Market Chatter: The E-Commerce Grinch That Stole The US Storefront?

December 21, 2017 / by NEPC's Chris Hill, Reino Ecklord, Bradley Rowbotham, and Michael Yang

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‘Tis the season to be jolly…and shop! By many accounts, this should be a robust shopping season: unemployment is low, the economy appears strong and stock markets are surging. In fact, holiday retail sales are projected to increase 4% from last year.1

Yet, the forecast is glum for the retail sector. The industry is struggling to contain the fallout from storefronts rendered vacant by the seemingly unstoppable growing domination of e-commerce. Retailers are trying to keep their head above water as they restructure their businesses to include a more effective online presence while reducing their physical footprint.

Those who failed to evolve or weren’t nimble enough—Borders Group, Sports Authority, Circuit City, F.A.O. Schwarz, to name a few—already have succumbed. Bankruptcy filings and default rates continue to climb higher amid pressure from e-commerce and heavy borrowings in better days. This has taken a toll on the sector’s perceived creditworthiness, with nearly 18% of US retailers debt rated CCC or lower by S&P Global. This is nearly double from the beginning of the year. As a result, $1.5 billion of high-yield retail bonds—or 18% of the distressed debt universe—are trading below 50 cents on the dollar, according to JP Morgan.

At NEPC, our outlook for the industry is less dire. For starters, online sales (as a percentage of overall retail sales) stand at less than 10%, with in-store brick and mortar sales accounting for the vast majority of retail sales. We would even go as far as to say that the disruptions being
caused by e-commerce and consumers’ changing retail habits are creating
investment opportunities across multiple asset types.

We believe painting all retailers with a broad brush is a mistake; some retailers trading down in price may be better positioned than their weaker peers. Investors can use these mis-pricings to their advantage. To this end, we have observed many investment managers take a balanced approach to investing in the sector. Within public equities, shorting companies in the retail sector has been a popular trade. On the long side, we’ve seen some managers buy securities that they feel are fundamentally stable but have traded down in sympathy with the broader industry.

Within fixed income, managers are snapping up debt of retail companies that are reducing liabilities through asset sales and simplifying their capital structures. Some are trading on collateral value, particularly real estate. Private equity investment managers are building longer-term positions around liquidations/restructurings. We are cautious given
the complex capital structures that combine different debt tranches, which may complicate potential bankruptcy proceedings.

Online shopping habits also are creating a new landscape for real estate investors. Retailers are now positioning themselves as a social and entertainment hub—not just a place to buy things. Malls and shopping centers are adding differentiated and experiential retail with restaurants,
coffee shops, gyms and (yes) bookstores where consumers, especially the
millennials, can gather to socialize, share interests and, more importantly, spend. Understanding the spending patterns of millennials—the biggest generation in US history, larger than even the baby boomers—over the next decade will have a profound effect on retail and is key to capturing investment opportunities. Born between 1980 and 2000, millennials spend $600 billion annually – that’s 28% of all daily per-person consumer spending, according to a Forbes report.

Of course, solid real estate acumen of picking well-located assets with population density and strong demographics remains critical. Not all malls or shopping centers will survive, but those assets with the right fundamentals carry potential to be repositioned by experienced managers
who can unlock value through renovations and creating the right tenant-mix for experiential shopping. The retail real estate that likely holds high potential for value-creation are grocery-anchored shopping centers, specifically those with differentiated offerings such as Whole Foods or ethnic-centric grocers such as H-Mart or Fiesta. Unlike many traditional
retail centers, which are experiencing decreasing foot traffic, grocer-anchored centers continue to bring in significant foot traffic, given that US households, on average, do a grocery run as often as two times a week, according to the Food Marketing Institute.

Another potential real estate opportunity created by e-commerce: industrial properties, namely last-mile distribution centers. This sector is vastly undersupplied given the scarcity of land within in-fill locations and/or high-cost basis for higher-density alternative uses, for instance, apartment buildings. Managers who can find sites to reposition or rezone
for development at the right cost will find overwhelming demand for the space, and eventually, strong buyer-pools for exiting those investments.

In the end, the so-called demise of brick-and-mortar retail may be a tad
overblown. What isn’t exaggerated, though, are the changes sweeping
across storefronts in the country. Case in point: Amazon’s acquisition of Whole Foods. At first glance, theirs is an unlikely alliance. The e-commerce giant specifically chose to expand its physical footprint through a grocer, a generally low-margin business where an online presence offers virtually no advantage and little penetration. However, when one considers the frequency and consistency of visits to the grocer’s, there is no better
physical channel to distribute goods purchased online. It is easy to conceive of a future where an online purchase and a weekly trip to the grocery store are complementary – that’s a win-win for landlords, tenants and consumers…and definitely something to be jolly about this
holiday season.

1 National Retail Federation

• Past performance is no guarantee of future results. 

• All investments carry some level of risk. Diversification and other asset allocation techniques do not ensure profit or protect against losses.

• The information in this report has been obtained from sources NEPC believes to be reliable. While NEPC has exercised reasonable professional care in preparing this report, we cannot guarantee the accuracy of all source information contained within.

• The opinions presented herein represent the good faith views of NEPC
as of the date of this report and are subject to change at any time.

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