Memo: The Forgotten Middle

The shift to eCommerce has been overstated, according to one common refrain. There’s some evidence to back that up: total eCommerce penetration accounts for an estimated 14.3-16.1% of all retail sales in 2021, a small slice. Anecdotal support of physical retail’s continued prominence is also regularly called to mind. In a well-researched essay by Elena Burger, an investment analyst at Gilder Gagnon Howe & Co, she explains: 

The takeaway shouldn’t be “eCommerce is eating the world” it should be “despite lockdown, store closures, mass layoffs, and global logistics networks that rival militaries in terms of sophistication, eCommerce was less than one-sixth of sales in the US.”

Intelligence, for the moment, is outpacing life. [1]

The essay is tremendous. A number of takeaways will leave you wanting to understand more about the fascinating times of digital agglomeration’s clash with traditional retail. My concern, however, is that it glosses over two larger issues: retail infrastructure is not solely resting on New York’s soil (the city is mentioned 12 times throughout the essay), and throughout the country, pockets of front-office employment has evaporated. As retail store managers and associates have faced furloughs or worse, there is opportunity for lateral movement to other retailers, brands, or comparable industries. This is not so with the tens of thousands who’ve lost their jobs in front-office retail.

One brand’s success in an area like Soho, New York is often held up as the anecdotal argument that retail’s demise isn’t so dramatic, with stories that read, “Retail is not dead, look at what Allbirds is accomplishing in physical stores!” Yet if you zoom out, recent reports from CNBC tell a different story: rents have fallen to $367 per square foot, a 62% decline from the area’s peak in the spring of 2015, and are declining 25% year over year [2]. The average gross margin of a major retailer fell from 28.44% to 16.76% between Q2 and Q4 2020, with EBITDA margin falling nearly 100 basis points over the same period [3]. Meanwhile, foot traffic has yet to return to pre-COVID form.

We built a bubble of physical retail that reflected changes in America’s social fabric. We did not account for what an even a single-digit change in foot traffic could do to those creations. Ms. Burger explains:

In that period, engineering solved the rather unwieldy problem of “how do we bring an unfathomably large number of people together so they can shop, and justify the millions of dollars we just spent building out this department store or mall.” While developers had other tools to ensure profits (mall operators used a 1954 tax change to accelerate their depreciation schedules and, in turn, realize higher tax write-offs) this is something really worth highlighting. [1]

It’s important to note that preceding this 1954 tax change was another major shift in society, taking place earlier that same year.

The U.S. Supreme Court abolished segregation in schools after Brown vs. Board of Education was decided. This meant that urban areas around the country were characterized as unlivable by some. Nowhere was this felt greater than in the midwest, where affluent families and government-funded veterans moved to the suburbs to allow their children to avoid certain schools. […] This massive exodus to the American suburbs corresponded with a construction boom in the outskirts of many metropolitan areas. [4]

We built these new malls as a means to modularize new cities removed from urban centers. We built these malls far too fast and far too often. America is simply over-retailed. Between 1950 and 1990, the aggregate population at the center of American cities declined nearly 17% while population grew by 72% in the suburban areas. Before the 1954 tax change was enacted (accelerated depreciation), there was one regional mall in the United States. By 1956, that number rose to 25. There was 6 million square-feet of retail in 1953 and nearly 31 million square-feet by 1956.

We did not account for a future of re-urbanization. We did not account for a future that saw a decline in car ownership. And we did not account for a future that saw digital means of trade as an alternative to the physical.

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When you learn just how little retail’s physical development is tied to population growth, you begin to understand why so many retailers relied on debt and persisting sales promotion to account for waning interest. eCommerce does not have to exceed 30-40% of total sales to negatively impact the retailers who failed to prepare for a future without the consistently high rates of foot traffic that mall developers advertise. In fact, eCommerce as a percentage of retail only needs to remain where it is to continue disrupting America’s 70 year-old model of mall retail. And eCommerce is not responsible for the “contraction of physical retail.” It’s more complicated than that.

Authentic Brands Group’s recent acquisitions are shaping up to be a bright spot in the mall retail sector (Frye, Nautica, Nine West, Volcom, Barneys New York, Forever 21, Lucky Brand, and Brooks Brothers among them). But there are a number of retailers whose positions are increasingly vulnerable. Foot traffic remains unreliable at many malls across America. A number of major retailers are enduring disruption, some worse than others. Your mall is overwhelmingly represented by one American city that is 560 miles away from Manhattan and 2,800 miles away from Los Angeles. It’s the forgotten middle.

As 2019 came to a close, I was sitting around a table with retail of executives from L Brands (Victoria’s Secret, Bed Bath & Beyond), Designer Brands (DSW), Ascena Retail Group (Justice, Lane Bryant, Ann Taylor), Abercrombie & Fitch, and Express. Each headquartered in Columbus, Ohio, the stakes of the conversation were alarming. According WWD, Columbus is the third-ranked city for fashion designer employment behind New York and Los Angeles. This region of Ohio depends on corporate retail like Pittsburgh once depended on steel mills or Detroit boomed on domestic automotive manufacturing. Even a fractional change in the retail ecosystem can cause seismic damage to the city’s tax base. The city’s economic development website boasts:

The Columbus Region is home to some of the world’s most recognizable retail and apparel brands who drive innovation globally – ranking No. 4 along large U.S. metros for concentration of retail headquarters. A concentration of headquarter operations is joined by businesses focused on market research, analytics, design, technology and omni-channel efficiencies – creating a market that uniquely connects retailers with customers.[4]

Well into the day, eCommerce rose to the forefront of the conversation. While some of the leaders were prepared for an eventual digital-first economy, few were eager to depend on it so heavily and so soon. By the second quarter of 2020, digital and logistical infrastructures would be put to the test as mall foot traffic fell precipitously. That foot traffic has yet to return to its pre-COVID form. And neither have the gross margins that sustain the large corporations that depend on them for the maintenance of five-figure workforces.

Retail is resilient but all retailers are not. Since that conversation, the collective of brands in that room has eschewed thousands of front-office jobs, disrupting suburbs and schools and places of worship that depended on the consistency of enterprise retail. The reality is that the No. 4 metro for retail employment and the No. 3 metro for fashion design has been impacted by the shift to digital agglomeration. And it’s a leading indicator for further disruption, if I have ever seen one. We are talking about a class of corporations that are commonly operated with extraordinary amounts of debt and little room to tolerate disruption. In The Credit Report, I explained:

A number of key retailers are carrying debt-to-EBITDA ratios that are not sustainable under COVID-19’s conditions. For example: JCPenney owes $8.30 for every dollar earned, Office Depot owes $4.60 per dollar earned, and Walgreens owes $5.80.

Perhaps the traditional retailers who’ve relied so heavily on foot traffic will find new ways to build omnichannel successes. It is a matter of margin, room for error, and tolerance for disruption. Retail is on shakier ground than many can understand. Here, in the forgotten middle, I see the struggle to pivot towards a digital-first economy. Digital agglomeration [6] and eCommerce are undeniable factors in this newfound vulnerability. It may be difficult to see at the New York or Los Angeles street levels, where luxury brands and popular stores are still thriving despite it all. But, without considerable changes, the mall retail system is incapable of tolerating further disruption. The shift to eCommerce is actually understated because the old guard will have to adopt the technologies of today just to survive the decade. In a wonderful excerpt, Burger explained:

Because technology made the relationship between the consumer and consumerism more convenient, and because its acceptance was relatively uncontested, shopping itself sponsored the complete alteration of urban and suburban sprawl. [1]

In the 1950s, malls were the retail technology of its time. Seventy years later, you wouldn’t possibly rely on olden technology to power retail for the next seventy. Mall owners will require its retailers becoming great eCommerce practitioners. Without that, these developments will struggle with delinquencies and vacancies, perpetuating a ruinous cycle. Physical retail needs eCommerce more than ever.

By Web Smith | Editor: Hilary Milnes | Art: Alex Remy | About 2PM

Editor’s Note: Elena’s essay is one that is sure to take the retail ecosystem by storm, and rightfully so. Within the hour that it was published, seven different people sent it my way. It is well-researched and well-positioned. The author is a hedge fund analyst, which informs her views. She explains that the narrative around eCommerce’s impact on physical retail is overstated. She and I hopped on a traditional old phone call to discuss what we agreed on as well as what I would contend with or elaborate further on. What I most appreciated about the exchange is that we discussed ideas candidly and constructively without as much as a prior introduction. It’s what I hope happens more often in this era of Substack creators, newsletter operators, and operators-turned-writers. If you’re new to 2PM, read the rest of this week’s Monday Letter here

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