With the release of third quarter economic data, the effect of COVID-19 on the retail industry is sharpening, suggesting pathways to recovery.
The devastation of the economy in the second quarter of 2020 was followed by a third quarter bounce-back with somewhat uneven effects, as illustrated in our attached study. Key trends include:
- The initial downturn affected the retail industry greater than the U.S. economy as a whole
- Reflecting this, the third quarter recovery was more pronounced for retail than the overall economy, suggesting many purchases were delayed instead of lost.
- A 40% jump in e-commerce sales kept retail figures from being even worse
- Unemployment and consumer confidence hits did not bounce back as much as other measures, suggesting some uncertainties to address.
An uneven impact and M&A opportunities
As Grant Thornton Chief Economist Diane Swonk observed in her blogpost “COVID-19: Impact by industry,” COVID-19 accelerated restructuring in the retail sector that already had been a major factor of the previous two years. While bankruptcy filings of big-name department stores grabbed headlines, such as J.C. Penney and Neiman Marcus, the economic downturn hit small retailers just as hard.
Swonk said even if customers came in the stores, the need to forcibly stagger customers and limit capacity, as well as commit to more frequent cleaning and disinfecting, added unexpected costs and labor demands. The loss of big meetings and social events specifically hurt luxury retailers dependent on those types of sales.
While the overall numbers for retail have been damaged by COVID-19, it is a mistake to view the entire retail industry as more or less subject to the same pressures, said Grant Thornton National Managing Principal for Retail Simon Jewkes.
“Grocery chains and others selling consumer staples have actually benefited from the pandemic,” Jewkes said. Furniture and home goods retailers, cars and sellers of outdoors recreational goods also have done well this year, responding to purchasing trends that may have been helped by spending curtailment elsewhere. We’ve seen private equity firms actively looking to invest in businesses focused on outdoor activities and sports, including cycling and skiing, and direct-to-consumer (DTC) retail businesses.
The overall benefit the grocery chains are experiencing seems to be coming directly at the expense of restaurant and bar spending. This point was made clear, said Swonk, when a September boost in sales at restaurants also led to a decrease in grocery store spending.
“On the flip side, apparel got really hit, especially formal apparel,” Jewkes said, singling out the Brooks Brothers bankruptcy filing this August as an example of this trend. The lack of formal events is an obvious cause, but even everyday wear companies have been suffering. This has presented an opportunity: Several apparel businesses have been acquired by investors who specialize in branding and will enhance the marketing and engagement with online followers and launch new brand collaborations to grow e-commerce and retail store sales.
When looking at M&A opportunities in retail it’s very important for investors to fully perform due diligence to understand the current state and potential of a business. Digging in through financial due diligence to assess the underlying EBITDA and how it may have been unusually impacted by COVID-19 both in a positive or negative way in 2020 and to understand how the business is positioned from a channel mix perspective to capture the increase in online purchases and changes in consumer shopping habits.
Department stores and shopping mall retailers have been hurt as well, caught in the middle with competition on price by online retailers. Department stores in trouble share a common characteristic in that they haven’t responded sufficiently to the increasing desire for online shopping capabilities. Wal-Mart and Best Buy, by contrast, are department stores that were already increasing their online offerings before COVID-19 and paired them well with such services as curbside pickup options, Jewkes said.
“Everyone wants to blame the COVID economy, but what I’ve seen – bankruptcy filings are up, yes, but it has really been a long time coming,” said Grant Thornton Strategy and Transactions Director Jon Labovitz. “It’s just a story of too many stores for too long, and companies have leases that are just not economical anymore.”
Paths forward for distressed businesses
The effect of COVID-19 on retail industries has put a sharper focus on where poor management decisions had already hurt a company, said Grant Thornton Transformation Principal Robert Schwartz, including the decision to forgo innovation. “We often tell CEOs, ‘You’ve got to be ready for what comes next.’ Many CEOs run their business so that good is good enough, and they don’t continuously look for ways to make more money.”
It seems that COVID-19 is exposing past performance failures and poor decision-making such as over-aggressive growth strategies or an over-reliance on debt. Grant Thornton Transformation Manager Daniel Forman said that while there is nothing wrong with a company taking on debt in a smart way, “There’s a point where a company still needs to take a disciplined approach based on its operating metrics.” A company needs to have a comfortable debt/EBIDTA ratio, essentially a measure of available cash to pay down debt, Forman said. Companies with a high debt/EBIDTA ratio prior to COVID-19 -- prior to the start of the downturn -- seem to be the ones filing for bankruptcy. Meanwhile, the companies with strong balance sheets are able to remain agile and invest strategically to enable future success.
“The timing of COVID didn’t help, but I would argue it was a lack of discipline in maintaining operational excellence,” Forman said, that, in general, led some retailers into becoming a distressed business.
A distressed retail business needs to look in a couple of specific places to begin to make decisions about a path forward for the company. Rationalizing the number of stores in a retail chain should be driven by historical store profitability and anticipated future potential, while also considering individual lease terms and concessions. One of the first areas brick-and-mortar retailers look is to close underperforming stores, and the place to start is to examine store leases. The terms of the lease can offer a handy, time-driven guide on when decisions can be made.
Mall locations for stores have presented a special challenge this year because individual traffic is heavily influenced by the performance of a mall anchor. If a mall anchor store leaves, has limited capacity or shuts down, that can spell disaster for nearby businesses in the mall dependent on it.
The sharp increase in online spending, as identified in recent macroeconomic data, should cause many retailers to reconsider their customer journey. Forman said the “winners” in the retail industry lately are those who were well along pursuing an omnichannel strategy – meaning that all points of customer contact, online, in-store, over the phone, curbside pickup and at-home delivery are not siloed, but are designed to cooperate, creating a seamless customer experience and repeat business. COVID-19 forced customers to rethink the basics of their purchasing methods and retailers who provided maximum flexibility to meet customers in the way they wish to do business are the ones that have survived and even thrived.
One thing that retailers should not worry about is a change of administration in Washington come Jan. 20. “There’s a lot of scare that goes out there in politics,” Schwartz said, “but the reality is that our markets are pretty resilient. No president wants to tank the economy. Every president realizes having jobs is the lifeline of our culture and our economy.”
If a business is troubled enough where a bankruptcy proceeding seems to be the best option, the ability to raise cash quickly, Labovitz said, is the key. As mentioned earlier, COVID-19 has already triggered some major retail bankruptcies. In the last 20 months, there have been 64 bankruptcies, the second most active sector after energy.
Starting a bankruptcy proceeding is best handled with a small internal team, finance and legal departments, that works closely with trusted outside advisors. Leaks about a potential bankruptcy can cause vendors, employees and customers to prematurely cut ties. This can hurt the bankruptcy proceeding in many ways – reducing income when it’s most needed and losing employees a business may want to retain.
At that point, dealing with existing leases needs to be a priority. Labovitz said management can deal with individual landlords one-on-one to negotiate out of some leases, but often a better solution is consolidating the leases in a bankruptcy proceeding. In that case, all the leases get treated the same way and are capped by statute, ensuring a consistent obligation to various landlords.
When the process begins administrative expenses take priority and they need to be paid in cash at closing to allow the retail company to emerge from Chapter 11, Labovitz said. But in successful bankruptcy, a company can clean up bad leases and its balance sheet, as well as deal with legacy liabilities such as pensions and healthcare costs.
Accelerating existing trends
Overall, COVID-19 has not been as much a game-changing event for the retail industry so much as an accelerant of existing trends. Retail businesses that were overleveraged, ran too many underperforming stores or were slow to embrace online sales and omnichannel customer strategies before the economic downturn are the ones paying the price for those shortcomings now. The strengths and weaknesses in the industry revealed by COVID-19 and identified here are lessons any business should heed when planning for the future. It remains imperative in retail, more so than in most other industries, that executives proactively and continuously capture opportunities to ensure their cost structures are efficient and effective in supporting the profitability of their businesses. Those taking a more reactive approach are bound to see the challenges presented by COVID-19 repeat themselves.
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