TSL TRENDING STORY
Thoughts on Retail
This article explores the challenges facing the U.S. retail industry segment and the malls and shopping centers that support it. The author contends the challenges are connected and overlap, not completely, but enough to make each situation more difficult. Not favoring the doomsday scenario re brick and mortar retailing presented by many recent articles, the author acknowledges this as an unusually disruptive period with winners and losers largely determined on basics like quality of management and financial leverage.
By Seth Bakes, President, Bakes and Company, LLC
The U.S. retail industry segment has been challenging for many years now due to improvements in technology and globalization and likely to stay challenging for many more. Strong macro forces are reshaping the retail landscape and shopping experience: foreign entrants, buying habits shifting to online shopping, the expense of simultaneously conducting both brick and mortar and online retailing, mobile and immediately competitive price and product visibility, price sensitivity, and pace of change. And the challenges extend to retail real estate which has additional issues to contend with.
Much has already been written about the demise of brick-and-mortar retailing and the ascendance of online retailing, typically making a direct causal relation between the two. And that is there, to be sure, but there is more to it. Several additional strong demographic and economic forces contribute to the challenges confronting retailers and their landlords: the long term real stagnation of wages and benefits for the middle class, labor force participation diminution, over-stored conditions, functional obsolescence of many retail centers, and leverage in capital structures. Regarding functional obsolescence, many retail centers simply lack a compelling reason to visit other than a direct purchase, which now can be done online. They lack interest.
And, while most brick-and-mortar retailers have created an online presence, there is more to it than building a website. Some simply do it better than others, having better, more sophisticated websites coordinated with social media and specific customer-research competence producing valuable insights into targeting and buying habits gleaned from information-gathering efforts such as surveys and data mining and related analytics.
It almost looks like the decline in brick-and-mortar retailing and the decline in the health of retail real estate are synergistically pulling each other down, without a stop order. As mentioned above, there are several very strong forces in play in addition to technology advances that are combining to disrupt the old order. Looking at it through a longer-term lens, we have evolved from local department stores in traditional downtowns to enclosed malls to club stores and discount centers to online retailing in about 50 years or so. It’s continuous disruption.
High levels of debt interfere with or crowd out the capital needed to evolve retail platforms. And high leverage can produce very large Chapter 11 bankruptcy restructurings that allow retailers to reject unwanted leases, thus increasing dark spaces and reducing venue traffic. Wage stagnation and employment participation diminution reduce discretionary spending and sales and engender price competition. And, the retail industry segment is a huge employer; so, when stores close, employment suffers, thus exacerbating the decline in sales. Over-stored and tired store conditions produce effective obsolescence in many retail centers that make a trip to the mall less attractive than it used to be. They are just not interesting places. Brick-and-mortar merchants’ and their landlords’ great challenge is to find a compelling reason for the customer to visit rather than shop online.
I don’t hold to the more catastrophic predictions regarding the demise of brick-and-mortar retailers, but it’s really disruptive out there now and it’s uneven. Geographically uneven -- some regions / corridors are healthier than others with high-density markets doing better than less-dense markets and uneven between prime and non-prime assets. Prime / high demand retail space tends to be doing better (lower vacancy, better re-tenanting outcomes) than secondary / class B assets. Basically, it’s just easier to deal with setbacks if you have a prime asset in a dense market.
According to CBRE Q4 2017 U.S. Retail Figures report, availabilities were about 10% in the neighborhood, community, and strip category and 6% in the lifestyle and mall category while the retail segment as a whole was 6.5% with the highest availabilities in less than Class B assets. These statistics do not, in the aggregate, indicate a retail apocalypse.
According to CBRE Q4 2017 U.S. Retail Figures report, availabilities were about 10% in the neighborhood, community, and strip category and 6% in the lifestyle and mall category while the retail segment as a whole was 6.5% with the highest availabilities in less than Class B assets. These statistics do not, in the aggregate, indicate a retail apocalypse. For more perspective, Green Street Advisors in its Mall Tenant Turnover Analysis report and Bloomberg’s article in November 2017 on the “Beginning Retail Apocalypse” mention that, while many stores are still opening, there are many more announced closings than openings and there are many examples of quiet closings where national tenants simply do not renew their leases. On a more positive note, there are some online merchants that have decided to selectively open stores.
Regarding specific types of retail, fast fashion is a good example of the shifting landscape and competitive pressures. While brand and customer databases are very valuable assets, they aren’t enough to ensure success. Name-brand retailers with high overhead require commensurate profit margins to remain healthy and it’s too hard for many of them to compete with retailers, comfortable with lower profits, using high-inventory turns, discounted pricing models, and online and omni-channel distribution systems. As retailers discount more to turn inventory, the situation feeds on itself and impacts merchants of all sizes. The $35 t-shirt price quickly becomes $10, but can you change your cost basis quickly enough to compete?
The use of substantial leverage in capital structures can compound competitive pressures, exacerbating a difficult situation as illustrated by bankruptcies in companies with leveraged private-equity ownership such as Toys “R” Us and others. In an article titled Death by Buyout in the October 2017 edition of Institutional Investor magazine, the author, Alicia McElhaney, raises the point that, by piling on debt, investors have made it more difficult for retailers to maintain their stores and also fund the transition to online retailing to keep up with juggernauts like Amazon. Also, escalating levels of maturities can prove disastrous if lenders decide that a sector’s fundamentals are deteriorating and leverage is too high. It can influence interest rates and also change sentiment in a refinancing or sentiment in a reorganization from going concern to liquidation.
My experience with distressed situations has been one where high leverage underlies a lot of problems. Something else serves as the tipping point, a rise in interest rates, a new competitor, a decline in a product or commodity price, for example, but high leverage / financial risk is the underlying cause. The specific change in business condition is inevitable; it’s just waiting to happen.
It’s interesting to take a step back and look at both retailers and the real estate-like bond portfolios with identifiable credit and risk attributes. What kind of a default profile do you feel comfortable working with? Low credit indicators and high business risk are not necessarily bad if priced appropriately, by the way.
Although geographically and demographically uneven and subject to varying interpretations, wage/income stagnation and labor-force participation diminution issues are particularly vexing because they point to slow structural long-term domestic economic decline with consequences to consumer spending. I am not an economist, but intuitively think that the benefits of lower prices do not compensate for the negative aspects of employee wage and benefit compression. It’s a troubling long-term per capita income/wellness trend. And one that is very relevant to the retail sector, one of the major employment categories in the U.S., as wages tend to be low, about $15 per hour on average, and work hours not always consistent. The U. S. Bureau of Labor Statistics recent release regarding The Employment Situation – October 2017 (see Table B-1 and B-8) shows that the retail sector employs about 1 in 8 private non-farm workers in the U.S., more than manufacturing at 1 in 10. For every construction worker there are about two retail workers. Production and non-supervisory retail workers earn about $15 an hour. In comparison: manufacturing workers earn about about $21 an hour and construction workers earn $27 an hour.
A quick look at a small sample of surviving large variety/department store retailers’ stock prices presents a picture of how different management teams are dealing with the disruption. If we look at simple 10-year closing stock price data, excluding dividends, from 2008 and 2017, the trend is evident. Kohl’s peak per share stock price back in 2008 was about $54, in 2017 $57. Not much share price appreciation in a decade. The stock market has been shifting recently, so it’s always a bit awkward to make period comparisons but, if we look at a post-2017 holiday season stock price at January 31, 2018, the story looks better. Kohl’s stock price increased to about $65, better, but still not a very attractive investment given the time value of money and other investment opportunities.
You can repeat this exercise with Target and see the same picture. Target’s peak per share stock price back in 2008 was about $58 in 2017, $74 at January 31, 2018 $75. Similar to Kohl’s, not very attractive. Walmart, doing better, peaked at about $63 a share back in 2008 and in 2017 $100, at January 31, 2018 $107.
You can repeat this exercise with Target and see the same picture. Target’s peak per share stock price back in 2008 was about $58 in 2017, $74 at January 31, 2018 $75. Similar to Kohl’s, not very attractive. Walmart, doing better, peaked at about $63 a share back in 2008 and in 2017 $100, at January 31, 2018 $107. For a very large mature company, much more attractive. Not big news but worth repeating, it’s when you get to Amazon that you see a really exciting trend. Amazon traded in the range of about $35 to $96 back in 2008, in 2017 $757 to $1,196, and at January 31, 2018 $1,451. It’s a steep long-term growth line.
These numbers quickly illustrate the difference in outcomes for large retailers. Kohl’s and Target don’t appear to be on top of the transition, but Walmart looks like they are dealing with things pretty well and Amazon, the original online retailer and lead disrupter, is on fire, with a P/E ratio of about 364. In comparison, Target’s is about 15, giving you a sense of how the investment community values the prospects of the two companies.
Clearly, investors recognize the challenges and also recognize that not all management teams, business models, and capital structures are created equal.
Real estate is also facing challenges. Many are directly related to their retail tenants’ problems, but additionally, obsolescence and store saturation, including venue spread to club stores, category killer and outlet centers, are problems. These challenges are seen in the total return performance of retail REIT stocks. According to NAREIT’s REIT Watch report for January 2018 (data through December 2017), YTD total return for retail REIT stocks is about -5%, the 3 - year annualized total return for the Shopping Center component is -3%, the Regional Mall component is -9%, and the Free-standing component is +12%. (Many companies in the Free-standing category pursue single tenant net lease financing / sale leaseback strategies. It’s a different business than shopping center management.) In comparison, the total NAREIT FTSE equity REIT index 3-year compound annual total return is about +7% and the S&P 500 is +11%. Much more attractive than the shopping center categories.
The effective obsolescence of many retail centers is very visible and hard to cure. One thing that is common, for example, is the older traditional mall with a dark or tired/slowly tiring anchor or, perhaps, both. Take your pick: Sears, Macy’s, J.C. Penney’s … The anchor goes dark, mall traffic decreases, national in-line tenants downsize or to opt out of lease renewals and are slowly replaced by local credit. Picture an in-line store selling purple velour rugs and wall hangings with pictures of deer and muskets on them. So, as the retail energy ebbs so does the value and health of the real estate. It’s possible to reinvigorate, but tough.
Regarding the sentiment that the U.S. is over-stored, some say it’s reasonable for the U.S. to have more stores per capita than other developed countries because the U.S. has more per capita income. The truth probably lies somewhere in between. The U.S. would naturally have more stores than countries with lower per capita income, but does have more stores than is healthy from a competitive standpoint.
We could be in for another decade or two of disruption if one considers the time it takes for large retailers to evolve or perish and to fully re-position all the old department store-anchored malls and category-killer discount shopping centers out there. Perhaps continuous disruption will be the norm for a while.
Metro-area malls are typically well located, visible and surrounded by rooftops, so the real estate tends to have good value, but most will likely need to evolve and some have already begun the process. Not necessarily a bad thing, as change can bring opportunity and be rent- and value- accretive, but the re-tenanting/adaptive re-use change in-use processes have business and political risks and are complicated and expensive, with potentially large capex requirements, and long timeframes for each project, all of which have unique tactical and strategic solutions and choices. Big bets: downsizing footprints of existing stores and partial adaption/reuse moving towards experiential retail, restaurants, fitness, healthcare, government, educational reuse opportunities or perhaps complete change over to residential or warehouse or … Broad real estate product knowledge, mixed-use development skills, and turnaround skills will come in handy. You have to be able to see the alternatives to assess them.
Regarding the grocery business and grocery-anchored neighborhood centers, interest was heightened this past fall when Amazon bought Whole Foods, a brick-and-mortar grocery retail platform. You can read a lot into this acquisition, both the grocery store / food retailing aspects and the brick and mortar product delivery model aspects. It connected the dots that, as consumers, and similar to other product purchase / delivery methods, many of us are beginning to purchase groceries online as well as splitting our grocery purchases between the many different local stores close by. Very similar to the evolution of the larger retail and retail real estate industries: brick and mortar vs. online retailing, along with venue competition that is impacting retailers as well as the real estate. As some parse the passing of the store, it’s good to keep in mind that Amazon, the original online retail disrupter, bought into brick and mortar, suggesting that physical stores will add value to their online efforts.
Many grocery-anchored retail centers have desirable infill locations, but with the contemplated changes in shopping habits and store pick-up and delivery service options brought about by mobile technology, the internet and innovation driven by robotics and artificial intelligence, it’s hard to see a future without some disruption. While this can create opportunities as well as challenges, looking forward, it’s likely there will be more tenant turnover and redevelopment. How much and how fast is anyone’s guess and it will be location/tenant- specific in many instances.
Mid-market grocery store chains without clear differentiation in price, quality, or service will struggle in this environment and high leverage will exacerbate the situation. And, thinking about a couple of recent grocery chain bankruptcies, it looks like the grocery business segment and grocery-anchored community retail centers will be disrupted, if not by Amazon directly, then by ruinous competition. How many of us now shop for groceries at several stores as we search for our favorite products and good prices, spreading revenue in smaller increments between merchants and venues?
It’s a tale with winners and losers, but also adaption both on the part of retailers and retail real estate owners. Both have valuable adaptable platforms. So, I don’t see an end to brick-and-mortar retailing. I see evolution. Perhaps more vigorous and painful than many would like, but evolution nonetheless, and perhaps better labeled continuous change and disruption.