June 2011

Carl Paraskevas Director of Sector Economics | Economic Research T: +44 (0)207 158 1741 E:

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


June 2011

Confidence remains low
Our own sales outlook is confirmed in retailer’s 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


Household textiles

Major household tools and equipment

Major household appliances

Information processing equipment


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



June 2011

This document, its contents and any related communication (altogether, the 'Communication') does not constitute or form part of any offer to sell or an invitation to subscribe for, hold or purchase any securities or any other investment. This Communication shall not form the basis of or be relied on in connection with any contract or commitment whatsoever. This Communication is not intended to form, and should not form, the basis of any investment decision. This Communication is not and should not be treated as investment research, a research recommendation, an opinion or advice. Recipients should conduct their own independent enquiries and obtain their own professional legal, regulatory, tax or accounting advice as appropriate. Any transaction which a recipient of this Communication may subsequently enter into may only be on the basis of such enquiries and advice, and that recipient’s own knowledge and experience. This Communication has been prepared by, and is subject to the copyright of, Lloyds. This Communication may not, in whole or in part, be reproduced, transmitted, stored in a retrieval system or translated in any other language in any form, by any means without the prior written consent of Lloyds. This Communication is provided for information purposes only, and is confidential and may not be referred to, disclosed, reproduced or redistributed, in whole or in part, to any other person. This Communication is based on current public information. Whilst Lloyds TSB Bank plc (“Lloyds TSB”) and Bank of Scotland plc ("Bank of Scotland") have exercised reasonable care in preparing this material and any views or information expressed or presented are based on sources it believes to be accurate and reliable, no representation or warranty, express or implied, is made as to the accuracy, reliability or completeness of the facts and data contained herein. This material has been prepared for information purposes only and Lloyds TSB, Bank of Scotland, their directors, officers and employees are not responsible for any consequences arising from any reliance upon such information. Under no circumstances should this material be treated as an offer or solicitation to offer, to buy or sell any product or enter into any transaction. If you receive information from us which is inconsistent with other information which you have received from us, you should refer this to your Lloyds TSB or Bank of Scotland Relationship Manager for clarification. Lloyds Bank Corporate Markets, Lloyds TSB Corporate Markets and Lloyds TSB are trading names of Lloyds TSB Bank plc, Lloyds TSB Scotland plc and Bank of Scotland plc. Lloyds TSB Bank plc. Registered Office: 25 Gresham Street, London EC2V 7HN. Registered in England and Wales no. 2065. Lloyds TSB Scotland plc. Registered Office: Henry Duncan House, 120 George Street, Edinburgh EH2 4LH. Registered in Scotland no. 95237. Authorised and regulated by the Financial Services Authority under registration numbers 119278, 191240 and 169628 respectively.