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Did COVID Actually Save Retail?

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COVID-19 Insights September 18, 2020
COVID-19 Insights September 18, 2020
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As retailers choose which stores to open, rather than close, on the heels of the COVID-19 outbreak, they face a once-in-a-lifetime opportunity to flip the switch on America’s growth at all costs mentality and ponder whether to shrink to grow. Is stronger better achieved by becoming smaller? In his latest research report, Did COVID Actually Save Retail? Deep Dive Into a Post Pandemic Path to Profits, BMO Capital Markets Retail and Services Analyst Simeon Siegel answers this question, and others, about the American retail landscape and opportunities for some of its biggest brands to use a COVID “cover” to change the game and re-fashion their businesses for future growth.

Following is a conversation on the subject with Simeon Siegel (edited for length).

Q: In a nutshell, what are the key takeaways from this report, and are they different for investors and corporates?

A: I think what’s fascinating in life, whether it’s for a person, corporate or a management team, is that we have been trained to focus on growth for growth’s sake, and that leads us, ultimately and unfortunately, to making decisions we feel we need to, rather than because we want to.

Retail is no different. For the last several decades, the retail industry has simply been fighting for that next level of sales, often reaching a point where incremental sales, as we say in the report, become detrimental sales.

What we did in this report was recognize that COVID has forced the entire world to pause, or to reset. With that reset comes the opportunity to take a very hard look internally to re-fashion businesses for the future, and determine the decisions that should be made rather than ones that are being forced to be made.

What that translates to for retail, is that for the first time in recent history retailers get to decide what stores to open rather than what stores to close.

So the analysis we ran over here was essentially identifying the path to getting stronger and healthier by being smaller. The two options are, predominantly, 1) via closing stores, eliminating costs, or 2) pulling back promotions, which elevates the brand. We found that while both represent an opportunity, the latter can turn out to be much healthier.

Q: You speak of major brands having a once-in-a-lifetime opportunity to “Shrink to Grow”. What is so unique about right now and in practical terms, amid COVID, how do you see that happening?

A: At the heart of this report, we are advocating a “shrink revenues to grow profits” story. Historically, shrink to grow has not worked, or it has carried a negative connotation. The reason is because you needed to shrink before you could grow.

What is so special and unique about now, is that the hardest part of the “Shrink to Grow” story is the shrink, but COVID has already shrunk the businesses. Now the question is who chooses to grow and grow healthy. In this report, we are looking specifically for under-earning companies that are not making money … the ones that were most hurt, that were stretched beyond reasonable levels and saw profits fall back. At the end of the day, if you are selling multibillion-dollars-worth of clothing and not making money, you are doing something wrong. Sell fewer goods, sell less, charge more, profits go up.

For those companies, if you have already been diminished, the question becomes: do you return to 2019 and rejoin the hamster wheel, or do you acknowledge that there is a gift in this crisis  and seek to grow from 2020.

Q: Do you think American retail is capable of shedding this decades-old credo that “Bigger is Better?”

A: I think the hardest part of this strategy is that at the end of the day, businesses are run by humans, and humans are not hotwired to acknowledge when they have peaked. The fact is that even pre-COVID, the world was already a story of over-stretching. As a whole, the US retail landscape was already in shrink mode; stores were closing, companies were filing for bankruptcy. That’s not new. That’s been happening over the last several years in response to the mistakes and the mishaps.

The question now is, with the advent of COVID, do you rip off a band-aide and start anew, or do you keep trying to plug bandages on and never actually heal?

Q: So is it shrink but promote, or one or the other?

A: Given that the over-retailing of America shows up left and right, the reality is that the easiest and often first decision is to close stores. What we found in the report is that certain companies would benefit from this. We really dug into what it would mean to close stores and the math behind it, and showed what companies would actually gain or lose by closing stores. What was fascinating about this was that there were a handful of companies that would definitely benefit by closing stores, but on the whole, most companies would lose money if they close a store. That is a good thing because it means that the stores are actually valuable. Yes, there are one-offs where the store is unproductive or even unprofitable, and then there’s a reason to close it, but the reality is that despite being overstored, most stores are still generating cash.

So, we think that this will be a company specific strategy, and in this note we build out the macro story and dig into the minutia of who would benefit the most and what they should do. We found that even though it’s the easier decision to close stores and normally the first and loudest decision, the real benefit can come with a very strong focus on inventory management, with a very strong focus on raising price.

Q: But can stores realistically raise prices and expect to keep customers?

A: Raising prices is hard. When you close a store, you lose expenses immediately, and it’s very easy to see the results. If the math works, it happens immediately. All raising price guarantees you is that you will fire customers. You will lose revenue. So to adopt this strategy takes a very strong will and an ability to look forward and sit through meaningful revenue decline. Yes, units drop because you sell less by charging more, even though what it means is that every dollar you give up, makes every dollar you still sell that much healthier and that is where we found the real benefit.

Q: How important is this opportunity for some of the companies you analyzed? Is this a strategy for survival as well as growth?

A: I think those that simply fight to get back in the rat race will put themselves back on the downward spiral. The definition of COVID insanity is to think that things are going to get better without doing something different. The reality is those that recognize they have been given the opportunity to affect change can chart a different course.

To the question of is this really important, what you show in our report is that there are brands that can actually double their profits by selling less, because those numbers are so low.

The best research reports are the ones where I learn something new. What kept coming up in this process was that some brands stood to benefit from affecting change on both fronts.

Q: You have applied a matrix in your report to the companies in your coverage universe, but could this method be applied more broadly?

A: We have a shrink-to-grow COVID roadmap where we look at the largest brands and the companies that would benefit from shrinking to grow. These are the companies in our coverage universe with very large revenues and don’t make money.

Once you’ve decided which company you want to hone in on, the model we’ve created allows you to type in a company name and input a handful of variables, decide what units, what price points, what average unit retail (AUR) you want to drive up. Then it will tell you what the corresponding impact will be. We’ve done the file for the companies under our coverage; however, we have created it so that other companies can be added fairly simply. So the goal is to be able to use this across the board.

Q: Do you expect investors to accept a shrink-to-grow strategy for public companies?

A: We have found that there is a meaningfully increased investor appetite for turnaround stories in a mall.

The reality is, it’s tough to get in front of investors and say you are going to shrink your business. Investors don’t like hearing that. However, in the same way that management teams don’t have to decide to shrink their businesses in the wake of COVID, investors don’t have to hear them say it because it’s already been done. So it’s much more palpable for investors to build expectations up after taking them down meaningfully, and that is the situation we now sit in.

Investors are growing increasingly more comfortable looking at opportunities to improve businesses that previously were generally viewed with much despair.

Q: Crystal ball time: What will this landscape look like a year from now? Three years from now? Will these big brands shrink to grow?

A: The way we frame this in the report is that this is a once in a lifetime opportunity. The question is who chooses to capitalize on it. Because COVID forced the hard part of shrinking upon the businesses, in reality, we could see the results much sooner than one would otherwise have thought.

If the world resumes some level of normalcy and these companies decide not to open 20 percent of their store fleet (rather than to close), and at the same time decide to raise prices between 10-20 percent, then we are going to see the results immediately, because 2020 becomes the base. The biggest fear factor and biggest question mark is going to be, will management teams be comfortable, and will investors be tolerant as the quarters go on, and results still look below FY 2019 numbers. Will people remember that they want the business to shrink to grow, or on the first sign of improvement will they say, “Giddy up, turn the ignition back on,”?

That, I think, is the biggest fear. I think the fear is less, “can this be a quick fix.” I think the question is, can people remember that smaller can be better.

Read more
Simeon Siegel, CFA Retail & Services Analyst


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