Beware the shrinking retailer

Businesses that voluntarily shrink can be a source of opportunity. That isn't the case for retailers. 

 Small is the stockmarket's latest big idea. BHP, Rio, Wesfarmers and the banks have all generated enormous value by shrinking, either selling divisions, spinning them off or limiting capital expenditures. 

Management teams have embraced the idea that smaller, most concentrated businesses can often be better than sprawling empires.

It's an idea that makes a lot of sense and has been remarkably successful. There is no better example than BHP which, after the end of the greatest commodities bull market in history, decided to shrink its business and thus was born South32 (which has been a terrific success in its own right).

Rio and Wesfarmers had similar ideas, each selling big, profitable parts of their companies to shore us cash and returns. Rio divested its entire coal business and other smaller mines; Wesfarmers, of course, spun off Coles.

Other companies have been more cautious about capital expenditures, being pickier with growth options. Until recently, Woodside was paying huge dividends rather than growing reserves and most miners have slashed capex.

You good thing

A business voluntarily electing to shrink is usually a good thing, signalling that management is interested in making a return on the capital at its disposal rather than building an empire. Yet shrinking should not be universally applauded.

Some businesses get better as they shrink. Take mining services, for example. When work dries up, labour and equipment used for new projects are relinquished and less capital is sucked in. A shrinking mining services business usually spews cash. This was a key factor behind our upgrade of several stocks in the sector in 2014.

In other industries, though, shrinking is expensive and hard - and retail is a prime example. Several retailers are currently closing stores or considering doing so: Myer will need to close many stores; Retail Food Group is trying to close over 200; and The Reject Shop will need to shrink its 400-odd store network to survive. 

A shrinking retailer is a completely different proposition and, almost always, it's a bad thing. 

Zombies

A retailer that wants to close stores will often have to buy out their leases. It can't just sell individual stores or walk away from unprofitable stores the way a miner can sell a single mine or a services company can sell equipment.

As mining services companies shrink, they release capital but, as retailers shrink, they suck in more capital at a time when it is scarce.

Sometimes a retailer can sell a large chunk of its stores in a single transaction - Specialty Fashion did this with great success - but that is a rare deal. In most cases, falling revenues and unprofitable stores still have to pay for high and inflexible fixed costs. 

Retailers trying to close stores and exit leases, especially in large numbers, become more capital intensive and are hence often zombie business, needing fresh capital or awaiting a slow death. It's one case where getting smaller doesn't always mean getting better.

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