SECTOR OUTLOOK

June 2011

Carl Paraskevas Director of Sector Economics | Economic Research T: +44 (0)207 158 1741 E: carl.paraskevas@lloydsbanking.com

CONSUMER DISCRETIONARY RETAIL

Overview
Despite the recent spate of strong headline UK retail figures, retailers are right to be concerned about the future outlook for discretionary consumer spending. Declining real household disposable incomes, combined with higher import prices are likely to prove challenging for high street operators over the next year. The latest estimate of Q1 2011 UK GDP indicated a second consecutive quarterly fall in household consumption, dropping by -0.6% on the quarter and by -0.3% compared with same period last year, highlighting the precarious position of the UK consumer. Fundamentally, elevated levels of unemployment, weak wage growth, a high degree of consumer debt, poor housing market conditions, and the prospects of higher interest rates on the horizon, and fiscal tightening are all acting as headwinds for discretionary retailers. In the absence of continued abnormal weather conditions or additional bank holidays, UK discretionary retailers therefore face an uphill struggle for the rest of the year, with sales in both a volume and value measure set to decline in the second half of the year.
54% of household spending relates to discretionary goods and services.
Household Expenditure by Type Furnishings, household equip. & maintenance 5% Non-discretionary spend 46% Alcoholic beverages & tobacco 5% Clothing and footwear 7% Communication 3%

Miscellaneous goods & services 12% Restaurants and hotels 10%

Recreation Education and culture 1% 11%

Source: LBCM, ONS

We expect real UK household disposable income to fall in 2011, as inflation outstrips wage growth, a key headwind to discretionary UK retailers
Real Disposable Household Income % change from previous year 2.5 2.0 1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5
0 20 4 20 05

Recent retail sales data prove misleading

There have been a number of contributing factors to the recent strength in retail sales year-to-date, including inclement weather conditions last December, pushing non-food retail sales into this year and seasonally better weather in March and April. In addition, inclusion of two additional bank holidays in May acted as boost to underlying retail performance. However, the recent underlying trend in retail sales data points to marked deceleration in non-food annual sales growth, with the 3 monthon-3 month change falling by from 3.3% in March to 1.2% in April in volume terms and a similar decline seen in value terms. In the absence of further weather effects, our non-food retail sales volume forecasts mirror this deceleration, rising by an annual 1.6% in Q2, before contracting by -0.5% in Q3 and -0.3% Q4. At the same time, we expect a sharper decline in sales in nominal terms, as retailers step up discounting in the face of weaker demand.

2.3% 1.5% 1.5% 1.2% 1.1% 0.4% 1.5%

2.1% 1.3%

-0.7% -1.0%
06 007 008 009 010 11F 12F 13F 14F 2 2 2 2 20 20 20 20 20

Source: LBCM

Non-food retail sales by value and volume are growing, but moderating in pace
Non-Food Retail Sales by Value and Volume % change 3 month change on three months a year earlier, SA 14 12 10 8 6 4 2 0 -2 -4 -6
20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09 20 10 20 11

Non-food sales volumes Non-food-sales values

Source: LBCM, Haver

SECTOR OUTLOOK

June 2011

Confidence remains low

Our own sales outlook is confirmed in retailers confidence about their own business prospects over the next six months, which has deteriorated rapidly since Q2 2010, according to the latest CBI distributive trades survey, pointing to weaker trading conditions for the second half of 2011. The retail sector is unlikely to experience the sharp drop witnessed in 2008, but is also unlikely to reach the rapid growth rates experienced prerecession in the short to medium term. Equally, consumer confidence remains at depressed levels, both the GfK consumer confidence and our own Lloyds Consumer Barometer survey are still at historically low levels..

Retail sector performance is set to moderate based on the latest quarterly CBI distributive trades survey
% balance 30 20 10 0 -10 -20 -30 -40 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Q2 Q2 Q2 Q2 Q2 Q2 Q2 Q2 Q2 Q2
CBI Retail Expectations Next Six Months 3 quarter moving average) - leading 1 quarter Retail Output - Services Index (RHS)

% change on previous year 8 7 6 5 4 3 2 1 0 -1 -2 -3

Durable spending is likely to struggle

Weakness in real disposable incomes is likely to disproportionately affect those retailers with addressable markets concentrated around durable goods retailers and home recreation goods, such as recorded media and games. These types of good have historically been highly sensitive to changes in shifts in discretionary income (income after paying for essentials), the net demand effect of a percentage point change in income ranges from 3.8x to 1.5x. Historically less susceptible to income changes are products such as tobacco, beer and small household appliances, which show little demand sensitivity as incomes decline.

Source: LBCM, CBI, ONS

Sensitivity is a decline in discretionary income varies across retail segments.

4.5 4 3.5 3 2.5 2 1.5 1 0.5 0 -0.5 Income Elasticity of Demand for Retail Goods

Small electric household appliances

Major durables for indoor recreation

Games

Household textiles

Major household tools and equipment

Major household appliances

Information processing equipment

Beer

Profitability improves
Despite the weak trading environment, retailers are showing resilience through better management of costs, inventory, and capital spending. There was sharp rise in retail inventories in Q1 2011, up 2.6bn in real terms, but inventory to sales ratios have hardly moved, reflective of the higher sales levels. In terms of capital spending, the distribution sector has shown signs of pull back, falling by -3.2% in Q1 2011 compared to the same period last year, after rising by 8.27% for the full year 2010. Such proactive measures combined with a better trading environment than experienced during the recessionary years have improved the bottom line of the majority of listed retailers, illustrated by increased profit margins and returns on capital. However, underlying uncertainty in future performance still weighs on valuations, which on EV/EBITDA basis remain relatively low compared to the pre-recession period. Valuations peaked at 9x EBITDA in 2006 and are now currently stands at 5.7x.

Source: LBCM, Haver, ONS

Profitability and returns on capital have improved for retailers, but uncertainty remains high
FTSE General Retailer Index Operating Margins and Return on Capital

% 10.5 10.0 9.5 9.0 8.5 8.0 7.5 7.0 6.5 6.0
01 03 05 07 02 04 08 09 06 10 20 20 20 20 20 20 20 20 20 20 C ur re nt

% 25 20 15 10 5 0

Gross Operating Margin

Return on Capital (RHS)

Source: LBMC, Bloomberrg

Electrical appliances for personal care

Major durables for outdoor recreation

Recording media

Tobacco

SECTOR OUTLOOK
DISCLAIMER

June 2011

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