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The Wrongologist

Geopolitics, Power and Political Economy

Here Comes the Retail Apocalypse

The Daily Escape:

The Oberlausitzische Library of Science, Gorlitz Germany

There is a growing concern that the mall as we know it is in big trouble. RadioShack, The Limited, Payless, and Toys“R”Us were among 19 retail bankruptcies this year. From Dave Dayden: (brackets by the Wrongologist)

This story is at odds with the broader narrative about business in America: The economy is growing, unemployment is low, and consumer confidence is at a decade-long high. This would typically signal a retail boom, yet the [retail store] pain rivals the height of the Great Recession.

Many point to Amazon and other online retailers as taking away market share, but e-commerce sales in the second quarter of 2017 were 8.9% of total sales. There are three reasons for so many sick retailers.

First, while online sales are “only” 8.9% of total retail sales, these businesses have very high fixed costs and low net profit margins. The Stern School at NYU tracks net profit margins on thousands of businesses across many sectors, including retail. The margins for Specialty retail for the year ending January 2017 was 3.17%. It was 1.89% for Grocery and 2.60% for General retailers. If a high fixed cost business loses 9% of sales, it can easily wipe out the bottom line.

Second, many retail companies carry high debt levels. Bloomberg explains that private equity firms (PE’s) have purchased numerous retail chains over the past decade via leveraged buyouts, where debt is the primary source of the money used to buy the business. There are billions in borrowings on the balance sheets of troubled retailers, and sustaining that load is only going to become harder if interest rates rise.

Third, there are just too many stores in our cities and suburbs to sustain sales in a world where online shopping is growing rapidly.

Worse, billions of dollars of that PE-arranged debt come due in the next few years. More from Bloomberg:

If today is considered a retail apocalypse…then what’s coming next could truly be scary.

This chart shows what percentage of retail real estate loans are delinquent by area:

Source: Trepp

There are large areas of America where more than 20% of the loans are past due. More from Bloomberg: (emphasis by the Wrongologist)

Through the third quarter of this year, 6,752 locations were scheduled to shutter in the US, excluding grocery stores and restaurants, according to the International Council of Shopping Centers. That’s more than double the 2016 total and is close to surpassing the all-time high of 6,900 in 2008…Apparel chains have by far taken the biggest hit, with 2,500 locations closing. Department stores were hammered, too, with Macy’s Inc., Sears Holdings Corp. and J.C. Penney Co. downsizing. In all, about 550 department stores closed, equating to 43 million square feet, or about half the total.

This threatens the retail sales staff and cashiers who make up 6% of the entire US workforce, a total of 8 million jobs. These workers are not located in any one region; the entire country will share in the pain.

These American retail workers could see their careers evaporate, largely due to the PE’s financial scheme. The PE’s, however, will likely walk away enriched, and policymakers will share the blame since they enabled the carnage.

Our tax code makes corporate interest payments tax-deductible. So the PE kingpins load up these companies with debt and when they walk away, they get tax credits for any write-offs, incentivizing them to borrow and play the game again. The PE firm might lose some or all of its equity, but in most cases, it already drew cash out via special dividends and fees, so it has made its money.

The lenders, employees, state development authorities are the ones left holding the bag.

The GOP’s new tax plan proposes a cap on the deductibility of interest payments over 30% of a company’s earnings. But, the GOP left a loophole: Real estate companies are exempt from the cap.

Surprisingly, this benefits Donald Trump’s businesses! It also helps PE firms that split the operating side of the businesses they buy from the property side, as most do. They put the borrowing onto the property side, and continue to deduct the interest.

So financialization businesses like PE will continue to strip the value out of companies with hard assets.

Billions in asset-stripping and thousands of operations sent overseas. Labor participation rate is stagnant, yet we are assured that if we pass big corporate tax cuts, the US economy will grow fast enough to more than compensate for the losses.

What’s wrong with this picture?

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Retail Stores Are Closing Fast

The Daily Escape:

Cougar with Radio Collar – Griffith Park, Los Angeles, via Nature Photography

Retailers are closing thousands of stores and going bankrupt at a rate not seen since the Great Recession, and tens of thousands of people are losing their jobs as a result. Retailers blame Amazon and other online vendors, and e-commerce sales are booming. While some brick-and-mortar retailers are doing well, many are losing money. The Atlantic reports that:

Overall retail employment has fallen every month this year. Department stores, including Macy’s and JC Penney, have shed nearly 100,000 jobs since October—more than the total number of coal miners or steel workers currently employed in the US.

Wolf Richter has the following chart showing the nature of the problem for retail stores:

But the e-commerce industry won’t rescue out-of-work retail employees. Most warehouses are regional, and located far from residential areas, which means they might not be within a reasonable commuting distance for displaced workers. By contrast, retail stores are typically located near residential centers. E-commerce warehouses also employ fewer people than retail stores, since the warehouses are increasingly automated.

Yves Smith offers this idea: (parenthesis by the Wrongologist)

One of the reason so many real world retailers are hitting the wall so hard is that private equity leverage and asset stripping made them particularly vulnerable. While the losses to online retailers would have forced some downsizing regardless, the fact that so many are making desperate moves in parallel is in large measure due to the fact that…their private equity (PE) overlords have made them fragile.

That’s a new angle for evaluating Amazon’s performance: it’s not that retailers are closing because Amazon is expanding, but Amazon is expanding because retailers are closing. Jeff Bezos should be thanking the PE firms for looting the retail industry.

The Federal Reserve’s low interest rates also made it easier for Private Equity funds to load these retailers up with debt. Management could borrow more money than necessary, pay themselves cash bonuses, and claim “interest rates are low; making payments will be easy“.

They would even show you the math. Of course, that math assumed that store sales would continue climbing in the future. If sales fell, high debt payments could quickly become an outsized burden.

The Private Equity all-stars often follow a particular deal model. After purchasing the retail company, the PE firm sells the real estate owned by the retail company to another entity (owned by the PE fund). Then the retail company makes lease payments to its new landlord. This splitting of the assets into an operating company and a property company allows the PE fund manager to make a cash distribution to its investors early on, producing a quick return on the deal. Later, the property company will be sold.

The problem with this approach is that businesses that choose to own their real estate are typically seasonal businesses, as all retailers are. Or they are low margin businesses particularly vulnerable to the business cycle, like restaurants. Owning their property reduced their fixed costs, making them better able to ride out bad times.

To make this picture worse, the PE firms often “sell” the real estate to itself at an inflated price, which justifies saddling the operating business with high lease payments, making the financial risk in the operating company even higher. Of course, those high rents make the property company look more valuable to prospective investors, who may fail to look close enough at the retailer who is paying the rents.

Companies with little debt generally can survive lower sales. They can engage in cost-cutting, maybe encourage some employees to retire early, etc. It’s easier to survive if they own their own property. But when you’ve got a lot of debt, and servicing that debt requires that sales continue to rise quarter after quarter without fail, then things become a LOT more fragile.

Trump claims he’s created 500,000 new jobs in his first 100 days. Notice that he doesn’t say what these jobs are, or where they were created. Certainly they weren’t in Retail. Or Coal. Or Steel. Those jobs aren’t coming back.

Here is Jonathan Richman with his 1990 song “Corner Store” which laments what towns have lost to the malls:

Those who read the Wrongologist in email can view the video here.

Takeaway Lyric:

Well, I walked past just yesterday
And I couldn’t bear that new mall no more
I can’t expect you all to see it my way
But you may not know what was there before
And I want them to put back my old corner store.

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