Deep Dive into Debt - How Retail Borrowed to Health through COVID

• More retailers are borrowing under COVID than during the Global Financial Crisis

• Retailers have borrowed multiples higher than what they borrowed in the Global Financial Crisis

• Many retailers have already begun paying back debt, buying back shares and paying dividends

• Companies may exit COVID in better shape than when they went in

Faced with the worst crisis in their history, U.S. retail turned in the pandemic to debt, normally considered the industry kryptonite, for a lifeline. They tapped every revolver, every credit facility that they could. They went to the debt markets, and converts were issued for the first time in a long time as retailers grabbed for cash to horde in the bank, just in case the worst played itself out. In his “Deep Dive into Debt” in the retail sector, BMO Capital Markets Retail and Services Analyst Simeon Siegel looks at how retailers borrowed even more during COVID than they did in the Global Financial Crisis (GFC) of 2008, in some cases as much as 500 percent of their previous year’s operating profits. However, Simeon also found, to his surprise, that they are paying it back faster and perhaps even setting themselves up to come roaring out of the gates as we track on the road to recovery.

Following is a conversation on the subject with Simeon, edited for length.

Q: Let’s start this conversation by identifying your coverage universe?

A: So, at BMO, I cover the retail and services category. That essentially spans discretionary services, whether they are apparel or other aspects of what people buy when they choose to spend, rather than on what they need to spend.

Q: How has the pandemic impacted consumer demand for discretionary, or “want-based” retail versus “need-based”?

A: When the pandemic first hit, we heard about lines out the door in grocery stores. Everyone assumed “need” retail was going to have its best year of all time, and “want” retail was going to evaporate, and while the former likely did play out, the reality is that the latter found a resurgence: want-based retail actually got a shot in the arm.

What we found was that for a decade, consumers have shifted to experiences over things. People wanted to go on vacation; they wanted to go to the Crayola Factory. What they didn’t want was to actually buy a set of crayons, and we found this shift in the pandemic: when the world is forced to stay at home, people need to create experiences out of their homes, and that triggered a reallocation of disposable income. For people who were not going on vacation, and not going out to eat, we found that they reallocated their spend, and we found that that spend spanned across leisure, home office furniture, anything having to do with fitness, and then it also started to trickle into handbags and luxury and watches and things that could be seen on Zoom. The amount of pants versus tops bought in 2020 would likely make for an interesting study.

Q: You recently published a “Deep Dive into Debt” in the U.S. retail sector. Why did you undertake this study? How does it fit into your broader thesis that COVID-19 has helped companies focus on health rather than growth?

A: To take a step back, over last summer, we published a report titled, “Did COVID Actually Save Retail?” and what we dug into and what we found, surprisingly, was that the pandemic offered this pause in time for retailers and brands to take a minute, re-evaluate how they were operating their businesses, and essentially refashion them for the future, evaluating and restructuring down to the core. What that meant at the heart of it was stopping to focus on growth for growth’s sake, and taking a closer look at how to be profitable, and what’s the right size and acknowledging that at some point, a brand’s incremental customer becomes a dilutive customer.

That was a very income-statement approach, that was a P&L, it was looking at the sales and the expenses. But the more we got into it, the more we thought that this transformation was also going to impact the balance sheet. So, my team and I spent a lot of time digging and looking at how people changed their capitalization structure. The hypothesis going in was actually the reverse of the Did COVID Save Retail.

Q: What did you expect to find? Were there any surprises?

A: We assumed anecdotally that every retailer and brand borrowed a lot of money at the beginning of the pandemic, essentially as protection money and just-in-case. So, we actually walked into this analysis, afraid that we would find that, although the P&Ls were healthier, the balance sheets were on the precipice. What we actually found was that, yes, companies borrowed as much as they could. In fact, they borrowed multiples higher than what they borrowed back in the Global Financial Crisis, but on the other hand, as we continued to look, we found a meaningful divergence across the coverage universe.

Most importantly, we found that although the gross leverage went up as companies borrowed more money, the net leverage, the amount of net cash they had on the balance sheet, was actually improving, and that was because a) companies that borrowed money did not actually spend it, and were still sitting on their borrowed capital, and b) expenses dropped. Companies stopped buying inventory, they stopped paying rent, they stopped paying other expenses and unfortunately, they furloughed employees, which, to hyperbolize, basically meant there was no cost of running the business.

So here we saw a picture that we thought was going to be bleak but what we actually found were companies that were cash-rich. Now, this money needs to be paid back, and those expenses will return, so what happens in the future will be critical, but being able to start from a position of strength, on both an income statement and balance sheet perspective, was not the conclusion we expected at the outset of the pandemic.

Q: So, companies are taking on debt as a direct result of COVID, correct?

A: Yes. So, as soon as the pandemic hit, companies borrowed. They tapped every revolver, every credit facility, they went to the debt markets, we saw converts issued for the first time in a long time, and essentially if there was a way to grab cash and hoard it in the bank, companies did so, just in case the worst played itself out. We found that of the 15 companies that we cover that were public during 2008, 60 percent borrowed back then, and ~90 percent borrowed this year. Every single company that we covered borrowed more during COVID, except for L-Brands and Lulu.

Q: I understand that part of your analysis was also around how companies spend?

A: How companies spend, and watching how they borrow and subsequently repay, is oftentimes the most accurate look into boardroom conversations. That is why we did this. We wanted to see, what were the companies’ prospects at the outset of COVID and what were the companies’ prospects now, and that’s why we took a very close look at who grabbed defensive capital who has subsequently paid it back, who stopped dividends and repurchases, and who has brought them back?

Q: So, how have companies fared overall during COVID, and how does that compare to how they fared during the Global Financial Crisis (GFC)?

A: The bottom line is that improving net debt actually left us more optimistic, and that was not the case in 2008. What we saw was that ~90 percent of this group borrowed more this time around, and they borrowed almost 150 percent of their operating profit last year, and some companies added almost as much as 450 to 500 percent. On the other hand, there were companies that didn’t borrow any.

If we synthesize, gross leverage went up one turn for the group versus pre-COVID levels. It’s now roughly 2 ½ times, whereas net leverage actually improved slightly. During the GFC, the picture wasn’t anywhere near this magnitude when companies on average borrowed around a quarter of the prior year’s operating profit.

I think what is more interesting than who borrowed, is where we have gone from there.

Q: We don’t know where we are in the pandemic, with different views of when there will be a return to normal. Do you have a sense at this stage about whether these optimistic signs will continue? Is the momentum on retailers’ side now?

I think in using the balance sheet to shed light into companies’ perspectives, it’s interesting to see that some are buying back shares again, some are paying a dividend again, and a couple have raised dividends. It’s encouraging that we are now seeing companies return to giving a capital return, a handful of companies that in some capacity are paying shareholders back. There are also a host of companies that are paying debt holders back, a clear signal that companies that grabbed onto the rails for dear life and took whatever cash banks would offer now feel comfortable giving it back. That’s a very encouraging sign, to see that there are companies that are increasingly telling the world, “We don’t need this cash anymore.” There’s no better sign than that because no company needed to pay back yet.

In contrast, during 2008, ~45 percent of total borrowed dollars were paid back within two years, 55 percent within three years, and 60 percent within five years. Around 40 percent of GFC dollars that were borrowed were never repaid and, over the last decade, those are the companies that have struggled. If you don’t pay back when you can, and you kick the can down the road, that’s when these interest payments and debt become a burden, and what we do know is that while it’s very hard to kill a retailer, debt is retail’s kryptonite.

Q: Has the fallout fully occurred in your sector, or will there be more casualties?

A: I think that for better and worse, there will always be casualties because retail is always evolving, and just as the consumers’ needs and desires change, so too will the companies who cater to these needs have to change.

Q: So COVID has been a driver of change?

I group those who have benefitted from COVID into four categories:

1. Companies that saw a rise in demand because of COVID and that are actually better off today because of COVID, like at-home fitness, home furniture;

2. Companies who had gone too far, too fast and could now pause and completely reorganize their businesses for the future;

3. Companies that are worse off today because of COVID but which will be better off tomorrow because the challenges that they face were cataclysmic to their competition; and

4. Companies that essentially filed for bankruptcies and were able to get a new lease on life by recalibrating their debt load by walking away from some interest payments and changing nothing else. All they did was buy some time. Ultimately, we are likely going to be having the same conversation about them for years to come… and that’s if they are lucky.

Q: In the end, do you stick by your thesis that many companies are getting healthier during COVID?

A: Yes, I believe that for the companies that took advantage of it, COVID was a forced reset that pivoted them for the future. COVID put the smallest start-ups and the largest brands on equal footing. It gave both zero-revenues, it gave both zero-expenses. What they do from here is up to them, and the companies who take advantage, the companies that recognized this, hopefully, once-in-a-lifetime opportunity, to make every decision anew and to build up, rather than take down, will find that on the other side of this, they are much better positioned.