In the famous Sir Arthur Conan Doyle story Silver Blaze, Sherlock Holmes discovers a vital clue: a watchdog that didn't bark while a racehorse was being stolen. This non-event -- the dog that didn't bark in the night -- proved to be crucial to unraveling the mystery.
Investors are overlooking a similar "non-event" in the midst of widespread sales declines across the department-store industry. Pundits have spent a lot of time talking about the so-called "retail apocalypse," especially in the past few months. Yet while many department-store chains have been closing stores -- and some smaller retailers have gone bankrupt -- not a single major department-store company has declared bankruptcy since the Great Recession.
This suggests that department stores are far less fragile than the bears would have you believe. On the flip side, the lack of bankruptcies is contributing to the depth of the current squeeze on earnings and profits across the sector.
The problem is obvious
The U.S. has way too much retail space -- and way too many retailers. There is almost 50% more retail space per capita in the U.S. than in Canada, and five to 10 times more than in most other developed countries.
This widely acknowledged fact is the biggest factor behind department stores' recent troubles. Many department-store chains, including Macy's (NYSE:M), Sears Holdings' (NASDAQOTH:SHLDQ) Sears stores, and J.C. Penney (NYSE:JCP) are closing numerous stores this year in an effort to slim down. In a few markets, these store closures may sufficiently rationalize the supply of retail space. But that's the exception, not the rule.
Yet department stores are resilient
Department stores have been surprisingly resilient in the face of this clear oversupply of real estate (and of retailers trying to fill that space). Several best-in-class department store chains, including Macy's and Kohl's, still consistently produce strong free cash flow.
J.C. Penney occupies a middle ground. It currently runs around breakeven on a full-year basis, but its profitability has been improving in recent years, despite the difficult retail environment. Canadian department-store conglomerate Hudson's Bay -- which owns U.S. luxury chains Lord & Taylor and Saks Fifth Avenue -- has also been operating around breakeven.
Lastly, there are a few department-store chains that have been struggling mightily. Sears tops the list, of course. Bon-Ton Stores (NASDAQ:BONT) and Neiman Marcus are also in serious trouble. All three chains have too much debt and have been reporting some of the worst sales results in the industry.
Despite these clear problems, Sears, Bon-Ton, and Neiman Marcus have all managed to hang on. Asset sales, merciless cost-cutting, and creative financing moves have helped them live to fight another day.
Bankruptcies are probably coming -- eventually
Neiman Marcus' problems stem almost entirely from the fact that its private-equity owners have burdened it with a mountain of debt. It has a strong brand in the luxury market and is reasonably healthy but for its crushing debt load. Thus, while bankruptcy is a strong possibility, the company should be able to emerge with its operations intact.
By contrast, it's not clear that there's anything worth saving at Sears and Bon-Ton. Last month, Sears told investors that comp sales were on pace to plunge 11.9% in Q1. It's been burning $1.5 billion to $2.0 billion of cash annually, and it looks as if 2017 will be no different.
A steady stream of asset sales, mainly real estate, has kept Sears afloat so far. But the company's stash of valuable assets is beginning to run dry. And now vendors are starting to panic. This situation makes a bankruptcy filing within the next few years almost inevitable. Given Sears' long-running history of losses, things would probably end in an outright liquidation.
Bon-Ton's chances don't look much better. The company has been losing money for years on end. However, it actually managed to generate a modest amount of free cash flow last year by cutting capex to the bone. Furthermore, it recently extended the maturity of its credit line, so it doesn't have to worry about any debt repayments until 2021.
That's the extent of the good news, though. Earlier this month, Bon-Ton's CEO resigned, effective late August. Meanwhile, comp sales plunged 8.8% last quarter, resulting in an ugly loss. Management is reacting by slashing costs even further, but this strategy doesn't seem sustainable.
Two things investors should remember
One of the most remarkable things about the ongoing "retail apocalypse" is that every major department-store chain has avoided bankruptcy so far. This situation won't last forever, but it suggests that those department stores that remain highly profitable (like Macy's) aren't in nearly as much trouble as investors seem to believe.
Of course, if department stores can do no better than stumble along, investors should steer clear of the sector. However, if weaker competitors such as Sears and Bon-Ton are on course to be driven out of business in the next few years, survivors such as J.C. Penney and Macy's will have an opportunity to pick up a significant chunk of extra business. This situation -- along with their existing profit-improvement plans -- could lead to stronger profitability a few years from now.
It's true that a few major department stores are teetering on the brink of bankruptcy. However, for the rest, the biggest challenge of the retail apocalypse is that it hasn't been apocalyptic enough to drive their competitors out of business.