Traditional Retail - The Fall Has Only Just Begun

Summary

• Traditional brick and mortar retail has been taking it on the chin since the 2016 holiday shopping season ended.
• The tea leaves are telling me that there is more pain to come for the traditional retail sector.
• Boomers, millennials, e-Commerce, and the economy are all playing a role in the fall of traditional retail.
• This article discusses the headwinds that traditional retail is facing.

Introduction

Today is Thursday, May 11, 2017 and Macy's (NYSE: M) reported another dismal quarter this morning before the market opened. Macy's stock is down 15% from yesterday's closing price as I begin writing this article. Macy's 1Q17 financial report brought pain to most of the traditional brick and mortar retail sector and the landlords that own traditional retail real estate. We could hope that the pain traditional retail is currently experiencing is temporary, that it will recover as the economy improves or during the next holiday shopping season. At best, I believe any recovery that comes is a long way off. At worst, traditional retail will not recover with revenue and earnings continuing to shrink driving dividends and valuations into the ground. The balance of this article presents the rationale and data supporting this sobering assessment of the current state and future prospects for traditional retail.

What Happened In Retail Today?

The short answer to that question is that Macy's reported another dismal quarter and brought down the house of retail across the market. Macy's dropped 15% as of mid-day May 11. Kohl's (NYSE: KSS) also reported 1Q17 financial results this morning and while earnings were a positive beat, revenue was down, investors were not swayed, and KSS dropped 7% by mid-day. In sympathy with Macy's and KSS, a number of traditional retailer's stock prices also fell including Dillard's Inc (NYSE: DDS) down 17%, Nordstrom Inc (NYSE: JWN) down 10%, J.C. Penney Company Inc (NYSE: JCP) down 7.4%, Ascena Retail Group (NASDAQ: ASNA) down 8.8%, Tailored Brands (NYSE: TLRD) down 7.9%, Francesca Holding Corp (NASDAQ: FRAN) down 7%, DSW Inc. (NYSE: DSW) down 9.3%, L Brands Inc (NYSE: LB) down 5.5%, Boot Barn Holdings NASDAQ (NASDAQ: BOOT) down 6.4%, Stein Mart Inc (NASDAQ: SMRT) down 4.7%, and Shoe Carnival Inc (NASDAQ: SCVL) down 5%. Discounters were not immune from the storm as Fred's Inc (NASDAQ: FRED) and Big Lots Inc (NYSE: BIG) also fell. Target (NYSE: TGT) also took a hit. About the only big retailer that did not take a significant hit was Walmart (NYSE: WMT).

The carnage in traditional retail was not isolated to the actual stores. Many of the landlords owning the real estate occupied by these stores also suffered stock price declines including Simon Property Group Inc (NYSE: SPG) down 2.8%, Kimco Realty Corp (NYSE: KIM) down 2.3%, Macerich Co (NYSE: MAC) down 2.4%, Taubman Centers Inc (NYSE: TCO) down 2.3%, DDR Corp (NYSE: DDR) down 2.8%, and Tanger Factory Outlet Centers (NYSE: SKT) down 2.4%. The triple-net lease REITs were also in the splatter zone even though they don't typically rent to the traditional retail giants. Realty Income (NYSE: O) down 2.6%, National Retail Properties (NYSE: NNN) down 2.7%, VEREIT Inc (NYSE: VER) down 1.7%, Spirit Realty Capital (NYSE: SRC) down 2.9%, and Store Capital (NYSE: STOR) down 2.6%.

Over the last six months or so I've become soured on the traditional retail sector and so I don't own any of the companies or REITs named above. The only two retail REITs I own today are Lexington Realty Trust (NYSE: LXP) and Whitestone REIT (NYSE: WSR). They were down 1.4% and 0.6% respectively about mid afternoon.

What is causing all the carnage in the traditional retail sector? I believe there are a handful of changes causing headwinds for traditional retail and they don't appear to be temporary.

E-Commerce

Of all the headwinds traditional retail has, I believe e-Commerce is the most significant. Sales through e-Commerce have grown every year for the last few years and growth of traditional retail has waned or altogether dropped over that time. For example, as of November 30, 2016 e-Commerce sales were up 11.6% for the year while traditional department sales were down 6.4% over the same period. That pretty well sums up the e-Commerce effect. This effect does not appear to be slowing down as can be surmised from the two charts below.

Source: The Future of e-Commerce

The graphs above show the growth of e-Commerce from 2000 to 2015 and the projected continued growth of e-Commerce up through 2040. Traditional retail's share of total retail sales is projected to consistently shrink. And here is the part that isn't spelled out in the charts above. The total retail sales on the lower chart includes sales that cannot be handled through the internet (e.g. gasoline) or are internet resistant (e.g. fresh foods). I was unable to find data excluding those sales that were internet resistant but, undoubtedly, that type of chart would show e-Commerce taking an even larger share of retail sales that excluded items like fresh food and gasoline.

The charts above may be optimistic with respect to future shares of traditional retail sales. With the advent and broad use of price comparison applications on smart phones and the internet, it is extraordinarily easy do price shop. I find myself doing this so frequently now that it is essentially standard operating procedure (SOP) on any significant purchase. I may find the best price for the item at Walmart, Amazon (NASDAQ: AMZN), eBay (NASDAQ: EBAY) or any number of other discount retail websites. With more and more people giving up landlines for smart phones, more and more people will have the capability to instantly price shop almost any item. The e-Commerce headwind is here to stay and it is only getting stronger.

Slow Wage Growth

While wages have recently started to increase at a measurable rate, we went for several years with no or very low wage growth.

Source: Federal Reserve Bank of Atlanta

The graph above shows the wage growth for full time, part time, and overall employment in the US from 1998 through March 2017. It is clear from the chart that the rate of wage growth slowed from 2002 through 2005 and again from 2008 through 2011 (through 2013 for part time employment). Overall wage growth is accelerating but we still are not back to the pre-2009 level let alone the pre-2002 level. Wage growth for some recent periods barely kept up with inflation and, for part time employment, wages did not keep up with inflation between 2011 and 2014.

Many people don't have the same level of discretionary income for retail expenditures that they had in past recoveries. Without real wage growth, it is really difficult to have any appreciable growth in retail sales.

While no or low growth in real wages definitely presents a headwind for retail sales growth (traditional or e-Commerce), lack of real growth in wages is hopefully temporary. If the Trump administration is at all successful in bringing back manufacturing jobs and initiating significant infrastructure projects, we should have meaningful wage growth to follow.

The Millennial Generation's Purchasing Habits

From all I can read and from what I observe, most of those in the millennial generation spend differently than either the boomers or generation X. Maybe this will change over time as age and the pressures of working and making a living set in, but at this point the millennial generation has not followed in our footsteps. Probably the best summary of the different approach to retail purchases by the millennial generation I've found is in a Forbes article found here. For those not wanting to read the whole article, I'll summarize the salient points below.

1. Millennials are not swayed much by advertising and tend to simply brush it off as hype.

2. Millennials, given the choice, would rather buy a vehicle and rent a home or apartment than the reverse. Maybe this is due to the large number of millennials still living with their parents. Regardless, with millennial home ownership not a priority, a lot of retail sales are lost via fewer new homes being furnished and maintained.

3. Blogs and other people's product reviews are important factors in millennials' decisions to purchase an item. Quality and authenticity are important considerations.

4. Higher wealth doesn't register with millennials as a reason to make more purchases. Estimates peg the millennial generation's total inheritance from the previous generation to be on the order of $30B. While that is a lot of scratch, more than 57% of millennials said this would not alter their spending habits. I'm surprised at this and I hope I'm around long enough to see if millennial spending habits remain constrained.

5. Engaging through social networking is important for the millennial generation. Companies that support, use, and engage through social networks will get more attention than those companies that do not use social networking. This point is probably a minus for traditional retail and a plus for e-Commerce since the latter has shown itself to be more adept at engaging on social networks than have traditional retailers.

6. Millennials use technology heavily in finding, evaluating, and making final purchases. Millennials are completely comfortable with e-Commerce. This does not bode well for traditional retail.

In addition, millennials simply spend less money per capita than either the baby boom generation or generation X. The chart below summarizes the spending habits for each of the generations by spending type.

Note that each successive generation spent more in total than the previous generation until the coming of the millennial generation. Granted, some of the decrease may be due to the number of millennials that have not yet launched either because they are still in school or because they can't find adequate employment. But, if this current trend sticks, future retail sales will suffer.

Baby Boomer Retirements

Retirees generally spend less in retirement than they spent while working. Retirees don't commute to work so they generally put fewer miles on their vehicles so fuel and maintenance costs are lower and the vehicles tend to last longer. Purchases of clothing for work, particularly business attire, generally drop. I have three suits and three sport coats and with the frequency with which I now wear them (maybe a couple times a month), I'll not be replacing them for a good long time. It's the same for the four or five pairs of dress shoes and collection of ties in my closet.

Not only do retirees spend less in total, they tend to shift much of their purchasing into other products and services. Generally, health care, wellness, leisure, and travel get more of retirees' dollars and fewer dollars go towards traditional retail purchases. While we tend to use the malls as a convenient place to walk for exercise during inclement weather, we don't spend much in those malls. The end result is that baby boomer retirements are a headwind to retail sales growth. The boomer generation is large and we are retiring at a torrid pace, on the order of 10,000 per day. It is instructive to take a hard look at future predicted demographics to see just how big this wave of retirees will be.

As can be seen in the chart, the wave of retirements (age 65 and up) and the 85 and over population increase has only just started. We will have many more years of large numbers of people transitioning from work into retirement. This headwind on retail sales will be with us for at least the next 40 years and maybe permanent.

The boomer retirement headwind is not just a US phenomena as the chart below illustrates.

Essentially all developed and developing countries will see the same large increases in retirees and in their elderly populations. The overall aging of the globe will be a problem for retail sales everywhere.

US Retail Space Glut

By global standards, the United States has a lot more retail space than essentially anywhere else in the world. The US has an estimated 25 square feet of retail space per capita. For comparison, the UK runs a close second at 23 square feet, Canada runs about half as much at 13 square feet, and Australia gets by with roughly one fourth as much at 6.5 square feet. The bottom line is that US retailers have built out too much floor space. The unprecedented number of retail store bankruptcies and store closings is not over. It is just starting.

Conclusion and Recommendations

I started to sour on retail mall REITs a couple of years back and on retailers in general and retail space REITs about 6-8 months ago. I've moved from sour to near complete avoidance. As I noted earlier in the article, the only retail REITs I currently hold are WSR and LXP and I'm looking for an opportunity to liquidate out of LXP. I own exactly zero retailer stocks unless it is indirectly through the Vanguard Group mutual fund shares I own. I believe retailers in general have some headwinds and traditional retailers have a lot of strong headwinds and those headwinds will be blowing for some time to come. This is the way I look at the empty half of the glass.

When I look at the half full portion of the glass, I see potential opportunities in package shipping stocks like United Parcel Service (NYSE: UPS) and FedEx (NYSE: FDX). I see potential opportunities in warehouse and distribution REITs like STAG Industrial (NYSE: STAG). Because of the large and long wave of boomer retirement and the increase in the elderly population, healthcare stocks should continue to do well. In health care, I prefer to use a diverse and actively managed mutual fund for those portfolio assets. I like the Vanguard Health Care Fund (NYSE: VGHCX).

If you must invest in retail space REITs, I strongly suggest that you stick with high quality diversified tenant REITs like Realty Income or NNN. Today I think both Realty Income and NNN are overvalued and so I don't own those names at this time. But, if valuations drop to a fair value, I'd consider owning both.

Finally, WSR is a special case of retail space REIT. WSR focuses on high per capita income neighborhoods in areas that are growing fast. WSR also focuses on e-Commerce resistant tenants. Located in the southwest sunbelt, I believe WSR has the potential to do well short of the US going into a recession.

Disclaimer: This article is intended to provide my opinion to interested readers and to serve as a vehicle to generate informed discussion in the comment postings. I have no knowledge of individual investor circumstances, goals, portfolio concentration or diversification. Readers are strongly encouraged to complete their own due diligence on any stock, bond, fund or other investment mentioned in this article before investing.

Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.

Disclosure: I am/we are long WSR, LXP, STAG VGHCX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.