The Death of Retail?
As part of project work on a current client, I’m spending a fair amount of time familiarizing myself with the economics of the big-box stores. There are obviously large variations in the strength of the sector, ranging from Best Buy at the weak end to Wal-Mart at the strong end. However, after spending some time examining the basic financials I would certainly be pretty dubious about the prospects of mass retailers over the medium term. Here is why:
· Margins are thin and shrinking: It’s no revelation that retail is a low-margin business for everyone except Apple. For mass retailers, the main advantage they have is attractive exclusive merchandise – the lack of this is the main reason Best Buy serves as “Amazon’s showroom”. Customers are buying stuff online, and mass retailers need to sell online to be competitive. But this cannibalizes in-store sales, margins are thinner, and “selling more stuff online” doesn’t necessarily equate to “freedom to cut staff”. Which, speaking of…
· Economic recovery could hammer their bottom line: Economic recovery is, obviously, a good thing in general and for retailers. However, the stagnant labor market has had enormous benefits for big-box retailers as it gives them access to an enormous pool of cheap and disposable labor. At our client, they’ve cut the SG&A share of their gross margin by 100 basis points over three years – economic recovery will send that straight up. Especially if they see a dramatic rise in wages due to [dum dum DUMMM] inflation. Which leads me to…
· Inflation could be a real kick in the teeth: Yes, big retailers can pass some of the costs on to their customers in the event of inflation. But there is a limited degree to which they can really do so, and inflation would take a bite out of their margins, as they all freely admit in their reports. Any economic recovery is likely going to involve some inflation, unless the Fed acts to stamp out inflation and thus the recovery. Most of them also have substantial credit-card loan portfolios, and it’s fairly common for retailers to bear a lopsided portion of the downside interest-rate risk on that.
Basically, the best-case scenario for big-box retailers is that the economy recovers, driving up their revenues while shrinking their margins, which are already under substantial pressure from the shift to ecommerce. It’s not all bleak – on the upside (for retailers, at least), a “hard landing” in China could substantially decrease their cost of merchandise. Furthermore, the continued mechanization of low-skilled jobs could substantially raise the long-run unemployment rate, which would soften the blow of rising labor costs. However, the era of high extensive growth has ended as the suburbanization of America has reached its apex. These retailers hold onto their margins as best they can while growing leaner and gradually cutting their deadweight stores. Finally, ecommerce stabilizes at a level only slightly higher than today.
The worst-case scenario? Stagflation in the US hammers both their top and bottom line, especially as dollar appreciation against the yuan sends the price of merchandise skyrocketing. Ecommerce asymptotically approaches full penetration, and Amazon’s Kiva robots crack the code of affordable same-day distribution while turning a profit. Even retailers’ “Amazon showroom” advantage is taken away by rapid-prototyping 3D-printing centers. Urbanization accelerates dramatically, and the suburbs of America are left as windswept wastelands haunted only by horrible howling things we once called dogs. Finally, after Bernie Sanders’s disembodied head becomes president in 2024, former Wal-Marts become the prisons of disgraced hedge fund managers and various sundry job creators.*
None of this should be taken as my point of view on the advisability of investing in these institutions’ common stock today, tomorrow, or ever after. I haven’t delved into the expectations of growth embedded in each of their prices. All I’m saying is that it’s pretty darn hard to see how today’s big-box store business model can grow sustainably.
*: This scenario may be a stretch, but I think it’s solid assuming that head-in-a-jar technology has matured by that point. You may, if you wish, substitute “Barney Frank’s personality uploaded to some sort of nuclear-armed destructo-bot”.