Fools Errand: Downsizing Your Stores is No Panacea

By Tom Mullaney, tmullaney@hmsinc.net

In the last decade, electronic commerce (e-commerce) has grown relentlessly. As more consumers have access to the Internet and have become more comfortable with purchasing products and services online, many e-commerce businesses are enjoying double-digit sales growth year after year – and there is no slowdown in sight.

Panic is probably too harsh a term, but more and more retailers are getting very concerned about the negative operating leverage that results from lower sales being made out of the same physical square footage in their stores. 

In the past year, there have been an accelerating number of retail companies trying to shrink their square footage in part because of the increasing amount of products sold online versus in a physical store (e.g., Best Buy, The Gap, Target). This change in market share between physical commerce and e-commerce has a significant impact on companies’ bottom lines. Unlike the proverbial frog in the slowly heating water pot, retailers are realizing that heretofore relatively minor annual sales losses to ecommerce are having a serious cumulative impact, particularly when one looks at lost contribution margin from those sales (which have a leveraged and disproportionate impact on lost profit dollars). Prominent companies have set forth new plans to implement a square foot reduction plan for new small format stores. When this involves opening a new location, the process is straightforward. However, when it involves downsizing existing locations in the middle of a lease term, many of these companies are headed for untold amounts of grief. Downsizing square footage of existing stores is much more difficult than it initially appears and retailers need to be careful to avoid promising more than they can deliver.

In choosing to downsize, companies have three options, each of which carries positives and negatives. 

The first method is to wait until a lease expires and upon expiration, open a new smaller store. However, most retail leases in the United States average from five to 20 years in duration, so using this approach will take five to 20 years to resize a typical retail system. And imagine how big ecommerce is going to be in five to 20 years: As the old saying goes: “You ain’t seen nothing yet.” Clearly, resizing on natural lease expiry is a legitimate and relatively low out-of-pocket cost approach, but the downside is that it takes far too long and lost sales to ecommerce continue apace – so it actually costs a lot more than it looks.

Another method is to sublease to a tenant, effectively splitting (often technically described as “demising”) the space in order to decrease the square footage, all the while maintaining the current lease. This option is easier said than done, as there are many costs that can pile up when trying to divide a space. For example, in past years former HMS clients Blockbuster and Sports Authority tried to split existing spaces, yet found that the theory most definitely did not pan out in practice. For instance, there were conflicts as to who would take how much front footage and who would get inline space versus an endcap.

Additionally, there was disagreement as to the size and location of each company’s signage. Some retailers have tried to get around the understandable armwrestling between a prime tenant and his subtenant over issues of carving up the building exterior by effectively opening up a store within a store. Similar to a department store, where there is, say, a Ralph Lauren Polo section in a Saks Fifth Avenue, a “second” store would be located within a primary store. However, from the subtenant’s perspective, there is often no exterior indication or promotion of their store on the exterior of the primary tenant’s store. As companies greatly value their identity to foot and street traffic, the idea of being buried within the prime retailer’s location is suboptimal, albeit certainly possible for retailers willing to cede storefront visibility. As a result, the second option of subleasing to shrink square footage is easier said than done. It is worth considering, particularly if it can be done on a national relationship basis with another, similar quality retailer. But that requires complicated negotiation, test marketing and, ultimately a lot of time to roll out -- all with the ecommerce clock relentlessly ticking.

A third method in downsizing is to buy-out the existing lease, which includes covering the rent and amount of space that is actually used. In effect, a retailer would inform the landlord of its need for only, say, 30,000 sq. ft. in a 40,000-sq.-ft. space. Buying out could entail compensating the landlord to insert a wall to split the space and funds to payoff the original rent payment as well as additional demising costs (e.g., additional bathrooms, HVAC upgrades).

However, this is a pricey option and it is difficult to convince landlords to agree to this approach. In today’s ugly economic environment, landlords are trying to keep their vacancy rates down from already high levels, not add increased vacant shop space. Accordingly, this third option of buyouts, while theoretically quicker, is the functional equivalent of hitting the landlord with your purse until he says “OK, OK; Deal!” But if time is of the essence, this is a viable way to proceed to stay in existing locations with a reduced footprint. Just bring money.

Clearly, the foregoing methods are time-consuming, expensive and complex. Imagine the amount of time, energy and manpower that goes into doing this for, say, a big box retailer with 1,000 locations around the United States? It is a huge undertaking. Companies should be wary before deciding to downsize and should presume that they will face a multi year, costly battle to shrink. And for public companies, they need to be careful not to overpromise Wall Street as to how quickly and deeply they will shrink their footprints; Wall Street has a long memory and likes to bring these kinds of issues up on a quarterly basis, providing repeated opportunities for spotlighting underperformance.

Instead of focusing on how to downsize square footage, many companies should take this opportunity to improve their business within their existing square footage. For example, rather than task their real estate departments with this hugely difficult task of downsizing, how about tasking marketing and operations to figure out how to drive more sales through the existing footprint? Or how about undertaking an initiative to transform cost of goods sold? With the advent of smart phone apps like Red Laser, consumers can immediately determine if a retailer’s price can be beaten online or by going to a nearby physical store competitor. Retailers who do not have razor sharp, competitive pricing in their stores are going to continue to lose sales to online commerce and those physical retailers (e.g., Costco) whose business systems allow rock bottom pricing – regardless of the size of their store footprint. The never ending battle to reduce cost of goods sold and maintain gross margin is only going to get a lot tougher going forward, and is going to require high cost retailers to make massive changes in their business system to avoid extinction. And if you think “extinction” is a term that is a bit hyperbolic, let me refer you to some fresh dirt in the retail graveyard, including companies like Blockbuster, Borders, Circuit City, Hollywood Video and Tower Records, all of whose demise was accelerated by the steady or (in some cases) rapid evisceration of their business model by e-commerce.

By all means, downsize, using some of all of the three methods described above. Lay in a lot of money, manpower and patience to do so. Don’t overpromise your board of directors or Wall Street. But be sure to focus on where the real opportunity lies: the time honored practice of driving more customer traffic, gaining bigger sales per customer, and managing cost of goods to keep competitive with lower cost ecommerce and physical commerce competitors.

Tom Mullaney is a founding principal with the financial restructuring firm Huntley, Mullaney, Spargo & Sullivan, Inc. He can be reached at tmullaney@hmsinc.net or (805) 259-9486.

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