Moving Forward Through Change

Five key trends that will shape 2017

Date November 2016

As we look back on the past few years, with its economic starts and stops and political surprises, we are reminded of the adage that “change is a constant.”  It’s a credo we live by here at Gordon Brothers.  A number of shifts – including chilling effects of China’s slowed growth, right-sizing international operations, a redefinition of retail real estate, digital disruption, and the growth of a new breed of leaner brand-centric consumer models – will have a lasting impact, shaping our business landscape in 2017 and beyond.

Global impact of China’s slowing growth
After decades of economic expansion, China’s 2016 growth is forecast at 6.6 percent, down from 6.9 percent in 2015. This is the lowest it’s been in 25 years. As the single largest contributor to global growth in GDP, the repercussions extend throughout the global economy, affecting many industries, particularly commodities.

Chinese steel production has been flat/negative since early 2014.  As demand wanes, product from excess Chinese capacity is being dumped worldwide resulting in trade practice complaints.  Additionally, iron ore prices have collapsed 56 percent from $128/ton in January 2014 to $56/ton in July 2016.  In this environment, the Australian and Brazilian majors (BHP, Rio Tinto, Vale and Fortescue) have invested in leveraging their scale to reduce costs, achieve profitability, and win share in seaborne trade.  With Brazil and Australia lifting their share of iron ore exports 6.7 percent in 2015 to account for 84 percent of world demand, the majors are successfully reshaping the market. Other iron ore players now find themselves sub-scale and losing market share.  As a result, we are seeing reduced production and increased restructurings in Canada, South Africa, and other markets, impacting asset values.  

Mining companies are also looking to shed underperforming assets. Case in point: Diversified miner Anglo American plans to exit iron ore and coal, focusing its business on copper, diamonds, and platinum.  These changes represent plans to sell or shut down about 65 percent of current activities.

At the other end of the value chain, reductions in Chinese demand have affected the German machine tool market.  Chinese demand accounts for about a quarter of German production. In 2015 orders were down 8 percent over the prior year and the trend has continued into 2016 as Chinese investment in manufacturing slows.  As a result, overall revenue for machine tool manufacturers has plateaued and is expected to stay that way through 2018.  We are seeing this impact first hand as our German operations has been busy providing liquidity to those firms impacted.   

With a shrinking working age population and continued upward pressure on wages, China is on track for continued weak growth.  Rising Chinese wages are driving on-shoring back to developed economies and prompting the movement of low skill, labor intensive processes to other countries in Africa and Southeast Asia.

Challenges in a relatively healthy North America
Despite generally positive economic growth in North America, we are seeing pockets of distress.  The number of larger commercial bankruptcies, with debtor liabilities greater than $10M at filing, is rising.  From 2010 to 2014, the number of large commercial bankruptcies was fairly steady at 15-25 per quarter. Through 2015 and into 2016, activity increased, reaching 96 filings in Q2 of 2016 alone. This has been driven by the ongoing changes in the energy, healthcare, and discretionary retail sectors.

The drop in oil prices from over $100 per barrel in 2014 to the sub $50 range is the primary driver of distress in the energy sector.  Oil and gas exploration and production, as well as related support services, have been hit hardest as rig counts have dropped sharply.  Energy has increased from just 1 percent of large commercial bankruptcies filings in 2010-14 to 17 percent of filings in 2015 and 2016 to date.  While values of energy-related assets certainly haven’t recovered, there has been some stabilization at these lower value levels. Companies that have survived the past two years have endured the biggest stress test the industry has faced in recent memory.  In some cases, these survivors will be stronger in the long run, as the capacity rationalization caused by the liquidation of weaker entities creates opportunity for those that remain.   Recently, there have been a few situations where private equity or distressed debt funds have stepped in to make an acquisition, which is clearly an early bet on the market improving.  This area continues to be one of our most active sectors at Gordon Brothers in both appraisals and disposition of energy-related assets.

Healthcare bankruptcies have steadily risen and are now at three times the levels seen between 2010 and 2013.  A combination of financial challenges stemming from reimbursement cuts and declining patient volumes is driving change in this sector. Payor and patient pressure for alternatives to in-patient treatment as well as new, minimally-invasive surgical solutions are driving growth in outpatient solutions and putting pressure on traditional hospitals.  Here at Gordon Brothers, we’re seeing a number of disposition opportunities in asset-intensive healthcare business such as hospitals and senior living centers.

Internationalization of retail 
For decades, leading retailers focused on internationalizing their business to chase growth and diversification.  Two thirds of the world’s top retailers have foreign operations. On average, firms of this kind are active in ten separate countries.  However, internationalization has not been smooth sailing for many of these retailers, with decisions to exit countries increasingly common.

Retail is still a largely local endeavor.  International brands comprise just 4 percent of U.S. and Japanese retail revenues.  Even in integrated European markets, domestic brands hold sway, comprising 80-85 percent of retail spending in France, Germany and the U.K.  A limited understanding of the consumer and a tendency to apply domestic values to foreign markets are the most common causes of international distress for retailers.  Home Depot’s expansion into China is illustrative.  Seeing a massive and rapidly growing market, Home Depot entered China in 2006 by acquiring a Chinese home improvement retailer and gaining an immediate network of 12 stores.  Six years later, the stores were shuttered and Home Depot exited the market.  The company cited its own misreading of the country’s approach to DIY as the primary driver of its exit, failing to recognize the “do-it-for-me” culture.  Despite its disappointing expansion into China, Home Depot has seen strong growth out of Mexico and Canada, with nearly 300 stores and 10 percent of revenues derived from these adjacent markets. Many retailers understand they cannot be successful everywhere and are focusing on markets where their business model best resonates. Tesco, Target and other strong brands have learned the same hard lesson, entering new markets only to undertake a full or partial country exit thereafter.  Here at Gordon Brothers, we see these country entries and exits first hand, working with many of the largest international retailers to facilitate this activity around the world.  While the local economics drive the decision, each jurisdiction presents its own unique challenges.  This dynamic provides an allegory of domestic U.S. retail, where operators are right sizing and optimizing to make their assets—stores and digital properties—work harder for them as well.

Reimagining the mall
With peak seasonal foot traffic down as low as 50 percent in recent years, North America’s 1,200 malls are facing some of the most profound change since the format was created in the 1950s. The factors are well known: digital disruption of traditional shopping patterns, the shift to experiences over material purchases, challenges facing anchor tenants, and ongoing restructuring within the apparel sector towards smaller footprints. 

The recent Aéropostale bankruptcy deal involving retail landlords reflects the fundamental oversupply of retail space.  The U.S. has almost twice as much retail space per capita than other countries.  As a result, analysts generally agree that continued mall closures are inevitable.  Hundreds of malls have already closed and hundreds more are expected to close over the coming decade. 

The situation is not dire, though.  Investors and entrepreneurs are looking at mall space with fresh eyes and seeing attractive opportunities to repurpose these properties.  Initial changes are often to sub-divide former anchor tenant space and to bring in new sub-anchor tenants.  Some developers are thinking bigger: Jose Legaspi redesigned a struggling Atlanta area mall to replicate the function of a Mexican village to meet the needs of the local Hispanic community. The property features many non-retail outlets, including medical offices, and money wiring services.  Other developers are building on these ideas and adapting former mall space to healthcare, education, church, community center, library, and residential applications.  These developments harken back to enclosed mall pioneer Victor Gruen’s vision: developments that included retail space, residential housing, schools, and health care facilities.

These new uses are the silver lining of the challenge that primarily faced “B” and “C” class properties. Over the last five years, the segment of flagship malls, “Class A,” has thrived, driven by premier tenants, affluent communities and a generally strong luxury products category. Recently though, “A” properties and their “High Street” counterparts have begun to soften, with an increase in vacancies in an otherwise healthy retail environment.

Reinventing retail and consumer business models
Many of these economic headwinds are prompting consumer-facing companies to experiment with their business models, and many are finding success as slimmed down versions of their former selves.

“Opti-Channel Retail” is emerging as a natural evolution of omni-channel techniques, putting more emphasis on maximizing return on investment in the omni-channel platform. In an Opti-Channel world, brick and mortar, social media, in-store mobile, beacons, and retail apps are measured against their impact on sales, margin, and cost of implementation.  With fifty percent of millennials saying social media influences their purchase decisions and 88 percent of Pinterest users purchased a product they pinned, there will need to be some level of investment to capture this shift in consumer interaction.  Similarly, 79 percent of smartphone owners have used their phones to shop and 84 percent of these shoppers use their devices in-store to shop.  Click-throughs of beacon campaigns are approximately 60 percent, roughly 10 to 30 percent higher than typical email campaigns.  Conversion is three times more likely to occur in apps than in mobile/web. Savvy retailers are incorporating these strategies into their sales and marketing to earn a higher pay-off on their investments. As retailers face the inevitable shift from bricks and mortar to digital commerce, proactive migration of customers from closing stores to nearby ones or online will be essential for the long-term health of the chain.  Here at Gordon Brothers, we’ve implemented innovative customer transition programs and have seen successful retention of customer and improved bottom line as the retailer’s least productive locations are closed. 

We are also seeing brands do away with retail completely to transition into leaner, more brand-centric companies, an innovative new structure that keeps a brand’s name—and equity—but loses the baggage.  This approach is a particularly good fit for companies looking to emerge from a financial crisis. Research has shown that even very highly publicized bankruptcies, like those of automakers GM and Chrysler, have little to no impact on brand perception among consumers. Strong attachment to well-established brands remains for consumers, often despite the company’s financial distress.

These leaner, revamped players take many forms. Some relaunch via strictly digital platforms, others find new life as exclusive in-house brands of established retailers. Others, like Polaroid, benefit from reinventing their products themselves. 

In closing
Here at Gordon Brothers we have a unique perch in the midst of all this change and volatility with clients along the spectrum of healthy to distressed, across the globe, and in all sectors.  Despite all these differences, one constant remains: those that embrace change get out ahead of the uncertainly by using “Opti,” rather than “Omni,” strategies to succeed. 

While we expect continued economic uncertainty around the world, many companies appear to be embracing the change that comes with it, taking bold action to redefine business growth. As we move into a new year, we see great opportunity for companies to pivot and reposition for long-term success, on their own terms.