R&I Rating Methodology by Sector Department Stores April 9, 2013 R&I applies its rating methodology for department stores when rating retail firms such as the member stores of the Japan Department Stores Association that manage large-format stores where the main approach to sales, as a rule, is face-to-face selling. Firms that have grown into major department stores, however, are involved in managing supermarkets and specialty stores as well, and are broadly developing their operations to encompass activities such as the credit card business or shopping center management. When assigning ratings, R&I also factors in evaluations of such non-department store operations (i.e., diversified businesses). I. Evaluation of Business Risk 1. View of industry risk Given their need for a commensurate amount of floor space, domestically it has become difficult for department stores to find branch store locations in the commercial districts of large cities that are appropriate for store placement. When compared with other retailers such as super markets and convenience stores, the risk that competition in an existing commercial area will intensify further because of the opening of a new department store branch is limited. The scope of competition has been broadened more than in previous years, however, by the emergence of shops offered in alternative formats such as train station buildings and shopping centers (SC) and by Internet sales. Combined with the maturation of domestic consumption this has resulted in contracting sales for the department store industry. Department store product lines include many nonessential items such as expensive, up-scale clothing, and sales are highly susceptible to changes in the economy or asset prices. During an economic downturn, department stores are the most seriously affected of all retail stores. A large burden for fixed costs such as personnel expenses and rent, and a lack of flexibility in the revenue and expenditure structure, are negative factors as well. Countering these is low inventory risk, because the majority of products are offered through outsourced stocking or consignment stocking, and products that remain unsold are taken back by suppliers. Companies are also able to recover their investments in stores over a long timeframe. Provided it can maintain its stores competitive 1/9
edge, a department store firm can ensure stable earnings, but once its stores competitiveness weakens, it will quickly begin accumulating losses and returning to profitability will be an uphill task. Comprehensively considering the above factors, R&I judges department store industry risk to be positioned within the comparatively high risk category. (1) Market size, market growth potential and market volatility Total sales for member merchants of the Japan Department Stores Association in 2012 (calendar year) were 6,145.3 billion yen. Sales are only about 80% of the 7,705.2 billion yen achieved before the bankruptcy of Lehman Brothers (2007), and have shrunk by more than 3 trillion yen from their peak in 1991. With Japan s population decreasing, the competition from other business formats is more intense than before, and over the medium to long-term, domestic sales are expected to continue along their downward trend. In the wake of Lehman s collapse in 2008, the drop in sales reached 10.1% in 2009 (calendar year). Because of the high percentage of fashionable, comparatively high priced products handled, including apparel and miscellaneous goods, department store sales are affected easily not only by any increase or decrease in disposable incomes but also by changes in the price of assets such as stock and property values. Within the retail industry, R&I judges department store market volatility to be high. (2) Industry structure (competitive environment) A flagship or large-scale store that supports a department store s earnings commensurately retains a repeat clientele from among high-net-worth individuals and middle-aged and senior customers and enjoys a comparatively high level of store loyalty for purchases of items such as gifts. Therefore a large collapse of the operational base within a short period of time is difficult to envisage. Although the scope of competition has broadened to include other retail formats, department stores are not exposed to the keen competitive environment faced by segments such as household appliance centers, which compete mainly on price, or specialty shops selling apparel and personal belongings, which are easily buffeted by the whims of fashion and personal tastes. On the other hand, local and suburban department stores continue to lose customers to formats such as large-scale shopping centers, and compared with urban retailers the competitive environment is severe. 2/9
(3) Customer continuity and stability Because list price sales provide the foundation for department stores, the same prices are used for the same product not only at other stores within the group but also by competitors stores. Moreover, because of the need to control inventory risk, suppliers are responsible for determining a large share of the product line-up. While there are differences arising from a store s characteristics and importance from the perspective of suppliers, including whether the store is the leader in a region, product lines also tend to resemble those at competing department stores. As making significant differentiation by product contents or prices and the product line-up is difficult, brand strength, convenience, store ambience and familiarity handed down from one s parents generation become the factors determining which department store a customer will choose. When customers have a department store they visit regularly, in many cases they will be awarded with preferential treatment and privileges, such as discounts on their purchase amount and points they can use toward future purchases, that keep them shopping at the same store. Compared with business categories such as household appliance retailers that have a high degree of pricing discretion, customer continuity and stability can perhaps be deemed high. Nevertheless, customers are being siphoned off by other retailing formats, including railway station buildings and commercial buildings in the central area of Tokyo and shopping centers in regional and suburban areas. Department stores customer retention rate is thus believed to be slipping gradually. (4) Capital and inventory investment cycles Opening a new flagship-class store or investing in a large-scale expansion of floor space and refurbishing demands capital in the range of several tens of billion yen. Even though many years are required to recover investments, this is acceptable because the sites where department stores are located, such as the prime sites around railway stations, are areas whose position as commercial zones is not easily altered. Companies often prepare investment recovery plans for lengthy periods that exceed 20 years. Upgrade investments such as those in store renovations are incurred continuously, but generally do not impose a heavy burden. For many items, department stores stocking takes the form of outsourced stocking or consignment stocking, in which suppliers must take back unsold products. Because department stores do not take ownership of the bulk of their in-store inventory, their inventory burden is light. 3/9
(5) Protection, regulation and public aspects For many years, Japan s Department Store Law strictly regulated department stores on matters such as new branch openings, increases in floor area and management integration. Although the Department Store Law was abolished and the Large-Scale Retail Stores Law was enforced in 1974, regulations on branch store size continued and had the effect of tamping down the increase in competition. Conditions were changed, however, when the Large-Scale Retail Stores Location Law was enforced in 2000 and pivoted regulation from restrictions on branch size to social regulations on issues such as traffic snarls, noise and waste management. Opening large-scale commercial facilities in suburbs became easier, and the number of large-scale commercial facilities filled with commercial tenants has grown, which has weakened the competitiveness of local stores and suburban shops of department store operators. With the subsequent amendment of the City Planning Act in 2006, establishment of large-scale commercial facilities in suburbs became considerably more difficult. In regional areas, however, it has been difficult to call back the customers who flocked to these new business districts in the suburbs, and in many areas, the law has not succeeded in revitalizing the business districts around stations where department stores are located. (6) Cost structure Although department stores handle a wide variety of high-priced goods, a large percentage of items are stocked using a format such as consignment stocking that places a certain amount of the burden on suppliers. Gross operating (sales) margins in the department store business remain at the 20% level. At the same time, however, the burden for fixed costs such as personnel expense, store rents and depreciation and amortization expense is heavy, and the cost structure has little flexibility. Although business strategy alternatives such as introducing popular tenants and enhancing food counters as countermeasures against competing stores have broadened, when the generally low profit margins from these attempts are considered, continuous review of the cost structure is essential. 2. View of individual firm risk In contrast to industry risk, which highlights the standard risks of the industry of which the subject firms are a part, the business risk of each company will differ depending on the individual firm risk as explained below. 4/9
(1) Strength of the operational base For many department stores, the main stores such as flagship and large stores underpin their entire earnings. When looking ahead, an improved operating environment for regional and suburban stores is difficult to anticipate because of factors such as Japan s shrinking population and the slump in income levels, and dependence on the earnings of the main stores is unlikely to change. Therefore the more a department store operator has the dominant regional store or several stores of nearly similar size in leading commercial districts such as the central area of Tokyo, the stronger the stability of its operational base will be. Given the severity of the competitive climate, however, it is critical to not only have the status of a leading store but to also ensure profitability that is appropriate for that position. (2) Store portfolio Among department store branches, regional stores and suburban stores in particular face a tougher competitive climate than their urban counterparts, with a comparatively large number of stores locked in fierce combat. Declining birthrates and the growing proportion of elderly are more advanced in regional areas, and compared with major urban centers the absolute number of people in higher income brackets is limited. Moreover, large-scale shopping centers and specialty store formats have been opened along major thoroughfares, and in many cases the competitive situation with these alternative formats is more severe than in metropolitan areas as well. Among suburban stores, outlets with weak operating results can be seen here and there as a result not only of the same competition with large-scale suburban commercial facilities that local shops face, but also because of the heightened competition with large-scale commercial districts such as those in central Tokyo. A store s ability to ensure stable earnings continuously under such a severe operating environment can be said to offer proof that it has gained a certain amount of customer support in the region it is developing. Conversely, should its sales continue to fall and a store be unable to make headway in boosting its earnings, this becomes a risk factor for the department store because it shackles the earnings of the entire group. (3) Competitiveness of diversified businesses Viewed from population dynamics and the severity of the competitive environment, it is difficult to forecast growth for the core department store business over the long term. Moreover, 5/9
sales are affected easily by changes in the economy and asset prices. While each department store is confronted by these issues in its main business, cultivating and strengthening diversified operations is essential to assure a certain amount of earnings for the entire group. Provided it can anticipate a certain level of profit contribution from diversified activities by increasing its competitiveness and improving its position in the related industries, a department store will be able to maintain steady earnings for the group as a whole. (4) Product proposal capabilities As the lines dividing business categories in the retail industry have blurred, competitors offering product line-ups similar to those at department stores have increased, including specialty stores, railway station buildings or commercial properties filled with such specialty stores, and apparel companies directly managed shops. Pursuing unique and novel products and services, and offering a uniform ambience and experience as a store, have therefore become strategically important. An additional critical point is whether a department store retailer has the capacity to introduce products and services tailored to its locations and the range of customers it is targeting. (5) Buffer against a fixed cost burden To maintain a certain degree of profitability even when earnings from the department store business are under pressure because of deterioration of the economy or the competitive climate, measures to mitigate the fixed cost burden, in tandem with strengthening the competitiveness of diversified operations, are essential. Some firms adopt a strategy of reducing store operating costs while introducing outside tenants, and others seek to maintain earnings by strengthening sales floors of their own design and selling high-margin items through laborious efforts such as in customer service. Although each store s image and range of customers differs, and it is impossible to say categorically which approach is superior, R&I believes that ascertaining whether a company is able to control costs while skillfully maintaining a balance between gross margin and selling and administrative expenses is important. II. Evaluation of Financial Risk In addition to quantitative factors in the form of financial data, R&I also evaluates qualitative factors, such as a firm s financial management policy and liquidity risk, in its analysis of financial risk. For the department store industry, R&I emphasizes the following financial indicators in 6/9
consideration of the industry s business characteristics. Because a comparatively large number of department store branches are leasehold properties, R&I places great importance on indicators calculated based on total assets, debt and EBITDA (earnings before interest, taxes, depreciation and amortization) adjusted for off-balance sheet transactions such as operating leases (including property leases), which R&I regards as assets procured or purchased with borrowed funds. (1) Earning capacity EBITDA/average total assets, operating income to operating revenue (sales) ratio R&I considers the ratio of EBITDA/average total assets to be important from the standpoint of assessing whether a company is efficiently ensuring profits and cash flow from assets such as stores in which it has invested. In conjunction with this, R&I also evaluates operating income as a percentage of revenues from operations (sales), in order to understand the business not only from the viewpoint of asset efficiency but also to grasp the actual strength of earning capacity as a department store and the extent of the fixed cost burden. (2) Scale and investment capacity EBITDA, equity capital Any financial analysis of a department store firm must look at whether the company has provided the investment capacity to implement well-timed, necessary spending such as investments to open branch stores or increase floor area and to refurbish store interiors. For this purpose R&I focuses on EBITDA. EBITDA can also be called an important indicator for examining the extent to which a firm can ensure the funds it needs to repay its debt. R&I verifies the amount of equity capital as well. Provided it has an ample equity capital cushion, a firm can raise outside funding smoothly when undertaking large-scale investments, and will also be able to withstand even if, for example, asset impairment risk is actualized. (3) Debt redemption period Net debt to EBITDA ratio While there are few examples of department stores expanding their business base by continuously opening new branch stores like other retailers because of the limited room for opening new branches, investment in store renovations is indispensable in the retailing industry in order to respond to moves by competing firms and changes in the business environment. Although amounts 7/9
invested in periodic remodeling to keep stores looking fresh are not large, firms may take on a considerable amount of debt including leases when they undertake large investments to expand floor areas or carry out large-scale renovations of selling spaces. R&I believes that understanding the amount of time required to repay such liabilities is critical for verifying future investment capacity as well. (4) Financial profile Equity ratio, net D/E ratio (ratio of net debt to equity capital) When a company is slow to close stores that are no longer competitive, or when it continues unprofitable businesses, its capacity for investments such as new branch store openings or floor area expansion and interior renovation will eventually wither, a development that could accelerate its decline in competitiveness. A firm therefore must ensure a certain degree of financial resilience to provide against losses resulting from actions such as closing stores and winding down money-losing businesses. III. Rating for Department Store Industry Issuer Rating Individual Firm Risk Financial Risk Importance Indicator Importance Strength of the operational base Earning capacity EBITDA/average total assets Store portfolio Operating income to operating Competitiveness of diversified businesses revenue (sales) ratio Product proposal capabilities Scale and EBITDA Buffer against a fixed cost burden investment capacity Equity capital Debt redemption period Net debt to EBITDA ratio Financial profile Equity ratio Net D/E ratio Industry Risk: Relatively high Note) Importance is indicated by : extremely important, : important, or relatively important. 8/9
* This report replaces all previous versions that have been released to date. The Rating Determination Policy and the Rating Methodologies R&I uses in connection with evaluation of creditworthiness (collectively, the "Rating Determination Policy and Methodologies") are R&I's opinions prepared based on R&I's own analysis and research, and R&I makes no representation or warranty, express or implied, as to the accuracy, timeliness, adequacy, completeness, merchantability, fitness for any particular purpose, or any other matter with respect to the Rating Determination Policy and Methodologies. Further, disclosure of the Rating Determination Policy and Methodologies by R&I does not constitute any form of advice regarding investment decisions or financial matters or comment on the suitability of any investment for any party. R&I is not liable in any way for any damage arising in respect of a user or other third party in relation to the content or the use of the Rating Determination Policy and Methodologies, regardless of the reason for the claim, and irrespective of negligence or fault of R&I. All rights and interests (including patent rights, copyrights, other intellectual property rights, and know-how) regarding the Rating Determination Policy and Methodologies belong to R&I. Use of the Rating Determination Policy and Methodologies, in whole or in part, for purposes beyond personal use (including reproducing, amending, sending, distributing, transferring, lending, translating, or adapting the information), and storing the Rating Determination Policy and Methodologies for subsequent use, is prohibited without R&I's prior written permission. Japanese is the official language of this material and if there are any inconsistencies or discrepancies between the information written in Japanese and the information written in languages other than Japanese the information written in Japanese will take precedence. 9/9