Trade War Brings Fear, Uncertainty, Doubt - And Potential Insolvency To Retailers
Uncertainty is the enemy of retailers and consumers alike. And we are living in a world of complete economic uncertainty as the US president’s trade war with China waxes and wanes. The risks are real. And there are unintended consequences that have scarcely been discussed. These consequences include the implications of retailers stocking up on inventory in advance of threatened and actual tariffs. My goal is to discuss those unintended consequences here.
This article originally appeared in Forbes. Since that time, we have seen some new tariffs take effect, and we remain in a state of uncertainty. We do know that Target has told its suppliers to absorb tariff costs. Most other retailers have said they will pass costs along to consumers and are calling it a new tax on its shoppers. Even though the US has been distracted by the grindingly slow march of Hurricane Dorian up the eastern seaboard (including this Miami-based analyst), the trade war goes on unaffected.
First a review: As of this writing, tariffs on goods imported from China are a mix of reality and threats for the future. Most recently, the US president has threatened to raise existing tariffs on $250 billion in imports from 25% to 30% on October 1, with an additional $300 billion raised from 10% to 15%. There’s an additional $300 billion in consumer products like toys, phones and clothing that will kick in on December 15.
Prices have already risen, and even without the new threats, according to the Federal Reserve, existing tariffs are already costing the average American household $800 a year. For many citizens, that’s a back breaker. We know that American farmers are being hurt by China’s response (it is a war, after all). We have to wonder how this will affect consumers’ holiday spending. The $800 number is basically the average consumer holiday spend in 2018 ($846), according to an Experian survey conducted in November 2018.
That’s enough to make any retailer nervous. Whether or not they pass price increases along to consumers, most retailers are headed for some real pain. Maybe most of it will come after they’ve brought in their holiday products (let’s be realistic…holiday merchandise is already on the water or arriving in the states. In fact, they may bring in spring product early as well to beat the December 15 deadline).
Footwear News pointed out that in this kind of environment, off-price retailers tend to be hurt less – they buy close-out product, which has been harder to come by over the past few years as retailers hone their forecasting engines with technology. But there isn’t a forecasting engine in the world that can manage this kind of chaos. And so brand managers and retailers are bringing in more merchandise earlier, hedging their bets to insure they can maintain their profitability and revenue in the face of price increases.
This may be a boon for companies like TJX, Burlington and Ross Stores; most of their products are bought domestically, after the tariffs have been paid by others, but they will not be immune to some level of gross margin pressure, along with their own uncertainty around how much to buy.
So what are the unintended consequences? An excellent piece of research produced by Hilco Global, a retail liquidator and investor gives us some real insight.
Consequence #1: Disruption at the ports. The report points out that import volumes have become “lumpy” and different from historical levels at both the ports of Los Angeles and Long Beach. This lumpiness results in delays and downtime, neither of which helps the ports predict their own staffing levels. And it can slow down the whole process during unexpected peak times.
Consequence #2: Increased retailer carrying costs. As retailers bring in product to avoid tariffs, they have to store it somewhere, typically outside their existing facilities. For example, if retailers are going to bring in their spring products before December 15, you can be pretty well assured they will have no room in their distribution centers to keep it. This requires short-term leases of additional storage space. Those costs will eat into gross margin/profitability and also raise the risk of inventory aging before it gets sold.
Consequence #3 (this is the big one!): Disruption and risk for retailers who rely on asset-based loans. I have written elsewhere about the world of asset-based loans. You can call them revolving credit lines if you like (which they tend to be called for the largest retailers), they are functionally the same, and they are the driver behind the industry in ways that most people don’t realize. They are the dirty little secret of retail. This is probably the single biggest risk to retailer health in the age of “maybe” tariffs and are worthy of some discussion.
On the surface, it’s a simple enough concept. Any company that has seasonal receipt and sales cycles also has lumpy cash needs. And these credit lines are used to pay for product that must be bought and paid for before it’s sold. As a general rule, the main driver of these asset-based loans is inventory. Typically, a lender will lend approximately 65% (at cost) of a retailer’s inventory.
That’s the simple part. But life isn’t simple.
Asset-based lenders also include what are called “carve outs” in their inventory calculations. Those carve-outs include inventory that is expected to age, or otherwise not sell at full price. The lender may also include carve-outs for unusual expenses. To wit: the Hilco report cautions asset-based lenders to “…know if, where and at what costs their portfolio businesses are maintaining added inventory.” Why? So that they can adjust their lending accordingly, as this represents a potential risk to gross margin (which Hilco generally estimates at 2.7% for Kohl’s and 2.6% for JC Penney). That spells more carve-outs.
I have worked for retailers that were thrown into Chapter 11 when their inventory dropped too low for their ABL covenant. And Circuit City was famously thrown into instant Chapter 11 at the worst possible time – right before the holiday season – when its lender decided its sales would not reach expected levels, and increased its inventory carve-out. You won’t find this in many of the articles on “what happened” back in 2008, but it’s not really a secret. That’s all it takes. The mechanics of it are too complicated to go into here, but the retailer suddenly didn’t have the cash to pay for its merchandise. Just.Like.That. Chapter 11. And who’s going to buy a big ticket item from a retailer that might not be around? Almost no one and by the end of the season, the retailer headed for liquidation.
And that’s the nut of our problem here. Retailers are stocking up to mitigate out of stocks and price increases, but lenders may decide these buys are too risky and cut them out of the borrowing base. For companies like JC Penney that are operating on the edge, this could be enough to throw them into Chapter 11, especially if spending declines on the sell-side.
Of course, the president’s exhortations to “find other places to buy,” given the current environment kinda sorta makes sense. And groups like the American Apparel Producers Network can certainly support those activities. It brings brand managers and factories in the Western Hemisphere together, and assuming the retailer/brand manager can support a more flexible sourcing model, it’s the way to go. Companies like Nike, Fruit of the Loom, Jockey, Macy’s and others already participate in this group at some level. But most retailers simply can’t turn on a dime. Life doesn’t work that way.
This is the long way round saying that retailers could well be the collateral damage from a trade war that gains us nothing. I have always been an advocate of near-sourcing, but that presumes a process to get from where we are to where we want to go. That process is not a tweet, and it’s not a mandate. It’s a process. Retail is in trouble now. These trade wars are helping no one in the retail supply chain at all. Fear, uncertainty and doubt are bad for business. And tariffs are the last resort of someone who has no understanding of economics or the dynamics of industry. It’s sad, really. And completely unnecessary.