Right, so basically the retail apocalypse story is quickly becoming a dead horse.
The only question is whether it still needs beating.
We think it probably does although, as we pointed out last week, the fact that the Wall Street Journal is now touting the CMBX 6 BBB- short is indisputable evidence that this is now a mainstream narrative.
Generally speaking, once a trade idea makes it to the Journal it’s too fucking late for you to “act” even if you, like Ben Bernanke, have the “courage” to do so. That said, the demise of physical retailers (or, as we like to call it the “brick and martyr” trade) is probably going to work no matter how you put it on. Why? Well, because this…
So you know, short CMBX 7 (where spreads are still tight despite a lack of differentiation in the underlying deals versus series 6), buy protection on the individual credits, buy puts, or just short the damn stocks. Whatever. Brick and mortar is dead – or at least dying.
At the risk of doing too much dead horse beating, we wanted to highlight some excerpts from a new Barclays note that touches on all of the above. As the bank puts it, retail will “sink slowly” right up until “it sinks quickly.” As it turns out, retail may be able to learn something from the print media and radio experience. More below…
Retail: Sinking Slowly, until It Sinks Quickly
Retailers have had their growth challenged by online competitors for some time, but the problem has now reached a scale at which it could actually shrink sales for brick and mortar stores. Looking at media businesses that have faced a similar transition shows clear potential for sudden and permanent damage to the business, but also the possibility of positive credit returns even as operations suffer. A model for whether enough potential weakness is already priced into valuations suggests that there is likely downside even in a stable market environment and room for significant underperformance in a recession.
Retail Has an Internet Problem
It has been apparent for several years that brick and mortar retailers were poised to face serious challenges from a shift to online sales. So far, though, that challenge has manifested itself more in slowing growth than actual top-line pressure (Figure 1). But that is poised to change in the near future: a simple model that assumes that both online sales and aggregate spending grow at their recent pace, with brick and mortar growth adjusting, suggests that we have probably reached the point where online will start to capture existing sales from brick and mortar. If those assumptions hold, as Figure 2 shows, e-commerce would account for more than 100% of the real growth in retail sales, with the implication that brick and mortar sales would need to fall. That is corroborated by a recent rash of liquidations among smaller retailers that have blamed falling sales at least in part on online competition.
The potential downside of this transition for brick and mortar retailers has been compounded by a simultaneous overinvestment in capacity. Since 2005, inflation-adjusted retail sales have grown 49%, while the number of stores has grown almost 99% (Figure 3). In our view, the quantity of store growth was a directionally rational response to how retailers were valued in the market: for the majority of 1990-2015, the sure-fire way for retailers to grow (and achieve a higher multiple) was to add stores. That strategic necessity likely contributed to the store-count overcapacity noted in Figure 3.
However, this year, a significant number of retailers have accelerated store closures, and the tried and true methods of buying growth are no longer effective. Given that retailers are now facing flattening (or potentially declining) growth, how should we think about investing in retail credits?
Media Offers Some Clues to How Retail May Evolve
Newspapers and radio offer two potential analogies for the consequences of increasing online competition, with key resemblances between media in the early 2000s and retail today. In particular, we think it is important that the potential threat from online competition is not new or unrecognized. The challenge for retail has been clear for years; similarly, by the early 2000s, newspapers had already seen years of declining paid circulations, and radio had leaked listeners to a range of digital alternatives (including satellite radio, MP3s and iPods, and the earliest streaming audio services). Both the media operators then and incumbent retailers now took steps to build digital businesses. Both experienced limited success relative to their dedicated online competitors.]
So what lessons should we take from the media experience?
There is significant potential for a one-time shock that ratchets industry sales to a permanently lower level, with a recession as a clear catalyst. Both radio and newspapers experienced sharp sales declines through the 2008 recession, with revenues for radio and newspapers falling 30% and 44% from 2006 to 2009 (Figures 4 and 5). For retailers, we assume that a similar patter will occur: some sales pressure while economic growth remains stable, but potential for a sharp one-time decline during the next recession.
In the longer run, there is potential for sales to stabilize, but also to decline perpetually. While radio has seen essentially flat growth since 2009, newspapers have continued to decline. For retailers, we see potential for either outcome. Given the magnitude of online’s growth advantage, it will eventually put newspaper-like pressure on brick and mortar sales unless the growth rates converge (something there has been no sign of thus far). On the other hand, there are real reasons for consumers to prefer in-person retail experiences: speed, convenience, and the opportunity to interact with merchandise all suggest that there should be a place for brick and mortar stores in the long run. There is also the possibility that brick and mortar retailers will eventually be able to capture significant online sales themselves. For now, it seems sensible to think of long-term flattening as the base case, with a perpetual decline as a downside.
Credit returns can still be positive even in the face of declining operating performance. Both the radio and newspapers industries have produced positive bond returns over the past decade (Figure 6) in spite of their sales declines. Radio did outperform with flat rather than declining sales, but both were able to eke out positive total returns. But the timing of those returns suggests that starting valuations matter for return potential. Starting from the end of 2004, YTW was 4.8% for radio issuers and 4.7% for newspapers; returns over the subsequent few years were poor: -60% for radio, and – 57% for newspapers through 2008. But even if we exclude the market-wide rebound in 2009, radio and newspapers started 2010 with YTWs of 12.9% and 12.7%, respectively, and through the end of 2013 showed strong gains: +65.7% for radio and +53.73% for newspapers. The implication for retail is that any investment decision needs to consider how much potential sales decline is already accounted for in valuations.
While it makes sense for the experience with media to inform our views on the risks to retail, the meaningful differences between industry structures mean that outcomes could diverge. For example, with both radio and newspapers, the threat to revenue was indirect – competitors displaced media consumers, and the advertisers who provided revenue eventually followed them. For retailers, the threat is much more squarely aimed at direct displacement, which could moderate or worsen the risk. Retailers may also be less competitively disadvantaged in developing online offerings: they already have significant scale and customer relationships and may be able to capture some of the online growth themselves.