March 2011

Back in Business: After a Rash of Bankruptcies, Retailers Are in Fighting Shape for 2011

Given what Spence Mehl calls “a bloodbath of bankruptcies” in the retail space in 2008 and 2009, last year brought surprisingly fewer bankruptcies than most had anticipated. And while bankruptcy still loomed heavily for nearly all the big chains in 2010, the difference was that retailers themselves executed their own top-to-bottom restructuring plans. But, Mehl warns, retailers aren’t out of the woods yet.



Back in 2009, analysts engaged in a lot of hand-wringing about the future of American retail. And why not? After all, it was a year in which a staggering 32 chains — some of which had been household names for years, if not generations — had filed for bankruptcy protection amid an economy that could only be described as disastrous. Given that 2008 had also seen a bloodbath of bankruptcies, it was natural to conclude that 2010 would be another docket-busting year for the bankruptcy courts. But while there were a few prominent filings last year — Blockbuster Video, A&P, Loehmann’s and Urban Brands among them — 2010 brought surprisingly fewer bankruptcies than most had predicted. In 2008 and 2009, landlords had looked on in horror as major traffic-drivers like Mervyn’s, Circuit City and Linens ‘n Things shut off the lights and handed over the keys to their stores. Thankfully, no such nightmares awaited them in 2010.

And yet it would be a mistake to say that reorganization played no role in retail last year. In fact, it loomed large for nearly all the big chains. The difference, however, was that retailers themselves executed their own top-to-bottom restructuring plans. They did so out of court, blissfully free of the edicts, deadlines and ultimatums brought about by the 2005 Bankruptcy Abuse Protection and Consumer Protection Act (BAPCPA).

Of course, retailers have always fought vigorously for their survival. But thanks to some of the unintended consequences of BAPCPA, they were more loathe to file last year than they might have been during, say, the 1990s real estate bust. While the so-called Bankruptcy Reform Act took flak for the new restrictions it imposed on consumer borrowers, the impact of its provisions on retail bankruptcies was arguably underappreciated at the time of its passage. In essence, the act shortened the timeline in which non-residential real estate debtors must make decisions and present a plan for reorganization. At the same time, it placed new restrictions and limitations on debtors’ leasing options. The net effect was to force bankrupt retailers to restructure faster than ever before. Wary of these limitations (and the leverage they give to landlords) retailers had every incentive to keep their restructuring efforts out of court in 2010. And that is precisely what they did.

Retailers Fight Back

In a smart response to the Wall Street meltdown and the collapse of the housing bubble, American retailers did everything they could to get lean and mean once the dust settled. Their efforts to chase down every possible opportunity to cut expenses and ramp up efficiency — in payroll, operations, inventory control, occupancy cost reduction, you name it — have been remarkably successful. Today, U.S. retailers have lower overhead, have smarter and cheaper ad campaigns, boast more affordable merchandise and maintain tighter inventories than they did prior to the bust. In a certain sense, 2010 was a year in which many of these chains finally “emerged” from their own self-imposed reorganizations. Much to the delight of their shareholders, they are now posting impressive gains in margin. And while there is no room for error in this tough economy — companies that fumble on the merchandise side, for example, will suffer the consequences as never before — this collective housecleaning has been fantastic for retail overall. It will help them stay out of bankruptcy court in 2011.

Looking Ahead to 2011

So what is the bankruptcy outlook for 2011? Certainly, filings always do occur and they will again this year. But there are grounds for cautious optimism that this year will look a lot like 2010, with its even-keel level of bankruptcy filings. In addition to getting lean and mean, smartly aggressive retailers — including Walmart, Best Buy, Dollar Tree, Big Lots, Forever 21 and Bed Bath & Beyond, to name a few — have taken full advantage of the buyer’s market over the past 24 months to sign some outstanding rent deals. Even if inflation hits the economy, these chains will be in a good position to post gains. As the cost of practically everything rises, in fact, their sales will go up at a relatively faster rate. Meanwhile, the low rents at their stores should translate into higher profits and lower occupancy to sales percentages. That is quite a different environment, in terms of retail bankruptcies, than what prevailed during the dark days of 2008.

But there is another reason that bankruptcy filings will be less likely in 2011: the growing role of private equity in the retailing sector. Simply put, the private equity firms are sitting on a ton of cash. By one estimate, buyout firms headed into 2011 with approximately $450 billion in uncommitted funds. Whenever private equity players make a major investment in a retail chain, the last thing they want that retailer to do is file for bankruptcy protection. If need be, in fact, they will double-down on their equity or secured debt investment in order to keep that retailer open for business. At the end of 2010 alone, private equity firms gobbled up Gymboree, Jo-Ann Fabrics & Crafts, Dots and J. Crew. They are ready to pounce again in 2011.

Plenty of Obstacles Remain

While there are grounds for optimism in 2011, the U.S. economy and — by extension, retail — clearly face major headwinds. There are downsides, for one thing, to getting lean and mean. This is a process that has reshaped and resized, not only retail operators, but also companies in a variety of other important sectors in the U.S. economy. When corporations learn that they can get by with far smaller payrolls than they ever thought possible, where is the employment going to come from as the economy sputters back to life? How long will it take and how strong will the growth have to be before employment returns to something resembling normality, particularly in retail?

Another important point is that it is impossible to make sweeping generalizations about retail. The dynamics at a top-notch property in New York City or Los Angeles, for example, could not be more different from those of, say, a half-vacant strip mall in a tertiary market out in the collapsed exurbs of Phoenix or Atlanta. This year, retailers will continue to be keen on expanding into urban areas and closer-in suburbs with vibrant populations and attractive demographics (after all, “chasing the rooftops” is no longer even possible). They will look askance at less-active markets and properties until growth ramps up in a major way.

Vacancies will be no problem for the owners of “A plus” properties in blue-chip residential enclaves, but in some of the secondary and tertiary markets, it will be a different story indeed. When it comes to renewals, landlords at the top of the food chain will be able to go for rent increases, while malls at the bottom will continue to beg tenants to stay, even giving away percentage-rent deals that would have been unthinkable anywhere in the country a few years ago. If “all politics is local,” the same is true of retail.

Fortunately, landlords and retailers alike have shown considerable adaptability since 2008. Today, even relatively upscale regional malls are willing to embrace the likes of Costco as anchor tenants, so long as doing so will drive traffic to the property. Likewise, landlords are now welcoming Dollar Tree into centers located in demographic areas that once would have been off-limits to this rapidly expanding discount chain. For their part, retailers are not just shrinking their stores in order to lower their occupancy costs, they are jettisoning one-size-fits-all store prototypes in a bid to break into dense urban markets. The best example of this, of course, is Walmart, which has announced plans to begin experimenting with smaller-format stores. A word to retailers in these areas: Watch out.

Sector-Specific Challenges

Nobody wants to compete head-to-head with Walmart. And this highlights the reality that retail bankruptcies often hit some sectors more heavily than others. In 2011, those filings that do occur will likely happen as part of shakeouts in sectors that have either over-expanded, or that face daunting competition from the likes of Walmart or the Internet. Long considered a safe harbor in tough times, for example, the grocery sector has clearly over-expanded in certain markets. Tough and plentiful competition is part of the reason A&P filed in 2010, and we can expect to see additional pressure on the supermarket sector as Walmart continues its push into new markets and goes toe-to-toe with established players. The drugstore chains clearly are savvy operators, with demographic analysis worthy of NASA’s Mission Control. But today, it seems that two or even three chain drugstores fight for customers at high-traffic corners in nearly every market in the country. Have the chain drugstores over-expanded? At some point, we will find out.

Likewise, at a time when bibliophiles get books beamed to their Amazon Kindles, families download movies to their Nintendo Wii systems and music fans log onto iTunes to get any album they want in a matter of seconds, chains that sell music or rent videos are under the gun to compete against some very formidable digital foes. Indeed, millions of shoppers are now learning to use their iPhones and iPads to buy stuff from just about every category and type of retailer in the United States. Clearly, Internet sales and the new phenomenon of mobile retailing will have an impact on brick-and-mortar stores. Personally, I believe there will always be a place for brick-and-mortar. However, the shopping experience is bound to become increasingly important. In 2011, those retailers that fail dismally at keeping their customers excited and engaged just might fall prey to Internet retail — and end up in bankruptcy court.

Moving forward, the U.S. economy still faces major headwinds. Unemployment remains high, home-equity and consumer confidence continue to be low, and widespread talk of inflation highlights the specter of rising gas and food prices. If inflation really does kick in at some point during 2011, it could have devastating effects on a fragile economy (we are already seeing rising wheat and commodity prices). Ultimately, the health of retail is inextricably linked to such macroeconomic fundamentals. Are we out of the woods yet? Absolutely not, but against the backdrop of the so-called Great Recession and all that it wrought, we finally seem to be headed in the right direction.

Spence Mehl is senior vice president of RCS Real Estate Advisors, a retail real estate advisory firm that specializes in analyzing real estate portfolios, reducing occupancy costs and expanding footprints. Mehl can be reached at 212.300.5375 or by e-mail at smehl [at] rcsrealestate [dot] com.