Why do retail companies with otherwise solvent balance sheets go out of business?
The answer has to do with a peculiar dynamic of the retail industry that makes companies like Best Buy (NYSE:BBY) and Barnes & Noble (NYSE:BKS) as fragile at certain points in their existence as highly leveraged hedge funds.
Coming to terms with the inevitable
If you're a student of history, particularly as it relates to retailing, then you'd be excused for concluding that companies such as Best Buy and Barnes & Noble are living on borrowed time.
It's no secret that their business models aren't sustainable. In short, specialty retailers that sell commoditized products must compete on price to survive. And those that rely on bricks-and-mortar stores for the lion's share of business simply can't do so against competitors with dramatically lower fixed costs -- namely, Amazon.com (NASDAQ: AMZN).
For instance, the "aggressive promotional activity" over the holidays caused both Best Buy's revenue and gross margin to contract. A similar picture formed at Barnes & Noble when it released sales figures for the same time period, which declined on a year-over-year basis.
To make matters worse, Best Buy CEO Hubert Joly acknowledged on the company's earnings call, albeit in a circuitous manner, that the pressure is here to stay, saying that a "permanent component" of the highly promotional environment is likely, well, permanent.
However, while falling sales and contracting gross margins certainly fuel a retail company's failure, they're not the inciting cause.
The lesson of Circuit City
The now-defunct electronics retailer Circuit City serves as an appropriate example. Falling sales weren't the reason the Virginia-based company filed for bankruptcy protection in November 2008. Nor was it the reason the company was forced into liquidation at the beginning of 2009.
The precipitating factor in both cases concerned financing -- and, specifically, vendor-supplied financing.
Here's a quote from the company's management at the time (emphasis added): "While management is working diligently to secure the support of its vendors and believes it has maintained good relationships with these important partners, the current mix of terms and credit availability is becoming unmanageable for the company."
Indeed, while it isn't as widely known, most big-box retailers work on a consignment-type basis with suppliers. That is, they're not obligated to pay for merchandise until it either sells or some other predetermined deadline expires.
In the book industry, the customary practice consists of "Net 90" agreements, which require a company like Barnes & Noble to either pay publishers for the books it sells or return them within 90 days of receipt.
As the bookseller explained in a recent regulatory filing, "Consistent with industry practice, a substantial majority of the physical book purchases are returnable for full credit, a practice which substantially reduces the Company's risk of inventory obsolescence."
This arrangement gives bricks-and-mortar retailers a vital source of liquidity, which, if constricted or altogether cut off, could stop the flow of new products and thereby trigger the at-that-point inevitable demise.
Here's how Best Buy phrases it in the risk section of its annual report: "Our liquidity could be materially adversely affected if our vendors reduce payment terms and/or impose credit limits."
And here's the company explaining what could happen if its credit rating is further downgraded: "downgrades may impact our ability to obtain adequate financing, including via trade payables with our vendors." For the record, the term "trade payables" is the balance sheet line item tied to vendor-supplied financing -- though it's often subsumed within the more general "accounts payable" line item.
Will you be left holding the bag?
My point in all of this is directed to short-term speculators in the stock of either of these companies -- or, for that matter, any other company similarly situated, such as, say, GameStop (NYSE: GME).
Will they go out of business anytime soon? Probably not. My guess -- though it's only a guess -- is that they each have a handful of years left to try to turn things around.
When they do go, however, and this is an important point, it will likely take on the urgency of a bank run. The net result is that then-existing shareholders will be left unwittingly holding the bag.
Do you want to be one of these? My guess is, no.
John Maxfield has no position in any stocks mentioned. The Motley Fool recommends Amazon.com and owns shares of Amazon.com, Barnes & Noble, and GameStop. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.