Tipping Point? How Apparel Inflation Could Accelerate the Decline of At-Risk US Retailers - MFS Investment Management
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Tipping Point? How Apparel Inflation
Could Accelerate the Decline of At-Risk
US Retailers
INVESTMENT
INSIGHTS IN BRIEF
March 2017 • Import tariffs would directly impact US retailers, who import most of their goods,
including 98% of apparel sold.
• Rising apparel costs could further pressure the retailers already reeling from online
competition and shifting consumer preferences.
• Retail stocks have slumped for 18 months as big-box and department stores have
retrenched and struggled to compete.
• We believe loss avoidance will be a key alpha driver in the retail industry in this
changing landscape.
While Amazon continues to increase its dominance of online sales, retail icons J.C. Penney,
Macy’s and Sears are closing hundreds of stores. Traditional retailers have lost sales over the last
decade as mall traffic has dwindled and e-commerce orders have skyrocketed. While this is not
a new story for investors, the retail industry faces another threat that could serve as a tipping
point for weaker players in a recession — the end of two decades of falling apparel prices.
Apparel prices have been deflationary since companies began offshoring most of their
manufacturing to lower-cost producers over the past 20 years. The deflationary era is under
threat, however, as US president Donald J. Trump and congressional Republicans consider a
remake of the corporate tax code and consider introducing new protectionist trade policies to
encourage a return of US manufacturing. The proposed “border adjustment tax,” for example,
would reduce the US corporate tax rate while imposing tariffs on imported goods consumed
in the United States. Apparel retailers could suffer severely under such a scheme, since 98% of
their goods are imported.1
An end to deflationary clothing prices has significant implications for the retail industry and
for investors in the coming years. Some retail companies are already suffering — share prices
have largely declined over the last 18 months as some of the larger names have struggled to
adapt to a landscape beset by shifting consumer consumption preferences. We think there are
alpha opportunities in this market by avoiding the companies most at risk of losing revenue and
market share in this environment. Stock price dispersion has risen in recent months, indicating
that the market is more discerning about outperforming and underperforming companies.
That’s why we believe apparel inflation could become the tipping point for at-risk retailers in
the next recession.
1
American Apparel and Footwear Association, November 12, 2015.
page 1 of 6INVESTMENT Marked down: How cheaper clothes helped fuel US retail expansion
INSIGHTS The major catalyst for falling apparel prices was China’s entry into the World Trade Organization
March 2017 in 2001. Until then, the treaties governing global trade included a system of quotas that limited
clothing and textile exports from China and other countries. The quotas were phased out
over a decade, driving a long decline in apparel costs and a corresponding rise in the amount
of clothing Americans purchased annually. US apparel imports rose from about 54% to 98%
during this period. Exhibit 1 shows that the price of apparel per unit has declined and stayed
mostly flat, bounding around $10.75 per unit, since 1990. Nominal clothing prices today are
estimated to be 3% cheaper than they were in 2000.2
Falling costs have also fueled rising consumption. The number of new apparel units per capita
in the US stands today at 85 compared with 50 in 1990 — a whopping 70% increase, also
shown in Exhibit 1. This means every man, woman and child in the US acquires 85 new apparel
items every year, on average.
“The issues impacting the
Exhibit 1: Falling prices led to higher consumption
industry are among a host
of factors that have started 90 $14.00
to change the landscape 85 $13.50
of retail real estate at an 80
$13.00
accelerated pace. Today’s 75
$12.50
preeminent retail landlords 70 Units/Capita (left axis)
can meet the challenge. $12.00
65
Recent store closure Spend/Unit (right axis)
$11.50
60
announcements could even
55 $11.00
benefit the retail industry
and retail landlords over 50 $10.50
the long term if it allows 45 $10.00
1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015
unproductive retailers
Source: MFS calculation using data sourced from Department of Commerce, Kurt Salmon, Bureau of Economic Analysis and
(tenants) to be replaced.” US Census Bureau, as of 31 December 2015.
Richard Gable
MFS real estate investment The increase in apparel unit consumption has also contributed to the massive growth of retail
trust portfolio manager.
store square footage. US shopping center space per capita today stands at 24 square feet,
which is 10 times that of Europe. But when including other freestanding retail space, the US
number balloons to 55 square feet per person.3
By comparison:
• In the UK, it is 5 feet per capita.
• In Italy, it is 3 feet per capita.
• In Germany, it is 2 feet per capita.
The US is clearly overstored, and recent closure announcements from J.C. Penney, Sears and
Macy’s, among others, come as little surprise as large retailers struggle to compete. Major
retailers have been shutting locations for the last several years and will likely continue to do so.
It has been estimated that as many as one-third of US malls could shut in the next five years.4
2
American Apparel & Footwear Association, November 12, 2015.
3
ICSC, September 2015
4
See, for example, http://time.com/money/4327632/shopping-malls-closing/, by Kerry Close, A Third Of American Malls Will Close Soon,
12 May 2016.
page 2 of 6INVESTMENT Consumers unlikely to buy at present rate if prices rise
INSIGHTS American shoppers are unlikely to continue buying 85 new units of apparel per person a year
March 2017 if prices rise, putting further pressure on already stressed retailers. Looking at the demand
elasticity of apparel, there is a clear correlation between falling costs and units per capita —
when clothing prices decrease, people buy more. The quantity of apparel purchased in the US
suggests that there is a strong “want” versus “need” component to US apparel purchasing,
which could be problematic for the retail industry should the historic price trends reverse. Given
the oversaturation of stores and the additional online apparel supply added with relative ease
by the Internet, retail pricing power is weak for all undifferentiated apparel products on the
market. That isn’t to say that all retailers lack pricing power, but successful ones will increasingly
need to drive prices through differentiation, be it through brand, distribution or styling, among
other factors.
Online sales: Small but growing fast
Proposed import tariffs couldn’t come at a worse time for traditional retailers. Total annual retail
sales in the US are roughly $5 trillion, a massive sum. E-commerce commands only about 10%
of the revenue now, as shown in Exhibit 2, but its rise has accelerated in recent years and has
disproportionately impacted the most vulnerable corners of the retail sector. E-commerce has a
tremendous economic advantage for the consumer versus physical stores. It discounts key items
by an estimated 13%–17%, has a larger selection and has a cost base that is 3%–4% lower.5
To compete, traditional retailers have also migrated online, while closing stores to cut costs.
General merchandisers and department stores have struggled in this landscape as their revenue
has declined dramatically in recent years, as shown in Exhibit 3.
American shoppers are It hasn’t just been online sales eating into their businesses, however; it’s been a combination
unlikely to continue of technology and budget-minded consumers. The segment’s post-recession recovery has
buying 85 new units of been weak, as consumers have preferred to shop at discount and outlet stores — while also
apparel per person a using their smartphones to locate specific goods, compare prices and read reviews to become
year if prices rise, putting more informed before making a purchase. Consumers have become more discerning in recent
further pressure on already years as prices and products become more transparent, altering the shopping experience for
stressed retailers. everything from food to clothes.
Exhibit 2: E-commerce has grown but is still only a small portion of overall retail sales
12%
10.3%
10% 9.3%
8.5%
7.9%
8% 7.4% 7.7%
6.8%
6.3% 6.5%
6% 5.6%
4.9% 5.2%
4.4%
4.0% 3.8% 3.9% 4.1%
4% 3.4%
2%
0%
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Source: US Census Bureau, as of October 2016.
5
McKinsey & Co., “Making Stores Matter in a Multichannel World,” December 2014.
page 3 of 6INVESTMENT Exhibit 3: Big box and department store revenue has dramatically fallen
INSIGHTS
260 $252
March 2017 $241
240
$225
220 $210 $206
Sales ($Billions)
$201
200 $192
$180
180 $171
$164
$157
160 $152 $149 $146 $143
140
120
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Source: Mazzone & Associates 2015 Retail Report, figures from 2016–2020 are forecast. Forecasts are not guaranteed.
Retail shares slump — except for Amazon’s
What investors often These issues haven’t gone unnoticed by equity investors, as retail shares — excluding Amazon’s
miss in large cap equity — have slumped over the last 18 months. The industry has lagged both the broader market
investing is that trying and the consumer discretionary sector. Amazon has been a glaring exception, dominating
to avoid losses is just as the industry and market in terms of growth and stock performance. Amazon has significantly
important as finding the outperformed both the S&P Consumer Discretionary Index and the S&P Retail Select Industry
next rising star. Index since July 2015, when the retail index closed at a record high, as shown in Exhibit 4. From
its July 2015 peak to January 31 of this year, the equal-weighted retail index returned -15.1%
while Amazon returned 73.2%. The S&P 500 Index, by comparison, returned about 7% over
the same period.
The winner-take-all growth of Amazon versus others shows up perhaps most clearly in a
market capitalization comparison, shown in Exhibit 5. Some of the largest names in the industry
have struggled and have declined precipitously over the last decade, a trend that seems to be
accelerating as some of the larger chains struggle with migrating online and cutting costs. It
would be easy to recommend buying Amazon and selling everything else in retail land, but it’s
not that simple. By most measures, Amazon’s stock is expensive (price/earnings ratio greater
than 160 times earnings versus around 18x for the S&P 500 Index). If Amazon is the “star”
in this universe, how can investors expect to outperform an index if its valuation is so high?
What investors often miss in a large cap equity strategy is that trying to avoid losses is just
as important as finding the next rising star. In an index strategy, investors are exposed to the
largest names in the market at any given time. Some of those companies have already peaked
by the time they achieve large cap status. By focusing on the good performers and avoiding the
laggards, an investor can potentially achieve alpha over time.
page 4 of 6INVESTMENT Exhibit 4: Amazon has dominated retail returns in recent months
INSIGHTS
80% 73.2%
March 2017
60%
40%
20% 15.9%
7.3%
0
-2.8%
-9.6%
-20% -15.1%
-24.2%
-40%
-60% -59.4%
-80% Amazon Market-Weight Market-Weight Equal-Weight Equal-Weight Wal-Mart Target Macy's
Retail Index Discretionary Discretionary Retail Index
Source: Strategas Research Partners, data as of 1/31/2017.
Exhibit 5: Market caps for some large retail names are melting fast
2006 2016 Pct. Chg
Sears Holdings Corporation $25.8B $1.0B -96.1%
J. C. Penney Company, Inc. $17.4B $2.6B -85.3%
Nordstrom, Inc. $12.7B $8.3B -34.4%
Macy's Inc $20.0B $10.9B -45.3%
Target Corporation $49.0B $40.6B -17.2%
Wal-Mart Stores, Inc. $192.5B $212.4B 10.4%
Amazon.com, Inc. $16.3B $356.3B 2092.0%
eBay Inc. $41.9B $33.2B -20.8%
Source: FactSet, MFS, data as of 12/31/16
We believe we are at Conclusion: Changes ahead in the retail landscape
the beginning of a Given the Trump administration’s rhetoric on trade, investors should consider the possibility
consolidation phase in that apparel won’t continue to be deflationary, at least to the extent it has been. Marginal
retail that will continue for retail players will continue to find the landscape inhospitable, and thus the shakeout we
some time, which means are witnessing now will likely continue and possibly accelerate when the next recession
stock selectivity is critical materializes. We believe we are at the beginning of a consolidation phase in retail that will
for investors. continue for some time, which means stock selectivity is critical for investors. Not all brick-and-
mortar companies will decline and disappear, but the next recession could be a watershed event
for US retailers.
page 5 of 6INVESTMENT The consumer discretionary sector, which includes the retail and apparel industries, among
INSIGHTS others, represents about 12% of the S&P 500’s total market capitalization. Investors who have
March 2017 an allocation to large-cap stocks most likely have exposure to the sector and to its underlying
industries, including some major household names. Performance of the sector and the
subindustries has varied dramatically over the last few years, a trend we believe will continue
in the coming years. Investors should consider the changing dynamics of the sector and its
underlying industries, and the potential to add value versus a broad market benchmark such as
the S&P 500 index. In our opinion, the value of active management increases dramatically when
volatility rises and fundamentals — good and bad — reassert themselves into asset prices. There
are many retail companies at risk of losing substantial market share and profits, given current
uncertainty surrounding online growth and, now, the potential for US import tariffs. We believe
there is an abundance of yet-to-be realized alpha in this sector by avoiding the most at-risk
names, and that selectivity will potentially benefit patient investors over time.
Author
Maile Clark, CFA
Equity Research Analyst
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