REAL ESTATE

FASB: The Biggest Threat to Retailers’ Earnings

BY CSA STAFF

By Bill Bosco

(November 1, 2010) Is the economy the biggest threat to earnings of U.S. retailers? I think that a bigger threat may just be a proposed lease accounting rule change.

The Financial Accounting Standards Board (FASB) has issued an Exposure Draft (ED) of proposed new rules for lease accounting that essentially will turn operating leases into capital leases for accounting purposes. (The ED is available for review on fasb.org.)

The degree of unfamiliarity among the nation’s retailers about the proposed rule change is stunning, especially considering the potential devastation it will wreak on earnings. Currently, the accounting rule (Financial Accounting Standard 13) requires only off-balance sheet footnote disclosure of future operating lease obligations. The proposed new rule, however, does much more than merely capitalize leases as the analysts do. It capitalizes estimated renewal and estimated percentage rents, so much more is capitalized than expected.

Many believe that estimated renewals and percentage rents do not meet the definition of a “liability.” The ED requires that the estimates be reviewed and adjusted when there is a material change (this could well mean monthly). Also, the FASB decided that average rent expense is not lease expense but rather amortization of the capitalized asset, and imputed interest on the capitalized liability is the reported P&L cost of the lease. The result is a front-ended lease cost pattern, which many believe doesn’t reflect the economic cost pattern of a lease.

The front-ended pattern causes the increased lease cost to accumulate until the midpoint of the lease term, at which point it turns around so that lease costs are lower in the second half of the lease. Given Wall Street’s “what have you done for me lately” philosophy, it is not good to have better earnings in the future, while you have lower earnings now.

In the chart below, I’ve estimated the impact of the ED’s lease-cost pattern versus current GAAP rent expense for a lineup of the largest U.S. retailers. (I used footnoted future operating lease payments from the retailers’ 10K annual reports.) The results are actually understated compared with the ED’s capitalization model, as estimated renewals and percentage rents are not captured. Looking at Walgreens, for example, if the impact is three times the above, its pretax earnings will drop by 50% in the first year under the proposed rule change.

The first step that every retailer needs to take is to become educated about the proposed rule change and how it can/will impact earnings. As I urged attendees of the National Retail Tenants Association annual conference in Anaheim, Calif., during my September keynote address, start by reading the Leases Project ED, evaluate its implications, and then write a comment letter to FASB. It is not too late to change the direction of the rules, and there are alternative views that have sound basis, but if you do not comment to the FASB, the ED will become reality.

The deadline to submit comment letters is Dec. 15, 2010. For a link to comment letter guidelines, as well as more details about FASB and its potential impact on retailers’ bottom lines, visit chainstoreage.com/webexclusives.aspx .

Bill Bosco is president of Leasing 101, a New York City-based lease consulting company. His areas of expertise are accounting, tax, financial analysis, structuring, pricing and training. An author and frequent speaker on leasing topics, Bosco has been named to the FASB/IASB Lease Project working group.

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Food for Thought

BY CSA STAFF

(November 1, 2010) Being all things to all people is a sure-fire recipe for failure in today’s segmented retail environment. And no one seems to understand this better than the expanding class of grocery chains focused on natural and organic products.

There is no denying that the recession took a toll on the industry, as it did on nearly every sector of the consumer goods marketplace. But the good news is that even in a difficult economy, consumers are still buying natural. In a study conducted earlier this year, market research firm Mintel International Group Ltd. found that only 21% of organic food buyers have cut down or eliminated organic purchasing, while 20% have switched to less expensive organic options. Meanwhile, nearly half (48%) are buying as much or more organic food than before the recession.

According to Mintel, organic food has become a core lifestyle element for many people who may make cuts in other areas of their budgets. Sales in this segment are forecast to grow nearly 20% from 2010 to 2012.

While the sector is dominated on the national level by Whole Foods Market, many regional operators—by tailoring their stores to their communities, fostering close ties with their shoppers and embracing locally grown merchandise—are thriving. Here is a look at four regionally focused concepts that have built up a loyal following and a growing business.

Natural Grocers: Keeping it in the family has proved a successful strategy for Lakewood, Colo.-based Natural Grocers by Vitamin Cottage. The company was founded in 1955—long before organic was a mainstream trend—by Margaret and Philip Isely. The couple started out by selling vitamin supplements and whole grain bread door to door.

Still owned by the Isely family, Natural Grocers has grown slowly but steadily into a chain of 38 stores located in Colorado, New Mexico, Texas, Utah and Wyoming. Stores run around 10,000 sq. ft. and combine natural and organic grocery items with vitamins and supplements.

More locations are on the horizon. In its current fiscal year, which started Oct. 1, the company plans to open 12 stores, including the new markets of Arizona and Oklahoma.

Kemper Isely, co-president of Natural Grocers, attributes the company’s success to the core values established by his parents.

“We only carry high-quality products, including 100% certified organic produce and meats exclusively from naturally raised animals,” he explained. “We are committed to providing affordable pricing, nutrition education for customers, exceptional benefits and working conditions for employees, and support for our communities.”

Natural Grocers stores range from 8,000 sq. ft. to 15,000 sq. ft., and the portfolio is divided between free-standing and shopping center locations. Sales remain primarily divided between food, 55% of company revenues, and vitamins/supplements, roughly 32% of total revenues. While the exclusively organic produce is one of the store’s most popular categories, three of its strongest and fastest-growing merchandise segments are fresh dairy, private-label bulk foods and pet foods.

To keep prices as affordable as possible, the company buys aggressively and maintains tight margins and low overhead. Whenever possible, it sources from local suppliers. However, even if produce has been grown organically, the grower must be certified USDA Organic or Natural Grocers will not stock its product.

Natural Grocers is very much a family affair. Seven family members are involved in management, including Kemper’s brother, Zephyr, who serves as the other co-president, and sister, Heather, who is executive VP.

Kemper Isely said Natural Grocers limits how much money is taken out of the company, preferring to invest profits back in the business and fund growth through internally generated resources.

In addition to helping nurture its customers with healthy options for diet and lifestyle, Natural Grocers is also intent on caring for the environment. Describing the sustainable focus of his family-owned business, Isely said the company typically expands into existing buildings that they upgrade to a higher green standard.

“All of our recently opened stores have upgraded the HVAC systems, including using heat that is generated from our refrigeration units,” he noted. “We also use recycled building materials, install LED lighting throughout the stores and use a non-toxic, environmentally friendly polishing technique on concrete floors.”

Sunflower Farmers Market: Sunflower Farmers Market promotes healthful living across every facet of its operations. The 32-store chain was started in 2002 by grocery store veteran Mike Gilliland, the founder of Wild Oats Market (which was eventually acquired by Whole Foods Market), who was intent on providing a value-priced alternative in the health food category. The company’s mission, echoed in its tagline—“Serious Food…Silly Prices”—is to provide quality natural and organic foods at the lowest prices.

“We are in a valid segment so our business does well, although we continue to face the same challenges with food deflation and heightened competition that all food retailers have,” said Gilliland, who serves as president and CEO of the chain. “However, our stores are serving the needs of a segment of the population that [are] not being met by Whole Foods or traditional grocers.”

Although he admits the natural foods industry is clearly dominated by Whole Foods, Gilliland believes independent retailers around the country are changing their focus to find ways to compete, and this has altered the competitive landscape and made for some unique ironies. For instance, Gilliland noted that Whole Foods has recently initiated a more value-oriented marketing campaign.

In a surprising revelation, Sunflower has found that some of its best co-tenant neighbors are other food chains. The company often locates in shopping centers with Kroger or Safeway, and one of its most recent store openings was in a Super Target-anchored center. Another Sunflower opened beside a Trader Joe’s.

“We see a lot of cross-shopping consumers; our stores are a secondary destination for produce and meat,” Gilliland explained. “We co-exist very well with Trader Joe’s because they don’t focus on produce or meats, and those categories are 50% of our sales. They take away from our wine business, but we take their produce and meat sales.”

Sunflower maintains its low pricing strategy by keeping overhead low, minimizing store build-outs, optimizing purchasing by buying in bulk quantities and self-distributing from its company warehouse in Phoenix. The company sources locally as much as possible—a bit of a challenge, as the chain is becoming more regionally dispersed.

Sunflower continues to grow at a steady but conservative pace. Expansion, according to Gilliland, is limited by its supply line.

“We can probably go up to 1,000 miles from Phoenix,” he said. “California is next up on the agenda. We will open stores there in early 2011 and plan to open eight to 10 stores a year for the foreseeable future.”

In 2009, the retailer opened Sunflower Farm, a 40-acre working farm east of Boulder, Colo., that provides organic product to stores as well as local restaurants. The intent of the farm, Gilliland noted, is less about becoming a sourcing avenue for the stores and more about becoming a demonstration farm. Sunflower shoppers have the option of participating in the company’s Community Supported Agriculture program, where consumers can learn about composting, visit a petting zoo and re-connect with how food is grown.

“At the end of next year, we will be approaching $500,000 in sales,” he reported, “which positions the company for more competitive purchasing decisions.”

The growing chain continues to do well, with double-digit sales growth in organic produce and consistent single-digit growth in other product lines.

Sprouts Farmers Market:
Since its debut in Chandler, Ariz., in 2002, Sprouts Farmers Market has become one of the nation’s fastest-growing grocery retailers. It has opened 50 stores in eight years—13 in the competitive Southern California market. With 54 stores in Arizona, California, Colorado and Texas, the chain is on track to open 12 stores this year and has seven reportedly in the works for 2011.

Sprouts emphasizes perishables with a limited assortment of packaged goods. It does a big business in produce and bulk items. The fresh items are displayed in a farmers market-style department, while bulk product is featured prominently in the center of the store.

Sprouts stores, which range from 23,000 sq. ft. to 37,000 sq. ft., are designed to be simple and spacious and are known for their friendly atmosphere. Low-profile shelves, old-fashioned farmers market decor and oldies music playing in the background are among the company’s signature accents.

Stan and Shon Boney, who introduced the Sprouts concept and continue to lead the company, have a long lineage of retail successes on their family tree, including health-food chain Windmill Farms from the 1970s and Henry’s Marketplace, which was purchased by Wild Oats Markets in 1999 and renamed Henry’s Farmers Market.

Earth Fare: On the Eastern Seaboard, Earth Fare, based in Fletcher, N.C., has a similar ambiance and is also growing rapidly with 21 stores in Alabama, Georgia, North Carolina, South Carolina and Tennessee. This year, the company opened its fourth store in Tennessee and entered Alabama with the opening of two stores. Earth Fare plans to enter the Sunshine state with a store opening in Tallahassee, Fla., later this year.

Committed to providing healthy and natural foods, Earth Fare refuses to carry any product with high fructose corn syrup, hydrogenated oils or artificial preservatives, sweeteners, flavors or fragrances. The company website hosts two blogs: one from its CEO, Jack Murphy, and another that posts healthful living stories from its shoppers.

In stores and online, Earth Fare’s intent is to make living a healthier lifestyle easier, more understandable and more enjoyable for its customers—reinforcing that organic and natural choices have become increasingly mainstream.

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