Retail: A mass extinction event?

We all know that until about 66 million years ago, dinosaurs more or less ruled the earth.  Then along came a dose of Really, Really Bad Luck, known more scientifically as the Cretaceous-Paleogene extinction event.  Imagine: you wake up one morning, have your cuppa joe, and smack!  Mass annihilation comes at you in the form of a gigantic asteroid that crashes near the Yukatan peninsula, sending up a toxic cloud of dust and sulfuric acid – and possibly global firestorms and impact winter effects – wiping out 50-75% of all the animals and plants on earth. 

Compared to that violent prehistoric episode, the current pandemic may seem like a gentle kiss from the bowels of the earth delivered by Batmail.  However, the business world may well be in the throes of its own version of mass extinction: the retailers who have dominated US consumption for the last 50-100 years.  At last count, there were 10 major retailer bankruptcy filings, as the chart below shows.  But don’t chisel the numbers in stone: the store carcasses are piling up by the day.

Covid may have delivered a kiss of death, but these companies were hardly paragons of health prior to the onset of the Pandemic.  Digital had been steadily attenuating the sales of brick-and-mortar retailers, although let’s keep in mind that the vast majority of the $3.8T in US retail sales still take place in brick-and-mortar stores (okay, okay, it’s hard to sell gasoline online).  2019 saw online retail sales reach 12-16%.  (There’s some squishiness in how the numbers are collected: The Fed Reserve of St. Louis pegs it at 11.9%, while Statista has a much frothier 15.9%) …and it’s too early to tally the new totals in the wake of Covid.)  

Certain segments of the retailing industry have been much more transformed by e-commerce.  In the apparel industry, digital sales grew to 34.4% of total US sales in 2019, up nearly 20% from the previous year.  And again, pre-Covid numbers.  Hence it’s not surprising that this wave of bankruptcies over-indexes on apparel and department store.  Compare that with consumer electronics, where digital sales have only claimed 14% of total sales.

Even retailers who seem to have been keeping pace with the transition to digital haven’t been spared: Sur La Table, with online sales estimated at 30% — exactly in line with the industry average for home goods pre-Covid – still faced bankruptcy.  These retailers are saddled with the expensive legacy of physical stores while having needed to invest tens or hundreds of millions of dollars to build out their e-commerce capabilities.  There is no Faustian bargain here, only hard choices.  Within this economic formula, the winners will continue to be the mega-retailers like WalMart, who can afford to invest the money to quickly build out e-commerce – and push massive amounts of product through.  Its $3.3B acquisition of in 2016 signaled real commitment, even if its ROI has been ambiguous and it was just the most visible indicator of the many billions of investment in ecommerce WalMart was making.  Ecommerce sales have surged at WalMart – around 35% in 2019 and estimated at 74% during Covid – but it’s unlikely it’s in the black with its ecommerce business yet.  It’s having to play a long game against ecommerce dominator Amazon, which has 40% market share of US ecommerce sales.  No surprise that WalMart continues to grow market share, notching 2.6% growth in 2019. 

And the other winners are the ever-proliferating digitally native retailers who have never had to invest in expensive stores and continue to spring up like mushrooms after a good rain.  MeUndies, anyone?  The barriers to entry to boutiquey digital brands and storefronts are negligible: you can outsource site creation, product design and manufacturing, logistics, and fulfillment, leaving the founders in charge mostly of digital marketing.  Granted, there has been an interesting trend of “pop-ups,” where digital retailers like The Real Real and Glossier are crossing over into the physical store space, but it remains to be seen whether this is a novelty trend or one with staying power.  Amazon, of course, is investing meaningfully in building out its own stores, as well as leveraging its Whole Foods and other pick-up locations to augment its digital footprint.

So what to do with those expensive storefronts for our legacy retailers?  Retailers have been slow to aggressively rationalize their store portfolios, for sure.  They’re going to have to do it within bankruptcy proceedings, and perhaps they’ve been waiting for that air cover to justify an unpopular, expensive, and demoralizing move as the larger economy has partied on.    With so many stores slated for shut-down, it’s an interesting question what will become of that expensive mall space.  Mall landlords have a vested interest in supporting and promoting engaging customer experiences that will entice consumers into their properties.  Simon Property Group had already invested in apparel brands Nautica and Aeropostale via SPARC, its JV with Authentic Brands.  SPARC just announced a “stalking horse” bid of almost $200M for Lucky Brand, which will give them a strong, premium consumer brand to try and transform into a viable retailer in today’s environment.  And, of course, it helps keep the storefronts occupied.  We may see increasing numbers of these vertical integration plays as landlords attempt to save the mall business model, but as my students will dutifully tell you, I am bearish on vertical integration as a strategy in any industry.

But retailers have also been slow to innovate the in-store experience to prevent customers from defecting fully to the Digital Dark Side.  Walking into a J. Crew store today is not meaningfully different from walking into a J. Crew store 30 years ago.  Ditto for other retail market segments.  Think through the last time you visited one of these stores: Neiman Marcus (luxury); Macy’s (mass); Target (discount).  Anything there knock your socks off?  Nope.  Perhaps they’ve improved marginally on brand portfolio, merchandise presentation and assortment, inventory management, and service, but interesting technologies that could have advanced the frontier of the customer experience have been in very short supply.  Sure, we’ve had some investment in products and experiences like smart mirrors and digital dressing room, but they’ve been the exception.

And the last nail in the retailing coffin, which we would be remiss without discussing, is the high levels of debt these companies carry.  Private equity investors adore the retailing industry, because it throws off hefty amounts of free cash to service high debt loads and repay the PE investors.  But many retailers already have high debt loads in the form of operating leases from their landlords.  So, caught between low margins and high debt, retailers don’t have a lot of wiggle room to navigate even a fully visible encroaching financial crisis – never mind a sudden sock to the gut like Covid.  So it’s not surprising that the retailing titans are the hardest hit of the publicly traded companies during the pandemic.

So, will this be mass extinction for the current cohort of retailing powerhouses?  Unlikely.  Toys R Us’s annihilation is an unhappy exception to the bankruptcy norm, where companies will typically emerge leaner and fitter to fight another round.  A better analogy is perhaps the aftermath of the Black Death in Europe, where 10-30% of the population perished.  But the C-P extinction event may be instructive in another way.  The apocalyptic aftermath enabled previously over-shadowed species to thrive and evolve, such as our proud forebears, the small mammals.  New customer engagement and retailing models will emerge, perhaps expedited by the retail space being left vacant all across America.

Click through the slideshow below for data analysis on five key retailers. Each dashboard includes three principle charts comparing the bankrupt retailer with a peer group. The first is a plot of EBITDA margin vs. Debt/EBITDA multiple, demonstrating the challenging position of high debt with low margins that several now bankrupt companies found themselves in. The second compares the ecommerce sales of the bankrupt retailer to peers and the industry average. As expected, retailers that have been hit especially hard by the pandemic have subpar ecommerce sales. Finally, the third chart compares either Capex as a % of sales or Debt/EBITDA multiples for the past 4 years. Retailers such as JC Penney, New York and Co, and J Crew failed to properly invest in innovation (as measured by CAPEX) potentially due to their crippling debt burden. For full functionality, view the dashboard here.

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