Thursday, September 03, 2009

Location, Location, Location

By Taesik Yoon - The other day I walked past the empty store front of what was a Circuit City location until the consumer electronics retailer went bankrupted this past spring. Taped on the inside of the windows were signs that read:

Best Buy Coming This Fall

The thing about this particular store front is that it’s across the street from Union Square Park—an extremely popular area in downtown Manhattan coveted by retailers due to the heavy foot traffic. This is evident in the sheer number of branded retail chains that line the Square, which include McDonald’s, Staples, DSW, Filene’s Basement, Forever 21, Diesel, Puma, Petco, Barnes & Noble, Babies “R” Us, Au Bon Pain, and Whole Foods.

The location’s significance is certainly not lost on Best Buy (BBY), which specifically highlighted the Union Square site in a recent press release announcing plans to open 22 new locations in the U.S.

This is a great move by Best Buy. Despite its desirable location, given the state of the commercial real estate market, it’s quite possible—even likely—that the lease terms were more favorable than they were for the former tenant. Residents are already used to seeing the location as a seller of consumer electronics, which should help the store assimilate quickly into the neighborhood. The location also bridges the gap between its two closest stores, which are nearly two miles away from each other—a fair distance in Manhattan terms. Yet at the same time, it’s probably not close enough to the other two to result in significant sales cannibalization. An added benefit is that the store is expected to open in enough time to take advantage of this year’s holiday shopping season.

In similar fashion, other retailers, such as specialty menswear seller Jos. A. Bank (JOSB) and discount chain Big Lots (BIG), have recently come out and said they plan on accelerating the pace of new store openings in order to take advantage of real estate deals in prime locations left vacant due to store closures by financially troubled retailers.

On the surface, accelerating store openings at time when consumer spending is weak and under duress seems counterintuitive. It goes against conventional wisdom, which would advocate profit preservation at existing stores versus adding new ones. And certainly this approach is not without risk. The most pressing would be the persistence or worsening of weak consumer spending trends, which could result in lower than expected returns from these new stores in the initial years of their existence.

However, a common trait found in all these retailers is their strong financial position. At the end of fiscal Q1, Best Buy has total debt of $2.14 billion, which represented just 13.2% of total assets and 28.0% of total capital. The associated interest expense in the quarter was $23 million or just 7.8% of total operating income, resulting in a healthy interest coverage ratio of 13. The financial positions of Jos. A. Bank and Big Lots are even more robust. Both companies are debt free and have seen their cash balances double over the past year. The strong finances not only allow these retailers to seek out these opportunities, they also provide a strong cushion should these new stores under-perform over the near term.

Over the longer term, the benefits of these real estate actions should prove their worth. Location may not be the only thing that leads to a retail store’s success, but it certainly is among the most important. Being able to obtain prime locations as discount prices should help these retailers get the most out of the eventual recovery in consumer spending and could result in strong sustainable growth that trend well above the industry average for years to come.

Given the rise in these stocks year-to-date—Best Buy is up 36% while both Jos. A. Bank and Big Lots are up about 70%—much of these expectations already seem priced in. But that might be more a reflection of the strong operating results these companies have turned in so far this year and not necessarily due to the long term growth potential the capturing of these prime locations offer. In my view, that makes them merit strong consideration even now, especially for anyone with a long-term investment horizon.