Retail Reckoning

There are just too many stores. Warning: Big shakeout ahead

Lured by a Nordstrom (JWN ) store and nearly 70 other new retailers, Cheryl Campbell went straight to the Easton Town Center in Columbus, Ohio, on the morning after Thanksgiving. With shopping bags in each hand, the 52-year-old surety underwriter looked like many other shoppers who kicked off their Christmas shopping season by heading to this gleaming outdoor mall. But even by the free-spending measure of the 1990s, Campbell says the last thing this city needed was more new shopping space. "It's really a question of who is going to survive," says Campbell, juggling her shopping bags in front of the new Nordstrom.

Indeed, it doesn't take an expert to see that Columbus can't support all its new stores. The Easton center, built to look like a quaint town with a fake train station and streets like Worth Avenue named for luxe-shopping districts around the world, has doubled in size to 1.6 million square feet since the summer. In addition to Nordstrom, Easton added an Anthropologie store and an American Eagle Outfitters (AEOS ). Meanwhile, ten miles northwest, the Polaris Fashion Place, an enclosed 1.5-million-square-foot mall, opened in October, bringing the city's first Saks Fifth Avenue and 149 other new stores. That's on top of Tuttle Crossing, a 1-million-square-foot mall that opened in 1997, and six other big malls built previously. "They're all engaged in a big game of chicken," says local retail consultant Christopher Boring of Boulevard Strategies. "There's going to have to be a shakeout."

It's an outcome that's likely to be repeated across much of the nation. Rampant discounting may yet save this year's Christmas shopping season from utter disaster, but retailers are still expecting the slowest holiday sales since the 1990-91 recession. And with so many bargains and promotions, profits will take an even bigger hit. That's just for starters. With expansion-minded retailers and developers coming off a decade-long building binge, what comes after Christmas is likely to be even more frightening.

Like the bull market in dot-com stocks, retail is just starting to come to grips with its own bubble. The industry added 3 sq. ft. of new store space during the 1990s for every man, woman, and child in the U.S., according to research firm F.W. Dodge, like BusinessWeek, a unit of The McGraw-Hill Companies. That 20% growth rate was double the rate of population growth during the decade. Most of it occurred during the past five years, as low unemployment and soaring housing and equities markets left consumers feeling flush.

But even under those optimal conditions, many retailers did not perform well, as the total consumer-spending pie was sliced thinner. In fact, as space grew, the industry became less productive. Average operating profit margins for retailers, after rising slightly to 3.97% in 1996, fell each year thereafter to a negative 0.17% in 2000, even as consumer spending accelerated, according to research by U.S. Bancorp Piper Jaffray (chart).

That was in the good times. Now, besides a shaky Christmas, store owners face a recession of uncertain depth and duration, one that could be magnified by another terrorist attack or other external shock. Adding more downside risk is that consumers are laden with record debt and worried about their jobs. There is also evidence that they are fundamentally realigning their priorities, suggesting that they may not return to their free-spending ways even when things improve. "Retailers who expanded, hoping that the consumption boom would continue, are in for a rude awakening," says Stephen S. Roach, chief economist at Morgan Stanley Dean Witter & Co.

This cycle is dealing out huge gains for a fortunate few. The dominant players are bigger and more aggressive than they were in the industry's last downturn. They will probably emerge holding a far greater share of the market, with two or three undisputed leaders in most sectors. In discounting, the likely winners are Wal-Mart Stores (WMT ) and Target (TGT ); in consumer electronics, Best Buy (BBY ); and in home improvement, Home Depot (HD ) and Lowe's (LOW ).

EMPTY SHELLS. The flipside? The next few months will be grueling for chains that are in the crosshairs, such as discounter Kmart (KM ), department-store giant Sears, Roebuck (S ), and apparel specialist Gap (GPS ). There is the potential for a much broader shakeout than last time, as weaker players are gobbled up, and survivors shutter underperforming stores and exit unprofitable product segments. While retailers have always "followed the rooftops," chasing new sources of population growth, this time the landscape could become even more littered with empty or underutilized retail shells, as a relative handful of megaretailers and regional malls consolidate their grip on the business. For shoppers like Campbell in Columbus, the wellspring of choice could narrow again.

No one is expecting the immediate succession of high-profile bankruptcy reorganizations seen in the early-1990s recession, when big department-store chains like Federated (FD ) and Macy's sought Chapter 11 protection. True, 31 publicly traded retailers have already filed reorganization proceedings this year, more than the annual peak of 25 during the last recession, according to bankruptcy-data.com. But most of those were smaller or long-declining operators like Ames Department Stores Inc. (AMES ) or drug chain Phar-Mor Inc. (PMORQ ) By contrast, most big retailers carry less debt than a decade ago and will be able to hold on longer, even if many of the weakest players have trouble securing new debt lines.

The emerging key players are those that have clear and understandable positions in consumers' eyes. Just as important, they have developed logistical and financial systems to deliver the goods more efficiently. Wal-Mart has staked out the turf of price leader, while the slightly more upscale Target stands for cheap chic. Kohl's (KSS ) sells leading casual brands but is cheaper and more convenient than traditional department stores. "Customers want a place that is clearly defined so they don't waste their time," says Kohl's Corp. President Kevin Mansell.

"FIVE-YEAR PHENOMENON." This is leaving legions of retailers with identity crises. One thing that is remarkable about this turn of the retail cycle is the number and diversity of major players that were struggling to generate a decent financial return even before the economy headed into recession. That includes nearly the entire department-store sector, which has been hemorrhaging share to specialty stores and discounters. Whole categories that once seemed so promising, like sporting goods superstores, have been decimated. The resulting stresses could make the coming retail downturn last far longer than the one in the early 1990s. "This could be a five-year phenomenon," warns Edward Yardeni, Deutsche Banc Alex. Brown's chief economist.

The wild card, of course, is the impact of the September 11 terrorist attacks. Surveys of consumers have provided some evidence that the attacks, coming right after the popping of the stock market balloon, may have left shoppers ready to move away from 1990s-style conspicuous consumption binges in favor of more modest spending focused on the family and home. Already, that is taking a bite out of high-end retailers like Neiman Marcus (NMG ), Saks Fifth Avenue (SKS ), and Tiffany & Co. (TIF ) "Before September 11, I used to worry about what that new outfit was going to look like," said Faith Lipton, 30, as she exited empty-handed from the Neiman Marcus store on Chicago's Magnificent Mile. "Now what matters is that my husband is going to come home from work to help raise our child. What used to be necessities are no longer necessities."

Plenty of other retailers are struggling to find a niche in the more crowded landscape, where retail concepts seem to grow stale faster than last night's eggnog. Remember the "softer side of Sears" campaign? Under former CEO Arthur C. Martinez, Sears spent nearly $4 billion in the mid-1990s to remodel its stores, spiff up its apparel offerings, and be more appealing to women shoppers. In October, new CEO Alan J. Lacy reversed course, saying he would remodel stores again, focus on a narrower but more potent range of apparel lines, and jettison its department-store heritage to find a new footing in an elusive niche between discounters and department stores. "We want to carve out a unique position," Lacy said.

Join the crowd. A similar strategy is in place at Toys `R' Us Inc. (TOY ), which in recent years was leapfrogged by discounter Wal-Mart. Toys `R' Us CEO John H. Eyler Jr. is repudiating past attempts to battle the discounters on their turf, narrowing product assortments and looking to add more exclusive items. Warren Kornblum, executive vice-president of worldwide marketing and brand management, recently told licensers that the retailer wishes to be viewed as a "large-scale, multiple-outlet specialty retailer. What we're not going to be is a discounter."

Will these stabs at reinvention work? Perhaps. But the strong don't plan to offer any quarter. Retail juggernauts like Wal-Mart, Target, Walgreen (WAG ), and Kohl's are adding more new stores than ever. Even at the expense of a lower return on investment, they're determined to seize long-term market share. Take Walgreen, which is poaching scarce pharmacists from rivals and opening a new store about every 18 hours, usually right next to a competitor. "It's almost like water dropping on a rock," Walgreen Vice-President Mark A. Wagner recently assured institutional investors gathered by UBS Warburg in New York. "It's a slow process, but eventually we're going to win the battle."

A steep downturn would accelerate an insidious cycle of weak finances that makes it even harder for the laggards to catch up. And even if they're not shouldering insupportable debt loads, some chains will be on the spot this coming year when unsecured debt lines come due, at a time when banks are retreating from lending, says bankruptcy attorney Conor D. Reilly, senior partner at the law firm Gibson, Dunn & Crutcher LLP. With new unsecured lines out of the question, those who are able will turn to the public-debt or commercial-paper markets, while others "may have to settle for a reduced facility of some kind with security involved," Reilly predicts. That will, in turn, reduce flexibility and constrain store upgrades and other improvements.

Suppliers, contending with their own sales declines, can ill afford to walk away from major retail customers. But they may be less inclined to extend payments and make other concessions to those, like Kmart and Saks, that were most aggressive in extracting concessions during the boom. Many retailers have "squeezed all the stuffing out of their suppliers over the last three to five years," says Burt Flickinger III, a consultant at Reach Marketing in Westport, Conn. "Now the suppliers have nothing to give, at a time that the appetite among retailers is the greatest." Capping the cycle, as sales and cash flow falter, retailers are forced to cut capital spending, including new stores and the information systems that are crucial to ordering the right merchandise mix and aiming marketing at the most loyal customers.

CASH SQUEEZE. Take the battle between Kmart and Wal-Mart. As Kmart's cash flow from operations sank this year, the company cut capital spending twice, to $1.2 billion from a planned $1.7 billion. It says it will hold investment at the lower level next year, and is spending all the money it needs. But after accounting for store closings and conversions of some stores to larger formats, it will open a net 10 new stores this year, and just seven next year. In some cases, rather than invest in expansive new sites for its grocery-and-general-merchandise Super K stores, the company is shoehorning food sections into existing discount stores. The cash squeeze could also make it harder to recoup ground it has lost in the important information-systems arena. Inventory control systems were so bottlenecked that at one point last year Kmart had to stash excess merchandise in 12,000 trailers parked at the stores.

Compare that with Wal-Mart. Its capital budget totals $9 billion, and that will climb by an additional $1 billion next year. Wal-Mart will open 199 net new stores this year and projects opening 248 the next, for 46 million sq. ft. of new space. Not only is Wal-Mart taking share from Kmart with new stores, but sales growth at existing Wal-Mart stores have far outstripped the rate of same-store sales growth at Kmart this year.

Similar stories are playing out in other sectors. Walgreen, the No. 1 drugstore chain, is planning a record 475 stores, up three from this year, while No. 2 CVS Corp. (CVS ) is scaling back openings as profits decline. Best Buy Co., the No. 1 big-box electronics store, will maintain its 60-stores-a-year expansion rate, while No. 2 Circuit City Stores Inc. (CC ) continues to slow openings and gravitate upscale to avoid competing head-to-head on price against the leader.

Very few retailers thought of slowing expansion in the 1990s, even those already wrestling with operational headaches. Indeed, Wall Street was impatient with those who weren't willing to expand as fast as possible. That was particularly true in the second half of the 1990s, when retailers had to compete for investors' dollars against booming tech companies. But the avalanche of funding merely invited poor decision-making, particularly on the real estate front. "The first 50 locations are real good, the next 25 are O.K., the last ones are just deals: `I'll take the crummy mall in Oshkosh to get a good location in San Diego,"' says Laura A. Weil, a former Lehman Brothers Inc. investment banker who joined American Eagle Outfitters Inc. as chief financial officer after helping to take the apparel chain public. Weil has had to fend off investor concerns that American Eagle's brisk 16% annual growth in square footage was insufficient.

But investors can't say there weren't signs of a looming retail glut. The feverish pace of new-store openings couldn't mask the fact that sales were hardly rising at existing stores. For most of the five years through 2000, total retail sales growth, excluding autos, grew at a faster rate than sales at stores open at least a year, according to Bain & Co. That's significant because when total sales grow faster, it suggests new stores are cannibalizing sales at existing stores, lowering overall productivity. Indeed, total sales growth outstripped existing-store sales growth every month during 2000 and the first six months of this year.

Nowhere is this scenario more apparent than among narrowly focused "specialty" apparel stores. Those chains opened 64 million sq. ft. of new space, a 30% increase, between 1996 and 2000, according to securities firm Lazard Freres & Co. Gap accounted for much of that new building. Each year, CEO Millard S. Drexler increased the rate of growth, from 21% in 1997 to 30% in 2000. In that time, square footage more than doubled at its Old Navy, Gap, and Banana Republic units, to 31.3 million sq. ft. Drexler couldn't fund that kind of growth internally. So he turned to the debt markets, going from a net cash position of $17 million in the third quarter of 1997 to a net debt level of $1.75 billion for the same period this year. Gap's debt is now 36.5% of total capital. Drexler's gamble didn't pay off. Sales at existing stores have declined for 18 months in a row. Profits have fallen for six straight quarters, and the company expects a loss for the fourth quarter. Drexler now admits he grew too fast and has slammed on the brakes. "It's easy to get distracted and lose sight of the fundamentals," he said at an investor conference in September.

MORE MERGERS? The new specialty stores were also stealing sales from department stores, but they had only themselves to blame. Following a wave of mergers in the '80s and bankruptcy reorganizations in the early '90s, department stores became less willing to take the financial risk of creative merchandising. Except for a small portion of in-house brands, they mostly rely on selling the same national megabrands, from Tommy Hilfiger and Polo Ralph Lauren to Jones Apparel Group, in branded boutiques that make it hard to remember whether you are in a Macy's, a Dillard's, or a Lord & Taylor. "I don't know how Rich's and Macy's survive," says James Crutcher, a retired Atlanta physician who visits units of both in the area's Cumberland Mall. "They're so much alike, once you get inside the door you don't know the difference."

Now things are only going to get tougher for department stores. It's not hard to figure out who are the likeliest candidates for the latest round of consolidation. Dillard's finances are deteriorating--sales have been declining, with the company posting a loss for the third quarter and analysts predicting it will post another for the fourth. The Dillard family, which controls 90% of the stock, could be forced to sell if business doesn't turn. The company won't comment on that possibility. Saks Inc., where cash flow from operations has dwindled as sales at existing stores have tanked, could face problems paying its debt, which is near the highest of any department-store chain. CEO R. Brad Martin denies Saks could run into liquidity troubles, but its junk-bond debt rating and low stock price say otherwise.

As the department stores and discounters have moved closer together in price, the importance of having a clear identity has grown. "The murky middle is where nobody should be right now," says Gwen Morrison, managing director of consulting firm Frankel Brand Environments. No retailer illustrates this better than Sears. While the chain is robust in home appliances, Sears has little credibility in clothing. Yet Sears needs apparel--it's far more profitable than appliances and electronics, where margins are thin and under mounting pressure from rivals like Best Buy and Lowe's.

DAUNTING TASK. That's why Lacy didn't exit the business when he announced the company's restructuring plan in October. But Lacy faces a daunting task moving Sears out of career wear to focus just on casual wear, in which Kohl's is the low-priced leader. Indeed, the two chains sell many overlapping brands, from Levi jeans to Nike shoes. To distinguish itself, Sears plans to create an overarching private apparel brand, much as it did on a smaller scale with its Canyon River Blues jeans brand. But it will be hard to stand out when there are already so many vibrant national and store brands, from Federated's Inc. line to Target's Mossimo. "When you think about Sears, you don't think about apparel. You think about screwdrivers and appliances," says Emanuel Weintraub, principal at retail consultants Emanuel Weintraub Associates Inc. of Fort Lee, N.J.

Although the strongest players are becoming increasingly dominant, that's not to say there won't be opportunity for newcomers--or for those willing to head in a radically new direction. Take once-sleepy Fred's Inc., a 374-store Memphis (Tenn.) discount chain that has more than doubled in size in five years with a concept that combines three of the fastest-growing formats--a dollar store, closeout store, and pharmacy. But for those chains that can't deliver on a crisp identity, there will be less and less room to maneuver amid the store glut. Once the holiday sales pass, the climate will only get chillier.

By Robert Berner in Columbus, Ohio, and Gerry Khermouch in New York, with Aixa Pascual in Atlanta and bureau reports

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