In a 2005 interview with students at the University of Kansas, Warren Buffett described the challenges of accommodating changing consumer preferences in the retail market: “Retailing is like shooting at a moving target … we would rather look for easier things to do.” Last February, in a move indicative of growing public doubt regarding the retail sector’s viability, Berkshire Hathaway sold $900 million of its equity interest in Walmart, American’s second largest brick and mortar retailer.
Recent market challenges in the retail industry have added credence to Berkshire’s soured opinion of retail investments. More than 300 retailers have sought bankruptcy protection in 2017 alone. Many others have announced store closures and have hit multi-year stock market lows. According to Reorg Research, retail bankruptcies in the first half of 2017 rose 110 percent from the year-earlier period. Notably, distress in the retail sector coincides with favorable macroeconomic conditions: GDP growth, low unemployment, and wage growth for middle- and lower-income Americans.
The most common explanation for retail’s challenges has been the so-called “Amazon Effect,” i.e., a shift in consumer preferences from brick and mortar stores to online sales. Amazon’s sales rose from $16 billion in 2010 to $80 billion in 2016. Some reports indicate that half of all American households now hold Amazon Prime subscriptions. E-commerce sales have grown from an adjusted percentage of 3.5 percent in 2008 to 8.9 percent in 2017. Companies without online technology infrastructure—or too much debt to invest in technology—have been choked by the necessity to develop and maintain a true omnichannel presence.
In addition to challenges the “Amazon Effect” presents, consumers are forgoing purchases of goods, electronics and clothing to accommodate experience-based spending. Several studies point to a growing American cultural preference to spend money on experiences over material items. One potential culprit is social media. After calculating whether money is better spent on goods or a “likeable” experience, Americans are choosing to spend money on travel, dining out with friends, or attending sporting events. This trend is not just affecting those selfie-taking demographic groups we typically associate with social media use—the Millennials, and more recently Gen Z—instead, the heaviest social media user group is Generation X (ages 35 to 49). According to a 2016 report from Nielsen, the average adult spends over five hours a week on social media, which represents a 36 percent year-over-year increase.
Additionally, adults and kids are spending more time and money on technology, reducing the demand and available funds for clothing purchases.
These trends all point to the inevitable collapse of brick and mortar retail stores, and may explain positions taken by investors like Berkshire. Accordingly, conventional wisdom suggests that as e-commerce continues to grow, traditional retailers will be unable to compete with Amazon and other online-based companies. But, online shopping only accounts for approximately 10 percent of the retail market share. So what gives? We do not believe it is a brick and mortar presence.
One indicator of brick and mortar’s potential resilience is the recent decision by successful online retailers to open physical store locations. Of course, Amazon’s $13.6 billion takeover of Whole Foods (recently approved by the Federal Trade Commission over wide-ranging antitrust complaints) is the most prominent example. Others, however, such as Bonobos and Birchbox chose to develop an in-person presence even in light of online success. For many of these companies, the benefits that result from providing personalized customer service outweigh the costs of long-term leases and hiring and training new sales staff.
Warby Parker, for example, was launched as an Internet site in 2010 by two Wharton School of Business students. Almost immediately, Warby co-founders Dave Gilboa and Neil Blumenthal received calls from interested customers who wanted to try the frames on in person. Unsurprisingly—the last thing a consumer wants to do is purchase a new pair of stylish-looking eyeglasses in a glossy online photo, only to receive a personally prescribed set of Steve Urkel spectacles. Warby opened its first store in 2013, just three years later. Since then, the company has leveraged its customer experience roots (most recently to a $1.2 billion valuation in 2015), and plans to open 25 new retail locations by the end of 2017, which will bring its total store count to approximately 70.
Similarly, Rent the Runway launched as an online site in 2009. In 2014, after experimenting with pilot programs for nine months, the company opened its first store, in New York City’s flatiron district. The idea behind the brick and mortar location was to put online shoppers at ease, allowing them to try on a number of dresses before making a decision as to which dress to rent for an important event. Just like Warby, Rent the Runway developed its brick and mortar presence to provide a customer experience that virtual shopping could not duplicate. Sources have estimated Rent the Runway’s 2016 revenues at $100 million.
These brick and mortar success stories offer a potential model of a path forward for distressed retailers, centered on adaption to blend online and brick and mortar experiences. Undoubtedly, there is still a place for physical stores. It becomes a question of scale and profitability that will drive this thesis. And with advanced planning, a good amount of creativity, and an ability to build consensus among stakeholders, brick and mortar is here to stay for the long term. Restructurings involving Payless ShoeSource, BCBG, rue21, Gymboree and True Religion, just to name a few, speak volumes to this proposition.
Payless, for example, faced headwinds in adapting to the modern retail environment. Payless’ debt balance and covenant restrictions left the company unable to invest in its business, limiting traditional strategic options. Prior to filing for Chapter 11 relief, the company gained commitments for $385 million in debtor-in-possession financing from existing lenders, including $305 million in ABL financing and up to $80 million in new term loan financing.
As part of its pre-negotiated Chapter 11 case filed on April 4, 2017, Payless restructured over $400 million in debt, closed approximately 700 U.S. stores, and was able to negotiate terms of leases on remaining stores and gain valuable trade credit arrangements with key vendors. Payless emerged from bankruptcy on Aug. 9, 2017, with a healthy balance sheet and a committed strategy for future success. Now, Payless is able to reinvest in its business and online strategy. In fact, Payless plans to invest $234 million over the next five years on inventory and online systems, which will be leveraged to sustain the company’s brand strength and growth strategy.
Likewise, the Gymboree Corporation and rue21 effectively used pre-filing negotiations to garner substantial creditor support for a restructuring. Several months of engagement with advisors and creditors garnered sufficient creditor support to employ restructuring support agreements with key lenders. These agreements formalized creditor support, creating a pathway for substantial debt reduction and continued business operations.
Similar to Payless, BCBG’s restructuring offers a glimpse into how the reorganization process can provide a platform for a distressed retailer to pivot to a new, sustainable business model. In the 1990s, BCBG was one of the first fashion retailers to make designerwear accessible. To capture growth potential and capitalize on its brand, the company borrowed to fund expansion efforts, eventually operating more than 500 stores globally. The company’s underdeveloped online platform and high leverage, together with a growing market trend of rapid consumer adoption of new fashion trends, made it difficult to keep pace with the latest consumer demands. On Feb. 28, 2017, BCBG entered Chapter 11 with $651 million in debt.
BCBG confirmed its Chapter 11 plan of reorganization less than five months later, under which the company’s assets were sold to two purchasers on a going concern basis. To drive the reorganization process, BCBG filed a creative “toggle” plan that allowed flexibility to pursue either (1) the sale of BCBG’s assets to a third party, or (2) a debt for equity conversion with certain term lenders. The filing of the plan, which did not include deal terms or specifics on creditor recoveries/treatment, served as a strategic forcing function to drive both consensus and a going-concern restructuring (on an expedited timeline). The confirmed plan contemplates a blended online and brick and mortar strategy, giving BCBG customers around the world a more developed Internet and omnichannel platform, while preserving 45 retail locations for in-person shopping experiences.
These going concern reorganizations provide examples of the benefits strategic planning in a Chapter 11 context can provide. Yes, it is true that the 2005 amendments to the Bankruptcy Code created challenges for retail reorganizations.1 However, these cases demonstrate that the restructuring process remains an effective tool—in a box that contains a wide variety of liability management and out-of-court restructuring transactions—in solving liquidity issues in the retail space.
In contrast to those companies that successfully restructured their businesses, many others—such as Eastern Outfitters, City Sports, and Wet Seal—have come to know the dangers of entering Chapter 11 without a paved path to emergence. Sports Authority, for example, was unable to consummate a pre-filing support agreement. Without creditor support or clear strategy, the process faltered and the company was unable to execute a restructuring.
Traditional retailers are operating in a difficult industry and legal environment. Yet there are still opportunities for retailers to succeed with a streamlined brick and mortar model that develops omnichannel technology while focusing growth on a company’s brand and operational strengths. Management and directors should consult restructuring advisors to guide them through all potential options, and if necessary, engage lenders in negotiations and strategic planning as soon as the potential for a distressed situation surfaces. It is only then that retailers will be able to hit the moving target.
1. See 11 U.S.C. §§365(d)(4) (providing that an unexpired lease of nonresidential real property under which the debtor is a lessee shall be deemed rejected if the debtor does not assume the lease within 120 days of the petition date, subject to one potential 90 day extension), 503(b)(9) (applying administrative expense priority to goods received by the debtor within 20 days before the date of a bankruptcy’s commencement).
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