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Sunday, January 18, 2009

Mis-Adventures in Big Box Retailing

Any time a firm goes down in flames destroying billions of dollars as it goes, there are lessons to be learned. One of the highest profile business failures for the week ending January 17, 2009 was Circuit City which announced a complete liquidation of all of its stores and the eventual elimination of nearly 34,000 jobs. (#1). Circuit City's failure could provide enough material for a semester course in an MBA curriculum, assuming of course MBA students were any more capable of learning from colossal failures than the public at large. The outline of the syllabus for Mis-Adventures in Big-Box Retailing 101 might look like this:

I. The Triumph of Branding Over Reality (NOT)
II. Pay For Performance (NOT)
III. Everybody Wins with TIFs (NOT)
IV. The Real Lesson

The Triumph of Branding Over Reality

Circuit City's annual report issued in April 2008 (#2) mentioned major efforts undertaken to:

* equip associates with notepad computers to better assist customers
* rapidly expand "the city" concept for new stores with glitzy oak floors and bold red and black color schemes
* continue emphasizing the "firedog" brand for in-home support of complex home theatre / PC installations

Anyone remotely familiar with the customer experience in virtually any Circuit City store over the past five years is probably laughing as they read this. In March 2007, virtually all of the firm's commissioned senior sales staff -- over 3400 -- were laid off in an effort to lower its pay structure and cut costs. In an environment with dropping sales and inexperienced staff, the least of the company's problems was the lack of notepad computers for staffers to use in looking up prices or answering questions.

The reality was nearly every store provided a poor customer experience because of poor integration in its inventory systems which produced different prices between the web and store and even hampered pick-up of products ordered on line after verifying in-store availability. The company apparently had a plan for that as well. It outsourced much of its back-office systems in an IT services arrangement with IBM and attempted to redesign its web portal so the web site was laid out like its newly designed stores. That way, if you couldn't find something in the store, you could go online and struggle to find it there and STILL not have it waiting at the store after buying it online. Again, management focused on 'expense" rather than the underlying problems with service and functionality. But man those new empty stores really made a bold branding statement.

Pay for Performance

While Circuit City was taking "a number of aggressive actions to improve (its) cost and expense structure" in 2007 by canning all of its competent sales staff, the executive team not only managed to escape pay cuts, they actually came out ahead. Way ahead. After the new CEO Schoonover replaced CEO McCullough in 2006, dollars tossed at the CEO of Circuit City nearly doubled. The insanity of that pay plan becomes more stark after comparing annual reports and proxy statements of Circuit City side by side with those of its arch-rival, Best Buy. (See #3, #4 and #5)

FY2006 FY2007 FY2008
BB Net Sales $30,848,000,000 $35,934,000,000 $40,023,000,000
BB earnings $ 1,140,000,000 $ 1,377,000,000 $ 1,407,000,000
BB CEO pay $ 2,330,674 $ 5,596,904 $ 3,596,873

CC Net sales $11,744,000,000 $12,430,000,000 $11,514,000,000
CC earnings $ 147,000,000 ($ 10,000,000) ($ 321,000,000)
CC CEO pay $ 3,654,701 $ 6,954,948 $ 6,516,568

* CC changed CEOs during 2006 and total compensation of the two
was $3.65M

Note that in each year, Best Buy recorded increased profits. Note that in each year, Circuit City recorded larger LOSSES. Finally note that in each year, Circuit City paid more in compensation to its CEOs than Best Buy paid its CEO. Schoonover finally resigned in September 2008 (halfway through fiscal year 2009) but took home $1.8 million in severance. Oh yea. He also gets two years of health care benefits and $50,000 in placement services. Of course, the insanity of the Circuit City board may pale in comparison to that of traders on Wall Street. From January 2004 to June of 2006, Circuit City's stock actually grew 183 percent (from $10.70 to $30.39) while Best Buy peaked at $56.66, a gain of only 62 percent which vanished in October of 2008.

Everybody Wins with TIFs

Most of its customers would like to forget Circuit City as a shopping experience as soon as possible. However, the firm will leave behind roughly 668 cavernous, hulking stores that will serve as an unwanted, lasting reminder of the firm. At a time when the retail sector is likely to shrink 8-10 percent, the abandoned Circuit City locations will have virtually zero value to any other retailer or the REITs that own the space. The more crucial part of this story is that REIT investors won't be the only parties financially hurt because the big box model for retailing used by Circuit City, Best Buy, Wal-Mart, Costco and Towels-R-Us is hugely dependent upon public subsidies for profitability.

Think for a moment about virtually every big box development you've seen:

* big-box stores don't fit just anywhere
* big-box stores need 20,000 to 40,000 square feet for the store
* big-box stores need high volume which means lots of customers which means lots of additional parking
* big-box stores like company and often co-locate with similar big-box stores
* massive stores and massive parking lots require major road improvements and major development or re-development
* major development or redevelopment means the public must help

And help the public does, in the form of tax increment financing (TIF) programs which shower developers with discounted or free road and storm water improvements required by acres of paved parking and reduced property taxes for many years (10 to 20 is the norm). Often local communities are abusing eminent domain statutes to clear land of existing businesses or homeowners to make room for the big guys to come in.

Developers tell local governments that start-up costs of big stores require a little help getting started but property tax abatements and road/sewer improvements will be more than offset by increased sales tax revenue and increased employment. Local governments swallow the lie and pass it along to voters by elaborating that the beauty of the scheme is that the draw of the stores will be so great that most of the extra tax revenue will be paid by citizens in surrounding communities so that "The Galleria" or "The Commons of Consumerism" or "The Mall of Mediocrity" will virtually pay for itself and local citizens will enjoy the added benefit of not having to drive so far to buy towels from a store that stacks them 30 feet high.

Again, the theory sounds good but the reality is vastly different. The reality is that, even when the stores succeed, the larger community often sees zero net increase in tax revenues because the stores are merely bleeding off sales from other stores, many of them big-box developments from 10-15 years ago. (In my neighborhood, a Circuit City store vacated a strip mall location built in 1994 for a new store built in 2007 six miles away. A Best Buy location moved from a store refurbished in 1997 to a new location four miles away built in late 2008 with TIF incentives and eminent domain. Irony of ironies, the eminent domain partly involved pushing out an established car dealer who moved elsewhere and probably now wishes he just went out of business.) When the stores fail, they may lie vacant for years producing no rents for their REIT owners, no sales tax revenues for their local patron governments and no jobs for local citizens.

Equally likely, many may be torn down because other businesses are growing acutely aware of the fatal flaws of the big box model. Big-box construction styles create enormous fixed expenses for a business in the form of heating and cooling bills for the buildings -- most of which are little more than piles of concrete blocks with tin roofs and florescent lights (and of course the white oak floors and bold red and black "branding"). Since most big boxes don't just look like warehouses but actually serve as warehouses, the big box model proves quite risky in markets selling "perishable" items, whether they are clothes that go in and out of style or electronics that become outmoded or cheaper every few months.

The Real Lesson

It's tempting to look at the collapse of Circuit City as a case study in bad marketing, bad execution and bad capital planning by a single business. However, Circuit City's story will be common in the weeks and months ahead which indicates its situation merits a more careful review from a macroeconomic perspective. Circuit City didn't just cling to life for the past few years, it continued expanding its footprint despite YEARS of concrete evidence many customers despised shopping at its stores. In an "efficient market" for management talent and capital, rapid growth all the way to a cliff followed by a complete collapse might be possible for more illusory "products" like banking, investing and insurance where "the product" often is a promise of future, deferred value. In retailing, where stores interact millions of times daily with customers providing tangible goods, such a pattern of steady growth to collapse should be next to impossible. If lenders and investors know customers are turning away, routine statistics should point out the folly of chasing declining profits with more dollars.

So how did Circuit City happen? Circuit City's collapse points out a much bigger problem with the strategies governments and business have pursued for the past decade. In a nutshell, the meltdown in retailing is in large part due to flawed tax schemes and misguided monetary policy that have artificially reduced tax rates and interest rates that have distorted the normal "creative destruction" that weeds out flawed businesses from the herd. Those policies produce particularly distorting incentives in the niche of business models occupied by big-box retailers, in particular those focusing on expensive but "perishable" goods like electronics.

If you were investing in a business on the ground floor and were acting as an angel investor in the firm, there are five key questions you would want to ask the prospective entrepreneurs about their business plan:

Financial Capital -- How much money does it take to enter and stay in the business? For businesses like utilities, vast amounts of money are required to enter the business, producing an enormous barrier to entry which improves profitability. However, if the product or service involved is not itself a proven commodity, those financial outlays are huge risks.

Intellectual Capital -- How much brain power does it take to enter and stay in the business? Even if financial capital barriers to entry are small or non-existent, if competition in an industry requires special expertise only available to a limited number of people and you don't have access to those people, entry is virtually impossible, creating opportunities for higher profits for the incumbents or an impossible hurdle for a competitor.

Product or Service Complexity -- Is the product or service at the heart of the business complex or simple? Is it new (and unfamiliar) or existing (and well-understood)? Too much complexity may make every sale a "one-off" preventing any economies of scale from contributing to profitability. Just the right amount of complexity can allow some economies of scale to help profitability while supporting an intellectual barrier to entry that stifles competition. Very simple products or services can be cloned easily by other competitors, lowering margins and profitability.

Delivery of the Product or Service -- Does the product or service require a hands-on experience to close a sale or support the product after the sale? Products which are safely, conveniently transportable and well understood in the market lend themselves to centralization and economies of scale. Products and services not well understood (complex electronics, computers, appliances, some clothing) that require a hands on factor to seal a deal or after-the-sale support resist centralization, producing challenges to economies of scale and staffing.

Labor Costs -- Are the people required to run the business highly trained and rare to find (and thus expensive) or does the product or service simple enough to allow lesser trained, more readily available labor to make, deliver and support the product or service? Using highly trained labor to sell low price, low-margin products doesn't make sense. Attempting to use low-wage labor to sell expensive, "perishable" products doesn't make sense either.

Highly profitable large businesses tend to the following combinations of these factors:

* high financial capital, moderate intellectual capital, low service complexity, local delivery, low labor costs (utilties)
* low financial capital, high intellectual capital, high service complexity, central delivery, moderate labor costs (software)

Less profitable but viable smaller businesses tend to the following combinations of these factors:

* high financial capital, low intellectual capital, low service complexity, local delivery, low labor costs (grocers)
* low financial capital, moderate intellectual capital, high service complexity, local delivery, moderate labor costs (lawyers, accountants)
* low financial capital, low intellectual capital, low service complexity, local delivery, low labor costs (barbers, lawn care)

Now think of the combination of factors Circuit City was attempting to deploy in its business:

* high financial capital -- in the form of expensive, oversized stores and expensive inventory
* low intellectual capital -- clearly no one in the management of Circuit City was in MENSA
* high complexity products -- electronics and over-accessorized appliances with short product life cycles
* local delivery -- complex products required good in-store support for sales and service
* low labor costs -- 3400 high-performing salesmen were fired because anyone can sell a $1200 television or $2000 washer/dryer set

For a firm with vast capital expenditures and expensive, complicated, rapidly outmoding product lines, the attempt to operate the business with sub-par management and under-qualified labor was virtually guaranteed to fail. Yet, as stated earlier, the firm continued to build more monster stores almost until the day it collapsed.


At the most macroeconomic layer, Circuit City survived as long as it did because

1) artificially low interest rates made big ticket items artificially more affordable on credit
2) artificially low property taxes subsidized construction costs of many big-box stores and distorted the long term profitability of the big-box model

The real lesson from Circuit City's collapse is that artificially low interest rates and artificially low taxes do NOT produce sustainable economic growth. The combination of low interest rates and low taxes actually creates a perverse set of economic incentives for business to attempt to operate in the "no man's land" of business strategies which can only succeed in the best of times with all economic cylinders firing smoothly. Such firms barely have enough profitability inertia to survive in normal downturns. In the type of financial rip tide hitting us now, such businesses have zero chance of survival and their sudden, complete collapses magnify the impact of the downturn that capsizes them.

Taxes and interest rates act as a brake on economic activity, as millions of "pro-business" advocates will tell you. However, when you consider that not all economic activity is truly viable over a full business cycle and some models are uniquely prone to bubbles followed by drastic collapses, the philosophical and strategic question becomes more challenging. This isn't to say federal, state and local government policies should try to pick winners by manipulating taxes and interest rates to provide a BARRIER for businesses not deemed worthy to enter the field. However, federal, state and local governments need to be VERY aware of the fact they are already intervening on the other side by manipulating taxes and interest rates which SUBSIDIZE huge businesses with well established strategic and operational flaws.

Circuit City is merely the latest poster child of the fruits of that manipulation. More examples are on the way.


#1) http://www.circuitcity.com/closed.html

#2) http://newsroom.circuitcity.com/secfiling.cfm?filingID=1193125-08-93063

#3) http://library.corporate-ir.net/library/83/831/83192/items/294174/051508Proxy.pdf ( Best Buy 2008 proxy)

#4) http://library.corporate-ir.net/library/83/831/83192/items/246554/bby_2007proxy.pdf (Best Buy 2007 proxy)

#5) http://investor.circuitcity.com/downloads.cfm (Circuit City reports)