By Kashif, Investment Analyst at PrivCo, a private company financial intelligence platform

On an earnings call with investors in March, Urban Outfitters CEO Richard Hayne admitted something his fellow retail barons have known all along but have been reluctant to say: their businesses are really struggling, overcapacity is to blame, and it could get a lot worse.

“Our industry, not unlike the housing industry, saw too much square footage capacity added in the 90’s and early 2000’s. Thousands of new doors opened and rents soared; this created a bubble, and like housing, that bubble has now burst. We are seeing the results; doors shuttering and rents retreating.

This trend will continue for the foreseeable future and may even accelerate…”

Industry data supports Hayne’s claim that retail is in a downward spiral. Bank of America’s February 2017 report on credit & debit card spending showed that department store sales plummeted 15% y/y, a rate unseen since the last recession. And Credit Suisse predicted that the pace of store closures in 2017 will surpass anything in recent history, including the past two recessions.

Source: Credit Suisse

Importantly, Haynes emphasized that the U.S. has several times as much retail space per capita than Europe or Japan. Record low interest rates have allowed companies to take on cheap debt to expand beyond their means, and all that extra square footage requires more employees and inventory. And all that debt needs to eventually be repaid.

When demand slumps below expectations, excess inventory must be sold off with endless promotions. Discounts become the norm and impact revenues. Struggling companies end up closing stores and imposing layoffs with greater frequency in order to boost margins and productivity.

In the best case scenario, shareholders are temporarily appeased with the improved metrics of a seemingly more efficient retail operation. In the worst-case scenario, piled-up debt comes due as retail sales slump, sparking credit downgrades from ratings agencies in order to warn investors of an imminent default and/or eventual bankruptcy.

Moody’s list of distressed U.S. retailers is particularly telling: in 2017, the number of retailers on the list tripled compared to the 2008-09 recession. Many of these companies expanded their physical locations as consumers shifted to e-commerce or their demand fell off entirely.

While it’s easy to measure the impact of this trend on large, publicly traded retailers, it’s much tougher to get transparency on how privately-held retailers players are performing in this challenging landscape. Which retailers grew too fast and added excess capacity that may need to be shed as retail sales suffer? Which retailers are poised to weather the storm with more responsible and manageable growth?

We took a look through PrivCo’s private company database to examine some large privately-held companies on Moody’s list of distressed retailers in order to see what warning signs they shared in common, and if those patterns could foreshadow financial troubles at some other privately-held retailers we’ve been watching this year.

In our analysis, we first evaluated changes in store productivity (revenue / store) and net new stores added from 2013-15, moves that may have later contributed to a credit downgrade in 2016.

In the chart of distressed retailers below (Part 1), we selected 5 now-distressed companies who rapidly expanded store locations in 2013-15 but experienced negative store productivity growth over the same period. Interestingly, during the first few months of 2017, Payless has already filed for bankruptcy and Gymboree and Claire’s are rumored to be incredibly close to filing. The other two, David’s Bridal and Neiman Marcus, remain in critical condition. Also, despite the large reduction in Claire’s store locations, sales and store productivity still declined, and the company is frequently called out as the next retailer to fall.

In Part 2 of the of the distressed retailers chart, below, we plotted two more privately-held companies that showed the fastest growth in adding store locations. In contrast to the five companies above, the two retailers in Part 2 experienced positive growth in store productivity. The benefits of rapid brick and mortar expansion were short-lived, however: rue21 is closing a third of its stores (400 locations) as of yesterday, while as of last week, J. Crew is struggling to restructure its debt to avert a rumored bankruptcy filing.

Examining our data above, there seems to be a pattern that could signal imminent financial trouble for a growing retailer, or even a bankruptcy. We can do this preliminary analysis without knowing the minute details of the company’s debt terms, which is particularly tough to obtain when dealing with privately-held companies.

Using PrivCo’s filters, we selected a handful of privately-held retailers (not yet on Moody’s distressed list) who rapidly expanded their brick-and-mortar presence over 2013-2015 while showing consistent store productivity declines over the same period. The results are in the chart below.

Forever 21’s precarious condition should come as no surprise, but the scale of its growth in brick-and-mortar locations coupled with the degree of decline in store productivity is actually pretty alarming. Despite the warning signals, the company announced last week that it’s opening 40 new value-based “Red” stores with double the footprint of its traditional shops.

Meanwhile, outdoors retailer Bass Pro Shops is proceeding with its acquisition of rival Cabela’s even after expanding its store locations (which tend to be massive) by 20% from 2013-15. Cabela’s growth far outpaces its acquirer’s, with the company adding 27 stores and seeing store productivity fall by 30% over the same period.

ShopKo and BJ’s Wholesale Club, while technically in different retail categories, both faced lower sales in 2016 after rapidly expanding through 2015 even as they lost ground to Amazon and other e-commerce. The same effect has impacted Fry’s, whose tepid revenue growth has been a drag on store productivity after the addition of just a few new locations.

In our next research note we’ll do a similar analysis on employee productivity figures for retailers to get a fuller picture of companies who may have overextended themselves while expanding. See you then!

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