SINGAPORE (May 8): In the movie I am Legend, Will Smith played the sole survivor in a pandemic. The post-apocalyptic thriller is set in a fictional New York City where a devastating virus wipes out most of humanity while turning a small percentage into violent mutants called darkseekers that were neither dead nor alive.
These darkseekers have superhuman survival skills and a lust for blood. Only sunlight can tame them. The movie was released in 2007 and is based on a 1954 novel, but it could also describe the troubled retailers in 2020.
JCPenney, a famous American department store chain founded in 1902, has fallen victim to the Covid-19 outbreak. It has closed 850 stores and furloughed thousands of workers to save cash. On May 4, this American retail titan — which survived wars, major recessions and the rise of online shopping — filed for bankruptcy.
But the chain’s troubles preceded the virus and JCPenney has long suffered from a vile mix of financial leverage and operating leverage.
The store is one of the many American retailers battered by online competition recently. Shoppers try out shoes, scarves and suits in the store. But, they then buy those items at a discount online.
Its long-term debt has also skyrocketed to US$4.6 billion ($6.5 billion). As a result, the net interest expense is US$300 million, which is hard to meet even before the lockdown.
Operational leverage is the degree to which operating income changes with revenue. JCPenney is vulnerable on this metric. Its ratio of fixed costs, such as staff and rent, to its total costs is high. In the last two years, revenue has fallen 14% but operating earnings have dropped twice as much.
Same store sales have fallen for the last two years. Many of the malls that housed the stores have also closed down.
The poor sales and heavy debt has bled the cash flow statement. At just US$386 million, its cash reserves are a fifth of the level in FY2015.
The lockdown also opened the doors of death for JCPenney: It had a US$105 million debt tranche maturing in June, which prompted the bankruptcy petition.
Other famous retailers such as Neiman Marcus and Gap are also on the brink. Neiman Marcus is desperately negotiating a haircut with lenders to cut its US$4.3 billion debt by half. Meanwhile, J.Crew — a one time retail trendsetter — has also filed for bankruptcy.
Like the darkseekers, the dying retailers may have a magic potion that is more powerful than oxygen — bankruptcy laws and ultra-low interest rates.
Sears, a massive American department store that once owned the world’s tallest building, went bust in 2018. However, about 400 of its stores are still functioning. Some of them have even opened their doors as the lockdown lifted in Georgia!
The Chapter 11 process in the US keeps businesses like Sears alive. It allows companies to continue while restructures the debt. There is an “automatic stay” that restricts foreclosure and debt collection.
The other source of solace for the troubled retailers is the incredibly low interest rates. The Covid-19 crisis has merely further cemented these rates.
JCPenney was on its knees for several years. As recently as 2018, it raised US$400 million of debt at under 9%. This would not have been possible if not for the hunger for yield in a low interest rate environment.
A similar issue may arise in Asia, where retailers have been on a debt binge despite adversity. Over the last decade, the net leverage at listed Asian retailers has risen over threefold.
The Hong Kong-listed clothing retailer Esprit Holdings may face JCPenney’s fate. Esprit is a producer of colourful sweatshirts that were once an aspirational item. Its sales rose 40 fold between 1993 and 2008.
But in the last decade, Esprit has been outclassed by new retailers such as Zara as well as e-commerce. Its net debt is now twice its market capitalisation. Plus, the toxic combination of falling sales and soaring debt has driven the stock down 90% in the last five years.
Last month, it shut all its stores outside China, its core market. The grim reaper is clearly not far.
Chapter 11 is not known in Hong Kong and China but the region’s complex bankruptcy laws allow the dead to survive.
Traditional retail is at death’s door and Covid-19 may hasten the end. But, as with the darkseekers, a virus may not be the end.
Nirgunan Tiruchelvam is head of consumer sector equity at Tellimer (Exotix Capital)