Why is Retail Forecasting Failing?
A record number of retailers have filed bankruptcy in the last three years. Changes in shopping patterns and a weak economic backdrop partially explain deteriorating sales trends and pressured profit margins. However poor real estate decisions and forecasting are equally to blame.
Retailers are addicted to growth. The idea of opening hundreds of profitable stores is exciting. So exciting in fact that many retailers keep opening stores well beyond the point of diminishing returns. Scalability is the number one factor investors consider when analyzing a retailer’s potential. It is not at all unusual to hear investors pushing for more growth and punishing companies for slowing growth.
So how do retailers measure and evaluate growth? Individual unit growth is typically modeled using a proforma template that projects performance over the life of a lease. However, the primary decision making metrics are 1) how quickly can the store performance pay back the original investment? and 2) what is the expected return on the initial investment? This is a great start, but falls short for a few key reasons.
The financial forecast is disconnected from the original proforma model. In many cases the last time retailers look at the proforma model is the day they decide to open the store. Then they set it aside and create a new forecast (often much different) for store performance. If this is the case, there is little accountability for the original decision making.
The cost of ongoing capital investment is often not included and can meaningfully change the returns. Most retailers remodel stores at least every five years. Customer demands for engaging shopping environments and newness are compressing this timeframe. Remodeling can be costly (as much as the original store buildout) and unlike the original buildout, landlords typically do not help pay for remodels. If a retailer is looking at a 2-year payback on an initial investment (net of landlords help) they may find the need to spend a greater amount to keep the store fresh and relevant. Those investments may take longer to recoup. If the refresh needs to happen sooner than five years because trends are deteriorating, it is not too difficult to imagine a scenario where getting a return on the investment is difficult.
Leases are long-term obligations. The typical retail lease is 10 years. Shorter term leases and deals with kick-out clauses are best when available. But if a retailer enters into a situation expecting steadily increasing sales, minimal need for ongoing capital investment and manageable expenses, and those assumptions prove wrong, they can often be on the hook for long-term lease obligations. Bankruptcy can be necessary to get out of bad lease decisions.
With a rapidly evolving marketplace, it is more important than ever to forecast and analyze store performance carefully and on an ongoing basis. Each store should be viewed as an individual business unit and investments, returns and performance of those stores should be measured both in absolute terms and relative to other stores and other investment options. Taking a ‘set it and forget it’ approach to store forecasting will likely result in earnings volatility and could result in financial distress.
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