Bricks & Mortar retail is suffering. People are shifting their shopping habits from in person to on-line. The on-line selection is greater, the prices are better and the shopping experience is relatively easy (in comparison to parking at the mall). Peter Drucker said that “What customers – at least a good many of them – want is not shopping that is enjoyable, but shopping that is painless.”
Although e-commerce will continue to grow, I suspect that on-line shopping will top out in the 20-30% range of total retail sales. The drawbacks of e-commerce (freight, timeliness, inability to touch or try-on) will limit sales to only a portion (although a very significant portion) of total sales. However, just losing another 10-15% of market share to e-commerce will make bricks & mortar returns even less attractive. It doesn’t matter if your retail chain is cannibalizing itself with a web site or it is Amazon, stores will continue to generate worse returns on investment. With lower returns, there will be less capital invested, fewer stores and fewer malls. The New York Times calls them Zombie Malls, the escalators are running but no customers.
There have been many, many articles on how the US is overstored. In 1990 the ICSC reported (Billboard 6/2/90) shopping central growth was dropping due to the country being overstored. ICSC reports the millions of net square feet added to U.S. Shopping Center space in their report “America Marketplace”. You can easily see the post 1980 recession slow down and the post 2008 recession collapse of growth. The dot.com era of 1999-2001 didn’t appear to matter. One conclusion is that the overstored retail space has gotten less overstored in the last seven years.
I don’t know what the right amount of retail space is in the US, but given this trajectory we will eventually reach an equilibrium where demand closer matches supply. However, when equilibrium is reached, a lot of today’s retailers will be gone.
Life Cycle
The usual life cycle for retail bankruptcies is a recession which weakens the retailer, a recovery which allows some breathing room and then another recession which puts the retailer out of business. This is the retailers’ version of the Eldredge & Gould “punctuated equilibrium”, where a significant event creates the opportunity for species growth (or death) followed by a long period of relative calm. Eventually another significant event punctuates the equilibrium and the game changes. This cycle is only slightly different from the normal recession/recovery/recession, as the punctuation now is the on-going loss of market share to e-commerce. If we get another recession, then we should expect even greater industry turnover.
The total profit of a transaction is split between the manufacturers (the product), real estate (the space), staff (the labor) and the retailer (the operator & the capital). This is an uneasy relationship, as total profitability is limited by the market. Each player takes the steps that create the most long-term value for their portion. The losers in the movement online so far have been staff and retailers. Next the cycle will impact real estate prices.
Tim Harford, who wrote “The Undercover Economist” suggests that over time, the landlord obtains most the profits of the relationship due to lack of substitution. Retailers combat this by negotiating long leases with renewals to lock in the lease costs. If business slows, those long leases can burden the parent company enough to cause bankruptcy. When retailers stop making money, they close stores, vacancies rise, the real estate centers stop making money and the price of retail space falls. Stores are closing at a record pace, and rents are beginning to drop (see here). Lower rents allow retailers a chance to recover and begin growth. However, things are a little different this time as e-commerce will still gobble up market share and retailers have loaded up on debt.
Debt!
One factor that is worsening the crisis is debt. Low interest rates and high equity valuations have caused growth companies to borrow funds to drive growth. When I was a student, we were told that carrying debt would lower the cost of capital as interest on debt is deductible and interest rates are usually lower than the cost of equity. This is an accepted part of finance theory and is used extensively by CFO’s to generate equity returns. Whenever you can invest at a rate of return that is higher than borrowed funds, you create a return to equity (see WACC). So if you can open units that generate a 40% return and are limited to 3 outlets due to limited equity capital versus opening 6 outlets with a mix of equity and debt you generate almost twice as much cash return. The only drawback is a subtle increase in risk and interest costs that comes with additional debt.
The risks aren’t always apparent. Low interest rates are great, but they don’t always stay low. When interest rates normalize, payouts will squeeze profits and options. Most loan agreements are based on covenants that call for enough earnings to pay a multiple of the interest and principal payments. Earnings in a growth company can be volatile as expansion, even if investment oriented, is accounted as expenses by GAAP. Banks use GAAP, not “reported” earnings.
Theoretically financing should not matter. Modigliani-Miller came up with a concept of capital structure irrelevance. They believed outside the tax effects of interest (vs. dividends which are rare), how you financed the company shouldn’t affect the intrinsic value. M-M’s insight was that you could imagine an investment pool that is half debt and half equity buying a company with no debt. The total investment would be leveraged, 50/50. If you bought the stock of a company that was half debt/half equity with a fund that was all equity, the pool together will still be 50/50 leveraged. Whether debt is held at the company level or at the portfolio level is irrelevant. However, the relative amount of debt in the system remains.
CFO’s that leverage their firms (as I did) find themselves taking on risk that may be better placed at the portfolio level. If the investors want leverage, they should borrow to make their investments. I’ve come full circle and consider debt a serious problem for growth companies. Yes, there are some instances when it makes sense, but in general it should be avoided.
The other big debt factor that will grow is lease debt. The great lease debate is now settled for the next decade. The FASB agrees that leases are debt. The new rules further muddy the financials as the value of the liability won’t represent the true value of the asset, and it will put another confusing and inaccurate calculation on the balance sheet. Retailers are readying to put trillions of debt on their balance sheets, drawing further attention to the risk.
Fear is the mind killer – Frank Herbert. Debt is the company killer – The Market.
Conclusion
The future is clear, malls are going to struggle and they are not going to turn into apartments (sorry Sears). The e-commerce story is only half over. Further retail consolidation is likely and we should be looking for new concepts that will be able to use that (now lower cost) space to deliver a product/service package that will compete with the convenience and prices of e-commerce.
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Dr. John Zott is the Principal consultant at Bates Creek Consulting. John is the chair of the Careers Committee at FEI Silicon Valley, a senior adjunct professor at Golden Gate University and comments regularly on issues that affect consumer businesses. If you are looking for a CFO for your e-commerce/retail/consumer company, or are a former student, colleague or would just like to connect – reach out.