In the latest instalment of our editorial series, Link, experts from Aviva Investors’ credit, equities and real asset teams discuss the consequences of COVID-19 on the retail sector and their implications for investors.
Sectors that had been among the worst hit during the lockdown – notably retail – may find they have the most to lose from the stop-start nature of economies reopening
Barely two weeks after non-essential shops were allowed to open in Leicester, they were ordered to close again on June 29 due to a flare-up in coronavirus infections. Travel into and out of the city deemed non-essential was also severely restricted until further notice, with residents ordered to just stay home. While bars and restaurants are allowed to open elsewhere in England, they will remain shut in Leicester.
The UK’s first local lockdown illustrates the difficulty of easing restrictions. The path will be bumpy and mirror the precarious nature of the COVID-19 outbreak. In its wake, many sectors that had been among the worst hit during the lockdown – notably retail – may find they have the most to lose from the stop-start nature of economies reopening.
Shops, restaurants and other venues already operating on the thinnest of margins and high fixed costs will need to increase expenses further to protect staff and customers, despite being the first in line to close again if COVID-19 cases surge. The social nature of their businesses makes them particularly vulnerable due to the higher probability of an outbreak on their premises. Some have already gone into administration, including Laura Ashley, Carluccio’s and Byron.
Not all retail sectors are suffering during this crisis, however. Supermarkets, for example, have reported record sales, while e-commerce continues to thrive as many customers have migrated online. Such trends, which were already putting pressure on the physical retail sector before the crisis, will likely accelerate.
To discuss the impact to investors, the AIQ editorial team brought together Jonathan Bayfield (JB), head of UK real estate research, Giles Parkinson (GP), global equity fund manager, and credit analysts Sandra Soyer-Berling (SSB) and Shaniv Muttiah (SM).
When will retail get back to ‘normal’?
GP: The hundred trillion-dollar question. In terms of the lockdowns, there was a huge panic to bring economies to a halt in the hope of slowing down the spread of COVID-19. However, from what we have been hearing and seeing, 'life has found a way' in that companies and consumers have tried to carry on as and where they can.
SSB: Social distancing measures bring additional costs for food retailers and consumer goods companies. Despite what some first quarter figures imply – with certain retail players benefiting from COVID-19 in terms of sales – the future impact on margins could be negative as social distancing measures have brought additional costs; for example, to protect employees and customers or to secure supply chain logistics.
According to Kantar data, sales in France for fast-moving consumer goods were up 14 per cent in April and 21.5 per cent in March and continued to be very strong even after the end of the lockdown at about 10 per cent between mid-May to mid-June. Hypermarkets were the main losers in the crisis as consumers migrated online or shopped at local convenience stores, but the trend could reverse as social distancing measures are lifted. Indeed, with a potential decline in consumers’ purchasing power, hypermarkets will likely remain attractive in terms of pricing compared to convenience stores.
The full impact remains uncertain and it is difficult to judge when things will go back to normal
We have also seen changes in consumer behaviour. French consumers, for example, shopped less often during the lockdown but the average basket size was bigger. In response, retailers have rationalised stock-keeping units on shelves; consumer goods companies adapted production to be aligned with retailers and consumer needs, for instance, by offering larger packages. However, the full impact remains uncertain and it is difficult to judge when things will go back to normal.
SM: The whole concept of social distancing is going to prevail for much longer than the end of the lockdown itself. What does this mean for retailers? Some pre-existing themes, particularly the move to online shopping, will simply accelerate and intensify. This is already evident. In addition, given unemployment could reach double digits in most economies and with real disposable income falling, the discount sector would be another channel along with online that will likely see growth.
JB: As Shaniv mentions, downturns often accelerate structural changes and we are likely to see less demand for physical stores. Several retailers will not make it through this crisis. Competitive tension on rents will therefore be massively reduced because there will be fewer players. Property values will likely decrease as a result. Firstly, the rents from which to calculate future cash flows are likely to decrease. And secondly, there will be significantly more risk around this outcome so yields and spreads will move out to compensate.
Pre-crisis, there was a clear move towards customer experience in physical retail: can that continue given the circumstances?
JB: We expect retail space to continue to be repurposed; for instance, discretionary retail in the form of stores offering entertainment and experiences that are difficult to replicate online. Oxford Circus is a good example in the UK: Apple and Microsoft have stores, and you have Nike Town as well. We expect more of this sort of thing, as well as more restaurants and bars because it is hard (if not impossible) to replicate the food and beverage experience online. The trend towards competitive socialising is likely to continue – like axe throwing, dance classes, mini golf and competitions linked to bars.
Longer term, convenience and leisure will win out, with increased demand for online retail and less demand for physical retailing.
What does the acceleration into e-commerce mean from a credit perspective?
SM: The flexibility of operating models is likely to grow. From a credit perspective, the debt and equity mix needs to change significantly. Companies that are shifting online should not need as much capital. Therefore, if a retailer were to come to the credit market, investors should question that. Why are they issuing bonds in a sector that is moving toward an asset-light model, with less reliance on physical stores? The capital structure question will really help investors understand this.
What are the implications for bricks-and-mortar supermarkets if people continue to shop online?
JB: In terms of supermarkets, the UK grocery sector announced record year-on-year growth of 11.3 per cent in March, with online grocery up by about 20 per cent. Ocado claimed at one point it had a tenfold demand increase, and some operators started to limit orders. Tesco, for example, limited online orders to 80 items in March but has since eased the purchasing restrictions. Longer term, we will see a larger percentage of the population becoming more reliant on e-commerce.
The UK proportion for online grocery pre-crisis was at about seven per cent. For e-commerce overall, the figure was around 20 per cent; it’s a fairly mature market. That seven per cent number is going to increase drastically as a result of this crisis towards the overall level. It is highly likely a significant number of consumers may not return to big physical stores and that is something to be concerned about as a real estate investor.
Online retailing, and in particular online grocery, will become much more competitive
However, online retailing, and in particular online grocery, will become much more competitive. Established e-commerce operators – pure plays as we call them like Ocado – will find themselves in a significantly more competitive world in 2021, or whenever the crisis ends. Sainsbury’s and Tesco are getting years of investment and experience in online delivery in a matter of weeks. Click-and-collect (which allows customers to order online and collect at a designated store) and the rise of discounters are trends that should gain more of a foothold, too.
SSB: I would agree. For example, in France, there have been significant investments in food delivery. Supermarkets have known for some time there are huge competitive advantages from moving towards food delivery and the digitisation of supply chains, inventory management and so on. A lot of companies have already invested in these capabilities, and we would expect to see more, particularly in the click-and-collect model.
Are retail companies changing their supply chains as a result of COVID-19?
GP: One way of looking at this is to think of COVID-19 as a slight variance on trade wars and analyse it from there. In that sense, supply chains aren’t really the disruption, it is more about the labour impact: are employees able to work in warehouses? This comes down to whether the company they work for is doing enough, but also government guidance and so on.
COVID-19 has effectively highlighted companies that are robust and have put the right procedures and culture in place
It is not completely obvious why some retailers have been able to continue delivering while others haven't. COVID-19 has effectively highlighted companies that are robust and have put the right procedures and culture in place. John Lewis, for example, carried on uninterrupted across a wide range of goods, whereas TK Maxx stopped taking online orders.
The other instance is the ability and ease with which companies could, in the white-collar world at least, switch to working from home. Many companies left this very late, almost until the last government-mandated minute, in what’s possibly an indication of insufficient IT infrastructure and contingency planning.
JB: I completely agree. COVID-19 has shone a light on companies that are better prepared. One thing you can be sure of is there will be an acceleration and further implementation of digitised supply chains. Many of the retailers we deal with haven't had a proper handle on where products are at any given moment, or where they are coming from. This is baffling and represents a massive wake-up call. Having a robust digital system that integrates all products and can be utilised across different channels and platforms will be a key trend in logistics management as we come out the other side.
JD.com, China's largest online firm, has utilised autonomous vehicles to facilitate the delivery of medical/commercial cargo in Hubei province during this crisis. So perhaps there is more to come in that area. In terms of near shoring, one example would be Unilever saying most of its products are made in the country of sale, so it can deliver them quicker. By not being reliant on global supply chains, the company has been able to weather this storm quite well.
SM: COVID-19 has exposed gaps in the supply chain. It is likely to lead to a diversification of supply chains, near sourcing and reshoring. This isn’t something that can be fixed overnight but is a theme that will play out over the medium to long term.
A lot has been said about 'just-in-case' vs 'just-in-time' inventory management. Is there real tension here between operational efficiency and operational resilience?
GP: This comes back to quantitative versus qualitative investing. A quantitative approach measures tangible metrics about a company – profit margins, return on capital, and so on. These can all be quantified and dropped into a Bloomberg terminal and then automated and factorised. That level of information is, almost by definition, available to everyone. It therefore cannot be an investment differentiator.
Focusing on the qualitative differences between businesses acts like a Litmus test
Qualitative information, on the other hand, can be. Focusing on the qualitative differences between businesses, like how they respond to a crisis such as the coronavirus, acts like a Litmus test. You can easily see the companies that are nimble and able to adapt. It could be that they have made the right investments for many years and we just hadn't noticed them in the investment community as they weren’t showing up clearly in their reporting. Costs that were showing up may have seemed profligate, but they were investing in the right areas and the extra cost is just a sign that the company was genuinely being run for the long term.
When comparing performance in recent months, there are some companies in which you can't even spot any coronavirus impact in their quarterly results. That infers there is something materially different about the way they are run versus their peers.
What about the repurposing of real estate assets? Will we see more of this?
JB: Less demand for retail space in the long term could well mean that buildings are repurposed into offices or residential. Conversions have been popular, particularly in London and the southeast where residential values are high, leading to some retail parks to be converted into dwellings for sale and rent. The shock to the retail market will probably be worse than the shock to the housing market, and therefore there should be more opportunities in this area. Indeed, we have done a quite a few, notably on the Old Kent Road in London.
Logistics facilities located close to large catchment areas are also in high demand, where last mile logistic delivery can take place. The rents for these locations are now getting close to the levels for pure retailing and there have been a couple of examples of retail warehouses being converted into distribution parks. We only see this trend hastening as a result of the crisis.
Are you seeing more long-term changes at the intersection of retail, leisure and real assets?
JB: Interestingly, a general trend in real assets, and real estate in particular, has been a move toward space being used as a service. I sometimes refer to this as the ‘hotelification’ of real estate. For example, shops were historically the only delivery method for getting goods to people. Now you can do that online – we know COVID-19 is only going to accelerate this. Hotels are an excellent example of an industry where unique experiences are created that people are happy to pay for.
We see physical stores taking a leaf out of hotels’ books and looking to draw inspiration to create unique experiences
In future, we see physical stores taking a leaf out of hotels’ books and looking to draw inspiration to create unique experiences. Some retailers are already paying for stores out of that advertising budget. Though people may not actually buy something in store, they do interact with the brand. This blurs the budgeting lines quite a bit.
Will there be material changes to the existing lease model? Could we see a tilt towards more performance-based, revenue-based model for physical retail as is the case in the US?
JB: Yes. Generally, grocery leases may be linked to the consumer price index or retail price index in the UK, allowing for some certainty of what companies will pay in the future. This should be maintained, both in distribution facilities and in physical store locations as there has clearly been a significant increase in demand for grocery: people can't eat out.
However, for discretionary retailing, it makes sense to look to America for a signal. Although we already have examples of turnover leases and performance-based leases in the UK and Europe, they are generally in the designer outlet centres, where there tends to be a high barrier to entry.
The huge shock to demand for physical space in terms of traditional stores could mark a major market shift towards turnover and performance-based leases, as well as a massive rebasing in pricing. I don’t expect this to happen instantly and all at once, but it seems likely that the trend will emerge. In high-quality parts of central London, some elements of this already exist within leases.
How do you see this affecting the relative attractiveness of the UK market to institutional investors?
JB: Institutions have historically been the biggest investors into commercial property. If we move to majority turnover leases (in which the rent is based on the turnover from the underlying premises), the income is effectively less secure. And I would suggest pricing will follow to reflect the increased risk of the sector. However, these trends are also occurring in offices given the trend towards flexible working and serviced offices, which have brought leases down significantly.
Real estate in all sectors is becoming more operationally intensive and asset management intensive
In essence, real estate in all sectors is becoming more operationally intensive and asset management intensive. You need specialists that can really work the assets and take on that operational risk for you as an investor.