Brick and Mortar Retail: A Case Study in Disruption—Or a Self-Inflicted Wound?
On October 15, Sears—once the largest retailer in the United States—announced it was filing for bankruptcy. Our team has been studying the decline of brick and mortar retail for the last few years, so for us, this wasn’t particularly shocking news.
But in the wake of the 125-year-old company’s Chapter 11 filing, it’s worth asking a pointed question not just about Sears, but about the broader landscape of struggling retailers. Namely: Who is to blame?
Is it purely the technological shift to e-commerce that’s squeezing brick and mortar retailers, pushing them towards an inevitable path of extinction?
Or have these retailers been complicit in their own demise?
In our view, there is no doubt that physical department stores are facing pressure from the rise of e-commerce. But we also believe that there has been a historic level of corporate mismanagement in this industry—and an obscene level of capital misallocation.
• • • • • • • • • • • • • • • • • • •
Let’s take a closer look at Sears.
From 2006 to 2011, Sears spent $5.4 billion on stock buybacks, according to its SEC filings. Today, the company’s market cap is valued at roughly $40 million (as of late October).
Let those numbers sink in. In a span of six years—starting at the beginning of a disruption cycle in which e-commerce began its ascent—Sears began buying up its own stock at historically high valuation.
In 2006, Eddie Lampert, acting as Chairman of Sears, authorized the purchase of $816 million worth of Sears shares at an average price of $133. “We allocate capital to initiatives that we believe will provide the greatest returns and create the most value for our shareholders,” he wrote in his annual letter.
As of this writing, Sears’ stock is trading under 30 cents.
By reducing the number of shares outstanding, buybacks artificially inflate a company’s earnings per share (EPS), and therefore make a firm appear more attractive to investors—at least theoretically. But buybacks are pure financial engineering; they do nothing to materially improve a company’s offering. Instead, they essentially vacuum money away from R&D and other innovation efforts. As the economist Bill Lazonick put it in our conversation with him last year: stock buybacks are a form of “value extraction.”
Sears could have allocated that capital toward its e-commerce platform, refurbished stores, launched new offerings to compete with its competitors, or even distributed cash directly to shareholders in the form of dividends—but it didn’t.
Instead, Lampert and management extracted value by doubling-down on its buyback program while cutting capital expenditures—amidst a surging e-commerce landscape that was ratcheting up competition on incumbent retailers. “Over the last three years, we have spent a total of $4.3 billion on share repurchases,” Lampert wrote in February 2008. “We have repurchased 33 million shares at an average cost of $132 per share.”
As the Los Angeles Times noted in November 2009, Lampert continued the buyback binge in the midst of the financial crisis, even as many of other retailers were conserving capital in a challenging consumer market.
The LA Times wrote:
Most retailers have suspended stock buyback programs as they conserve resources to cope with cash-strapped consumers who are shopping less and expecting bigger discounts. Not Sears. It's spending more on its stock than on its stores.
Sears cut capital expenditures, or investment in fixing up its stores, 44% for its fiscal year through Oct. 31. And it trimmed inventory spending 5% going into the holiday season. Amid this frugality, the owner of Kmart and Sears stores spent $224 million to buy back about 3.5 million shares at an average price of $64.30 a share in the third quarter, which is more than it invested in capital expenditures in the first nine months of its fiscal year. Morgan Stanley analyst Gregory Melich called the move a "questionable practice given the state of the store base," in a report Thursday.
From 2009 to 2011, Sears spent another $1.001 billion in buybacks. Meanwhile, store revenue and gross profits continued to decline.
Make no mistake: We believe competition in physical retail is becoming increasingly cutthroat and risky for physical retailers. Online and mobile shopping offers convenience to consumers—and better margins for the platforms.
In the last two years alone, there have been a rash of retail bankruptcies and liquidations. Among them: Nine West, Claire's, The Bon-Ton Stores, The Limited, RadioShack, Toys R Us, and many more. Business Insider is tracking about 3,800 brick-and-mortar retail stores will close in 2018. Last year, Fung Global Retail & Technology tracked 6,985 store closures. The Atlantic called last year’s disruption the “retail apocalypse.”
There is unquestionably a secular trend of a contraction in brick and mortar retail. And in our view, in times of increasing risk and uncertainty, capital should absolutely not be spent on buybacks. If management decides there’s nothing left to invest in—i.e. no new innovation efforts that would improve their value proposition—managers should at the very least preserve cash on their balance sheet as a cash cushion.
However, we have begun to track several other retailers that appear to be falling into a similar pattern as Sears. This tactic, in our view, is a poor long-term strategy for an industry in the midst of disruption and change.
For instance, Bed, Bath and Beyond—which recently announced more store closures—spent $5.4 billion on buybacks from 2013 to 2017, according to SEC filings. Today, the company is valued around $1.85 billion. Jim Cramer, for one, said this might be “the worst buyback” ever. I might have to agree.
The list goes on, even if the examples are less extreme. Target, for instance, facing increasing competition from Amazon, chose to spend $8.15 billion on buybacks from 2015 to 2017, representing nearly 20% of its current valuation. (Full disclosure: Worm Capital is short both BBBY and TGT and long AMZN).
In our view, the rise of e-commerce and Amazon will continue to pose a challenge for retailers, but it’s a threat that is not insurmountable for savvy retail management teams.
Smart physical retailers will focus obsessively on their core value proposition with customers—and experiment with innovative ways to drive store traffic and retain customer loyalty. Many of these initiatives may be expensive in the short-term—but stores that invest for the long-term have a better chance of retaining relevance. And, ultimately, capital allocation strategies that consider the future landscape of retail will benefit long-term shareholders.
If there is one lesson investors can learn from Sears, it’s that financial engineering is not a long-term strategy. And the secular shift to e-commerce is only partly to blame for its current woes. As Business Insider put it last year:
The man in charge of Sears, Edward S. Lampert, has blamed the company's decline on everything from shifts in consumer spending to the rise of e-commerce, and even — at times — the weather. More recently, he's taken to attacking the media, saying reports speculating on a Sears bankruptcy are thwarting his efforts to turn the business around.
But what sets Sears apart from other suffering retailers is something that's not as obvious as the rise online shopping and falling foot traffic in shopping malls. It's the steps that Lampert took when he first acquired the company: putting shareholders like himself in front of everyone else, he drained the company of vital resources.
When Sears was flush with cash, this took the form of billions of dollars of share repurchases, even as the stores suffered years of underinvestment. Repurchases, or buybacks, are common among cash-rich companies, but also derided in some corners as a waste of a company's resources as they only serve to create the appearance of improving earnings.
Count us among those critics. For industries experiencing disruption, buybacks are almost never the answer. Unfortunately, for companies like Sears, it appears that these lessons are learned too late—and long-term shareholders face the collateral damage.
Worm Capital, LLC does not accept responsibility or liability arising from the use of this document. No document or warranty, express or implied, is being given or made that the information presented herein is accurate, current or complete, and such information is always subject to change without notice. Shareholders and other potential investors should conduct their own independent investigation of the relevant issues and companies involved in this article. This document may not be copied, reproduced or distributed without prior consent of Worm Capital. Arne Alsin and Worm Capital clients are currently long Amazon (AMZN) stock and call options. The opinions expressed herein are those of Worm Capital, LLC and are subject to change without notice. This information should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any of the investments or strategies referenced were or will be profitable, or that investment recommendations or decisions we make in the future will be profitable. Past performance is no guarantee of future results. Worm Capital reserves the right to modify its current investment views, strategies, techniques, and market views based on changing market dynamics. This article contains links to 3rd party websites and is used for informational purposes only. This does not constitute as an endorsement of any kind. Worm Capital, LLC is an independent investment adviser registered in the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about Worm Capital including our investment strategies, fees, and objectives can be found in our ADV Part 2, which is available upon request. WRC-18-17.