As the dollar gains strength against the pound and inflation creeps up, George MacDonald investigates how badly the shift could hurt retailers in this already stricken climate.

As if retailers do not already have enough to contend with, another problem looms dark on the horizon.

Already battling in the face of shattered consumer confidence, pressure on shoppers’ disposable income and the effects of the credit crunch on their financial arrangements, store groups must now work out how to cope with the impact of a strengthened dollar.

For much of this decade, the weakness of the dollar against sterling has brought UK retailers a windfall. Increased overseas sourcing, typically paid for in dollars, enabled stores both to buy more cheaply and at an advantageous exchange rate.

But those days are over. A combination of rising inflation in the cost of goods sold (COGS) and the depreciation of sterling against the dollar and euro threatens to undermine the buying edge enjoyed for so long. From a high of US$2.10 to the pound, the exchange rate had fallen to less than US$1.80 as Retail Week went to press.

In the past week, some of the biggest retailers have highlighted the likely impact of the new circumstances. Home Retail, owner of catalogue store group Argos, does most of its buying in dollars and has benefited from the currency’s weakness. However, the foreign exchange impact in the second half of this year is likely to be neutral and, as the dollar gains strength and cost inflation rises, a foreign exchange “headwind” is likely to have an effect, the retailer confirmed. Every cent change costs the retailer between£4 million and£5 million, says Home Retail finance director Richard Ashton.

Similarly, Next warned at last week’s interims that it will notice the difference. Chief executive Simon Wolfson said: “We anticipate that in 2009/10 there will be downward pressure on margins, or upward pressure on selling prices, as inflation in producer countries and the weaker pound push up cost prices in our major sources of supply.”

Other retailers will be under the same pressures. As sourcing increasingly moved offshore in the late 1990s and early this century, China and other emerging economies trading in dollars took on an ever increasing proportion of supply of a vast variety of products ranging from toys to greetings cards and cabinet doors.

What are the implications?

The implications of the foreign exchange power shift are being pored over by City analysts, who fear margin erosion at already embattled businesses. Landsbanki analyst Paul Deacon, for instance, puts the potential extra cost to Home Retail alone at about£90 million.

In a note examining the implications of a higher dollar for the retail sector generally, Kaupthing analyst Matthew McEachran notes: “We envisage a material gross margin reversal as COGS are pressured by fast-recovering dollar/euro rates.”

He estimates that “most retailers face more than a 10 per cent hike on dollar-denominated buying” and says: “While some may be partly able to offset FX pressures, or pass price increases on, the heady days of the 50p dollar are long gone. On average, each 100 basis point unmitigated gross margin fall would hit most retailers’ profit before tax by approximately 20 per cent.”

Because retailers typically hedge their dollar purchasing, the effect of the strengthened dollar is unlikely to be felt until around the middle of next year. The signs are clear, however. Argos – which has typically brought prices of reincluded lines in its catalogue down by an average of3 per cent each time it republishes it – says the effect is “almost neutral” in this season’s catalogue because of the rising COGS.

The question retailers must struggle with is what they can do: to what extent, if at all, can prices be put up and can sourcing be switched to cheaper locations?

PricewaterhouseCoopers retail section leader Mark Hudson says retailers have little room for manoeuvre and store chiefs must be canny about price rises in the tough trading conditions that are likely to persist throughout next year.

He points out that customers are most alert to opening price points so they should probably be left unchanged, while prices of middle and upper point lines could be nudged up.

Wolfson, who believes that retailers will not be able to take a margin hit on the chin, is taking that approach. Although he does not intend to raise prices across the board, Next will put higher tags on certain products.

However, ING analyst Peter Brockwell is uncomfortable about how price increases by retailers would go down with shoppers. He notes that ONS retail data shows continued price deflation in key retail categories and warns: “As price pressures start to come through, we may find volumes decline markedly.”

Next is also shifting some of its manufacturing from southern China to the north of the country, which has been less affected by inflation. However, Hudson is sceptical that retailers will find much benefit by changing location, because that region’s supply industry and infrastructure is less developed than in the south.

On a positive note, he believes that Chinese prices may fall across the board because of the low level of demand from the US and falling orders from hard-pressed Europe. “China is going to be seeing lower volumes, so there could be an opportunity to reduce inflation,” he explains.

But McEachran fears that any early US recovery would have an impact. “The problem is that as US demand kicks back in, and when factory capacity is taken up again by the likes of Wal-Mart, UK buyers which have thus far taken advantage of under-utilised capacity will then face a squeeze,” he says.

The impact of inflation and the dollar’s strength may be felt particularly by value retailers, which have based much of their success on efficient sourcing and made hay while the sun shone on sterling.

Now the fear among some industry observers is that value groups will have no option other than to increase their prices. And because their prices are already so low, increases – potentially dramatic – will be immediately obvious to shoppers.

That risk is downplayed by some observers. Hudson says that value specialists such as Primark and Matalan operate sophisticated price architecture models already and have their own equivalents of premium brands on which prices can be increased while opening price points are kept low.

Matalan chief executive Alistair McGeorge takes a similar view. “Those with a huge reliance on opening price points are likely to be the most exposed. Matalan feels it is able to manage it [exchange rate impact] as well as anybody else as we develop the business,” he says.

Brockwell believes the best value retailers will remain strongly differentiated on price, while other retailers may find it hard to get shoppers to pay more. He argues: “There may be a narrowing between opening price points and the mass mid-market but, with pressures on disposable income, will customers trade up? I’m not convinced.”

The silver lining

Despite the penal impact of a stronger dollar on many retailers, there may be some upside. Shops in central London, for instance, and luxury retailers may benefit as foreign consumers take advantage of their bolstered buying power to splash out while visiting. Last month, retail like-for-likes in central London climbed 8.2 per cent and, on the back of a strong euro, tourist spend was one of the driving forces of performance.

Similarly, retailers generating dollar and euro denominated revenues should have some protection. Kingfisher’s pan-European operations, or Ted Baker and Burberry’s overseas sales – including in the US – for example, might limit downside.

Big electricals groups DSGi and Kesa might also ride the currency storm – perhaps surprisingly, neither retailer buys much in dollars.

But for many in the sector, the pairing of a strong dollar and inflation means more misery. Broker Numis says retailers are “staring down the barrel” at Far East factory gate inflation of about 10 per cent, freight costs up 50 per cent and, of course, domestic inflationary pressures such as energy and minimum wage rate increases.

Numis analyst Andy Wade says: “In all, we could see input costs rising by 10 to 15 per cent, placing significant margin pressures on the sector. By way of illustration, consider a garment bought for£10 and sold at£26. If input costs increase 15 per cent, even a price increase of 10 per cent would see approximately 150 basis points off gross margin – equivalent to an approximate 10 per cent pre-tax profit downgrade at, say, M&S.”

Because the impact of the dollar’s strength has yet to be really felt, it is just possible that another weakening will relieve the pressure on retailers. However, it cannot be banked upon. Even as Lehman Brothers – a pillar of the US banking establishment – collapsed on Monday, there was little immediate change to the dollar-sterling exchange rate.

It looks likely that retailers must say goodbye to another of the cushions that supported them through the good times.