Navigating the New Retail - Part 2 By: Gabriel PotterMBA, AIFA® 2017.06.16

Adapt & evolve

In our previous monthly article, we examined the scope of the unusually hostile business environment for retailers and the causes of it.  In this article, we will discuss ways the key players are changing their approach in this new retail reality.

Retailers have seen the future of businesses which don’t adapt, and they don’t like it.  It used to be products themselves, consumer goods, became obsolete; how many households buy buggy-whips anymore?  Retailers can manage this sort of change by swapping out their inventory and stocking their shelves with different products.  A bigger problem is when an entire subset of products fall out of favor and a store chain has to change the class of products they sell; for instance, Radio Shack has struggled to find a raison d'être, navigating through multiple types of consumer electronics over the decades, starting with hobbyist radio equipment and components to cell phones and desktop computers.  The current retail struggles have broader impacts because they threaten the traditional business model for providing consumer goods at a time when the industry is overextended on debt. 

There are three categories of players which have to navigate this new retail environment. First, we should consider the producers of consumer goods people buy – from low-level staples like dish soap & t-shirts, to high-level discretionary items like electronics & cars.  Second, we should consider the plight of the retailers themselves – from the boutique jeweler to the large department store chain.  Third, we should consider how the owners and lessors of retail space – the shopping mall managers and the real-estate landlords – are managing the slowdown in retail. 

The producers

Producers of consumer goods may experience lower profit margins for their products because of the high competition and availability of substitutes online, but the slowdown in the retail sector doesn’t necessarily mean consumers are buying fewer goods and services.  Non-traditional relationships, i.e. e-commerce resellers like Amazon, are drawing sales away from traditional retailers.  To a lesser degree, cyclical and “one-off” events can depress retailer revenue; for instance, inflation has been low, which limits expected revenue models and consumer expenditures for key products.

Admittedly, the May retail sales numbers from the commerce department showed slowing consumer spending growth and limited positive momentum.  However, consumer spending is stable and supported by high employment, low inflation, improved finances, and great consumer confidence metrics.  How are producers navigating the new retail environment?

  • Direct producer-to-consumer sales, thus eliminating the retailer middleman and their cut of the profits, are possible in a way they’ve never been before.
  • Producers which do manage their own retail environment can still succeed when they have competitive advantages in strong brands, high competitive moats, and deep consumer loyalty.  Walk inside any Apple store for an example.
  • Producers can supply storefronts without ownership risk by operating as a franchise.  Franchise outlets provide goods to the store owner and provide branding, marketing, and operational consistency.  Franchise brand stores offset the location specific risk to the franchise owners.

 

The retailers

Several retailers are making constructive changes to adapt to the new environment.

 

  • Retailers may augment their traditional brick-and-mortar space with a strong online storefront. For example, Wal-Mart is a discount department chain which should be prone to the retail slowdown, but they’ve planned for this, purchased Jet.com (a fast growing e-commerce firm) and reported a 63% rise in their online sales figures from last year.
  • Retailers can create in-store services and perks to generate store traffic.  For example, Best Buy offers a free battery and electronics recycling service to encourage people to visit the stores and, ideally, replace their obsolete cell-phones, headphones, computers, and so on.
  • Retailers can focus on the experience of being in the store as opposed to the goods they are selling.  As an example, consider two book stores – Waldenbooks and Barnes & Noble.  Do you remember Waldenbooks – the book store chain which used to be in shopping malls?  Their business model was a pure book store. You go inside, find a book from a stack, buy it, and leave.  Compare that experience to a Barnes and Noble.  Barnes and Nobles doesn’t sell books alone.  They offer an environment where you are encouraged to relax, browse an extensive selection of books with their faces out, and read freely in comfortable chairs while drinking brand name coffee.  Patrons are invited to linger or take part in community events like author signings, or costumed children’s book readings.  Barnes and Noble isn’t immune from retail slowdown and competition from Amazon, but they’re better equipped than most. 
  • Retailers can create consumer loyalty by appealing to community connection, promoting social responsibility, and appealing to millennial shopping trends.  This approach isn’t entirely new. For instance, Target has given 5% of profits to their communities for years.
  • Retailers can reduce their physical footprint.  Brick-and-mortar stores have a cost disadvantage because of overhead costs – staff salary, renting property, and keeping the lights on.  How can consumers get the physical-store advantage - buying a product and getting it immediately without waiting for it to ship - while keeping costs low?  This disadvantage for physical storefronts is compounded when selling information goods.  For instance, Blockbuster couldn’t complete with Netflix, because they both sell data.  Blockbuster video stores can’t get a DVD to a consumer as quickly as a Netflix download; there is no necessary shipping for an information good like music, movies, or video games.  Despite Netflix crushing DVD rental stores, there was still a niche audience for physical DVDs.  How can they be serviced? Automation.  Redbox DVD and console game rental kiosks don’t generate as much revenue as Netflix, but they still make a profit given their minimal overhead. 
  • For physical goods, there are untapped opportunities for automation.  For instance, Best Buy kiosks in airports selling smartphones & tablets generate profits. Maybe the US will ultimately look more like Japan, which has one vending machine for every 20 people.  Maybe there will be more automated storefronts, like Amazon Go stores, or hybrid automatic systems with self-service ordering and check-outs found at grocers & chain restaurants.

 

The owners

  • We’ve been making broad generalizations about weakness in the retail sector, but it’s important to remember “all retail is local”.  In other words, some retailers continue to perform despite the pressure broadly affecting the sector.  Malls get letter grades based on sale-per-square-foot; the Class-A malls materially outperform their Class-D peers.  Upscale malls in rich suburban environments are maintaining a healthy customer base but their experience is deeply dissimilar to mid-tier strip malls & traditional malls, which are hemorrhaging customers.  Why?  Obviously, there are differences in proportional disposable income in the clientele, but the competitive advantage for “Trophy malls” is the environment of the mall and those of the high end boutique stores within.  Visiting the mall is an experience, not merely a collection of stores.  What can the mid-range mall do to avoid store vacancies given the expanding bankruptcy of their anchor stores?
  • Focus on experiences, not products.  Malls are renovating lots into cinemas, gaming rooms (arcades, indoor mini golf, bowling alleys, laser tag), restaurants and sports bars.
  • Some malls have made the decision to turn into outlet malls, replacing traditional department store anchors (Macys, Nordstrom’s) with discount or premium outlet fronts. 
  • Other retail environments are working overtime to keep occupancy rates up and their space attractive.  This means diversifying the available lots away from consumer retail stores into mixed-office space, medical offices, and even environmentally controlled storage.
  • If full time tenants leave, retail space landlords can allow short term lessees.  There are a variety of seasonal pop-up stores – prom dresses, holiday stores, haunted houses for Halloween, art displays, and even spring-cleaning community garage sales which can pay rent for a period of months or weeks.

Finally, when all else fails, a number of players have admitted defeat, recycled building materials and redeveloped the land.  Sadly, property closure is happening at a pace which exceeds the demand for new space, which can lead to community owned green-space at best or the common, aforementioned dead-malls at worst.

Final thought

We said there were three categories of players which have to navigate the new retail environment, but we missed an important one:  investors.  What should you or I do?

If there’s one lesson to keep in mind, maybe it should be the old financial adage:  “don’t catch a falling knife.”  Day-trading individuals and contrarian professional investors looking for bargains may be tempted to buy retailers or real-estate owners with depressed prices.  Indeed, that retailer may look like a bargain-buy based on last years’ sales numbers, but you might need to do some research before buying their stock.  Listen to management reports on quarterly earnings calls and find out what the plan is to get back to last years’ sales numbers before jumping in.  Stressed companies can turn around for the better (Apple, Starbucks, Delta), but they need a plan to stay ahead of trends or create new opportunities.  Savvy investors should know how the producer, retailer, or owner plans to navigate the new environment.

 

 

 

 

Gabriel Potter

Gabriel is a Senior Investment Research Associate at Westminster Consulting, where he is responsible for designing strategic asset allocations and conducts proprietary market research.

An avid writer, Gabriel manages the firm’s blog and has been published in the Journal of Compensation and Benefits,...

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