Aug 12 2020
Corporate Decision-Making in the Fog of the COVID-19 War, Continued ...
In my inaugural newsletter I covered the first four of nine fundamentals necessary for prudent decision making. These oft-forgotten market fundamentals always matter, especially now during this period of extreme, unprecedented stress and uncertainty.
Today I’ll focus on the fifth fundamental. Due to its intricacies and interconnections, there are many pieces to the puzzle to consider. I believe this the most important installment to this four-part mini-series; that’s why I’m devoting this entire article on just one topic.
No rocket science here, but you should be attentive to the details. Hopefully, the summary will tie the many moving parts together.
Fundamental #5: Understand the Stresses of SMEs, Especially Small Retail-Based
Small- and medium-sized enterprises (SMEs) carry significant weight. In most economies they employ a substantial slice of the workforce, contribute an outsized portion of national product, and account for millions upon millions of businesses. According to official estimates, SMEs with under 250 employees account for 99% of the total number of enterprises in many countries, including the US, the UK, Australia, and Canada.
A high percentage of companies are micro-businesses—those with less than 10 employees—many being family owned and operated. Although small retail-based “mom and pop” shops are notoriously sensitive to market risks, a myriad of other small businesses find themselves teetering on extinction. Hence, there’s no denying the importance of SMEs, both economically and politically, with the COVID-19 pandemic rattling the cage of SMEs, their creditors, and suppliers.
What are the underlying characteristics of SMEs? Here are a few you should keep in mind as you analyze your exposure to SMEs:
The precise definition of an SME depends on the country where the business operates. Nonetheless, SMEs operate in virtually every industry group, though there is typically a preponderance of small players in the service sector. This includes lawyers, insurance agents, accountants, health care providers, local trucking companies, personal care businesses, restaurants, and bars. Specialty retail outlets that resell commodities are also in this grouping and, along with restaurants, are quite fragile.
Failure rates are historically high, primarily for newly formed enterprises.
In the UK, 80% of small businesses (under 250 employees) fail within the first year of operation while only about 40% survive after three years.
In Australia, one-third of small businesses (with under 100 workers) go under in their inaugural year and less than one-quarter make it beyond five years. Retail failure rate is one-and-a-half times the all-sectors average.
Similar patterns are evident in America, Canada and other market-based economies.
Many SMEs, particularly brick and mortar retailers, are, by nature, highly competitive, have low barriers to entry and live on low margins. As price-takers, they don’t have control over the pricing of what they sell or the cost of their operations. Plus, many carry significant inventories requiring short-term debt financing.
For IBISWorld clients, you may want to check out our Industry Wizard to uncover which industry segments have low concentrations, i.e., are populated by many small operators.
As an illustration on how SMEs fared during the Great Recession and through the first few recovery years for the US and the UK respectively, see Figures 1a and 1b. One might expect that the current pandemic-induced malaise might be even more acute for small-sized brick and mortar retailers like florists.
Figure 1a: American Florists Hammered During the Last Financial Crisis (source: IBISWorld)
Figure 1b: Florists in the UK Debilitated in the Last Downturn Struggling to Recover (source: IBISWorld)
Figure 2 depicts similar data for convenience stores in Australia and Canada, clearly showing the vulnerability of small-time operators. Unfortunately, many establishments in this space simply will not survive, with younger vintages being particularly susceptible to the current economic strain.
Figure 2: Convenience Stores Succumb to Recessionary Pressures (source: IBISWorld)
The Retail Apocalypse
A core stress factor for many SMEs is the so-called “retail apocalypse” where the shift to e-commerce retail across the globe is gaining momentum. The retail revolution isn’t a transitory cyclical bubble, it’s a pervasive structural wave. As you can see from Figure 3, the COVID-19 crisis has accelerated an unstoppable process that was already engrained prior to the onslaught of the pandemic.
Figure 3: E-Commerce Gains Amid Pandemic (source: US Census Bureau, UK Office of National Statistics)
British shops have been battered as a hastened shift to e-commerce and the fallout from Brexit have taken its toll in the form of a cataclysmic number of store closures and massive job cuts. The same is true in America, even to a greater degree as online grocery sales hit a record $7.2 billion in June according to research provided by Brick Meets Click and Mercatus.
In Australia, National Australia Bank’s Online Retail Sales Index showed that in the 12 months to June, Australians spent almost 25% more on online retail than during the previous 12 months, or around 10.7% of the total retail trade. And according to Statistics Canada, e-commerce sales in the nation literally exploded in May, almost double the figure recorded in February.
The rub here is that brick and mortar establishments without significant online sales capabilities, that are comparatively inexperienced (less than 3 years old) will find it difficult to cover costs of operation and find it difficult to navigate through the crisis. Remain attentive should you provide credit, supplies, services, or commodities to be resold by such firms, as defaults and failures will abound.
Changes in Anchor Stores
Another key factor is that many SMEs cluster around so-called anchor stores—venues related to sporting events or other large gathering places like concert halls. Many of these anchors have been downsizing, filing for bankruptcy, or moving to better locations, a trend underway in many countries even before COVID-19. Serious reductions in foot traffic dilute the power of these commercial magnets leaving smaller, neighboring enterprises in its wake.
In the US, the “retail apocalypse” or “Amazon effect” marches on. Once the jewel of retail, Sears announced that this year it will have only a combined 182 American retail stores, down from 425 a year earlier and almost 2,000 five years ago. This latest reduction occurred after filing a Chapter 11 restructuring plan intended to salvage the company. One clear casualty of the retail retrogression is America’s shopping malls, and the innumerable SMEs that were tenants.
In Australia, the decline of brick and mortar retail has been exacerbated by the pandemic which has major shopping centers struggling for survival. As in America, small retailers have been pushed to the edge, and beyond. And in Canada, shopping malls were already moribund before the coronavirus. According to a recent Deloitte study, traffic fell by 22% in Canada’s top 10 malls between 2018 and 2019, and by February 2020 it was down 42% year-on-year.
Commercial Real Estate & The Demise of Shopping Malls
There is the related issue of commercial real estate. Reconfiguring existing shopping malls isn’t easy. In some localities many are either in disrepair or being demolished. The question here: is your business exposed to the owners and lessors of retail-dependent properties? Risks vary country-by-country and city-by-city so make sure you do your homework.
In an ironic twist, a recent article in the Wall Street Journal reported that America’s largest Mall owner, the Simon Property Group, is discussing the possibility of converting anchor department store space into distribution hubs for Amazon. Apparently, Simon is offering to reconfigure footage formerly occupied by bankrupt J.C. Penny (63 locations) and Sears (11 stores). The “Amazon Effect” is a key reason behind the demise of anchors like Penny’s and Sears! It is unclear where negotiations will lead; regardless, these are indeed strange bedfellows! Even if Amazon does locate warehouses in these locations, that will do little to foment sufficient foot traffic to support SMEs.
Government Support Programs
One more issue that’s on my mind. I wonder about the potential unintended consequences of the many government support schemes: The US Paycheck Protection and Main Street Lending Programs; the Canadian Emergency Commercial Rent Assistance plan for small businesses; the UK Coronavirus Job Retention Scheme; and Australia’s JobKeeper Payment policy, to name a few.
This suggests two classic caveats.
The first is “adverse selection.” Adverse selection refers to asymmetric information (information failure) that arises when one party to a transaction has better knowledge than the other. Let me explain paradigmatically. In this context, an SME recipient of government support may know they were on a trajectory toward failure prior to the pandemic, and that accepting government support will simply prolong their existence. The other party, say a creditor for the sake of argument, might find solace (perhaps false comfort) in the guise of the government support initiative.
The second is “moral hazard.” This is defined as the absence of motivation to guard against risk when one is shielded from its consequences. In my example, this cuts both ways, potentially distorting the risk appetite of both parties, since the ramifications of government support policies, however necessary, are nebulous at best. In many cases it is unclear who will foot the bill in the case of defaults or even fraudulent applications for government assistance.
The downside risk is that the unintended, and perhaps underestimated, consequence will be a second wave of SME failures even after the COVID-19 crisis ends, since government support is providing a temporary lifeline to businesses that are doomed to die.
SMEs live at the epicenter of a complex world, surrounded by swirling forces that have become increasingly tempestuous as the coronavirus rages on with renewed furor in many parts of the world. Chart 1 provides a schematic that I’ll walk through to summarize my thoughts.
Chart 1: Determining the Risks of Your SME Clients and Partners is No Easy Task
Obviously, COVID-19 has had far-reaching impacts. Some of these have accelerated trends already in motion prior to the pandemic, whereas others have amplified long-standing forces. Certain effects will evaporate quickly once the crisis finally bids farewell, while others will stubbornly linger.
Let’s take a stroll around Chart 1, starting at 9:00 hours, and trek clockwise.
The four market fundamentals I covered a few weeks ago are still in play. Review part 1 of this series if you need a refresher on these.
The wave of unprecedented, hastily administered government assistance triggered by the pandemic may involve unintended consequences associated with adverse selection and moral hazard. Be mindful of the possible risks of doing business with SMEs that were poorly positioned prior to the current crisis.
The “Amazon Effect” has become even more formidable owing to COVID-19 directly impacting brick and mortar SMEs. The story doesn’t end there as the relentless surge in e-commerce has wreaked havoc on anchor stores that generate the lifeblood foot-traffic of neighboring small businesses. Owners and lessors of shopping malls and centers have been unable to avoid the fallout as tenant revenue melts away once anchor establishments vanish.
Other magnet venues that support large gatherings like major sports facilities and concert halls support neighboring SMEs. In contrast to my anchor store argument, these facilities are likely to recover more quickly enabling a return to some semblance of normalcy for nearby SMEs.
At the 6:00 hour of Chart 1 is the bottom line. The financial health of SMEs will determine the performance of their suppliers of goods/commodities (paper, fuel), providers of sourced-out services (tax preparation and accountants), creditors (banks, FINTECHs), and manufacturers and distributors of resalable commodities.
In the next installment, available in two weeks, I will entertain three additional fundamentals:
- Coping with emerging technologies and industry life cycles
- Recognizing the nuances of substitutable products and services
- Understanding the opportunities and risks of supply chains
Hope to “see” you then.
Rick Buczynski, Ph.D.
IBISWorld Chief Economist
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Liked this article? Read Part 3 of this series