increasing its investment in new products, trying to balance its product-value equation, and continuing to broaden its product mix. (Next: Gaming & lodging, airlines, carmakers, and technology.)

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