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CRISIS IN PRICES

Retailers, landlords clobbered by deflation

BY MICHAEL BAKER AND JEAN LAMBERT

Click image to view chart (684k PDF).

The lack of pricing power in the hands of retailers (and of most U.S. companies, for that matter) has become the topic du jour among economists and industry analysts. Federal Reserve Board Chairman Alan Greenspan really put the subject front and center in May, delivering a homily at an Open Market Committee meeting to the effect that Fed policymakers are now more worried about a sustained fall in prices than about an increase. Closer to home, this magazine recently carried a front-page report on the broad impact of deflation on retailers and shopping centers (SCT, June 2003).

Though the offering of yet another primer on the dangers of a general price decline would be superfluous, it is well worth looking beyond the broad picture to the ways in which individual retail and consumer spending categories have been affected.

The results of this more in-depth study are interesting because, for all the industry’s focus on the travails of the apparel segment, it becomes clear that there are other categories that have been clobbered a good deal harder (see upper chart).

Consumer electronics
Electronics and appliance stores, for example, experienced a 16.7 percent retail price decline in 2002 alone. Prices of personal computers fell by 24.7 percent, video equipment (such as DVD players and VCRs) was down by 12.5 percent, and the prices of TVs were off by 10.5 percent.

Consumer electronics products fall into two basic categories, both of which are subject to declining prices, though for different reasons. First, there are the products that have been around for a while and have already achieved significant household penetration. These are the “commoditized” consumer electronics products that require little in-store customer service and are available across a wide range of retail channels. They are subject to fierce pricing competition and incessant promotion, which drive prices ever downward.

Second, there are the products at the cutting edge of innovation, which are apt to be relatively expensive at first and require high levels of customer service and support in the selling process. As consumer acceptance and product knowledge increase and manufacturing capacity ramps up to meet rising demand, however, prices on these products can fall precipitously. Prices for digital TV sets and displays, for example, declined by almost 10 percent in 2000, 17 percent in 2001 and 11 percent in 2002, according to the Consumer Electronics Association. Those price cuts drove down the average price from about $2,200 to roughly $1,635, bringing digital TVs within reach of the mass market. This is how digital TVs, which are at today’s cutting edge, will become tomorrow’s commodities.

The office supplies, stationery and gift store deflator also declined substantially in 2002 (-9.5 percent). Consumer electronics products, now a major component of office supply store sales, contributed significantly to that decline. Compounding this, most kinds of office supplies are widely available through mass channels such as discount stores, supermarkets, drug stores and the Internet, so the lack of pricing power across the category is neither surprising nor likely to abate.

Although there isn’t much shopping center merchandise currently escaping deflationary pressure, there is one stark exception: prescription drugs. The consumer price index for prescription drugs rose 3.7 percent in 2002 and has been a critical factor behind the profitability of drug store chains, where sales of so-called front-end items (cosmetics and over-the-counter drugs) have been disappointing in recent months. The price increases in prescription pharmaceuticals explain why the health and personal care store category is the only segment to record inflation in 2002 (3.4 percent).

Apparel
As for apparel, with the exception of a brief interval in 1998, these prices have been falling since 1994. There are several reasons for this, including cheaper imports, ruthless competition across retail formats as discounters move increasingly into the fashion apparel arena, and the frequent promotions that make consumers increasingly value-oriented and reluctant to pay full price for clothing. Moreover, brands that had been exclusive to certain retailers are now obtainable through multiple channels (witness the migration of brands from department stores to stand-alone mall boutiques and discount stores). As a result, consumers shop for those brands exclusively on the basis of price.

Apparel deflation could intensify, barring a strong pickup in demand. One of the key drivers of deflation has been the constant shifting of production from higher- to lower-cost countries, including China. U.S. import quotas against many apparel items manufactured in China will be lifted in 2005, which is likely to result in increased market share for China’s producers and, in the probable scenario that U.S. retailers are forced to pass on the savings to consumers, further downward pressure on retail prices. Morgan Stanley estimates that China’s share of U.S. apparel imports will surge from 8 percent in 2002 to 24 percent in 2008.

Deflation has been constantly evident across the broad GAFO (general merchandise, apparel, home furnishings and other merchandise) category of goods since the recession of the early 1990s, meaning that current-dollar retail sales growth for GAFO stores has rarely been higher than unit-volume sales growth during that time. The impact on mall sales productivity in the 1995-2002 period is shown (see lower chart), with current-dollar annual sales per square foot falling below zero in both 2001 and 2002, while the unit volume figures remained modestly positive. Put another way, the fall in dollar sales productivity disguises the fact that sales volume has been ticking along, if not merrily, at least respectably.

When will it end?
Many are wondering how long this can go on. The answer is, until demand strengthens. In the apparel segment, for example, prices for men’s clothing were particularly pressured in 2002 as men just about stopped shopping in response to the uncertain economic and political environment. As the men’s clothing business has shown signs of stirring in the first half of 2003, however, the deflationary pressure has eased. Prices for some products, such as shorts and woven shirts, have started to rise again. This could be a model for what will happen in other product categories as well.

For shoppers, then, deflation is a wonderful thing. You can buy for less, freeing up valuable dollars to reallocate to those categories whose prices are rising: housing (+3.7 percent in 2002), health care (+4.7 percent), college tuition (+6.2 percent) and our gas-guzzling automobiles, with retail pump prices still up more than 11 percent over a year ago.

But for the retailers and landlords struggling to protect and boost their bottom lines, these falling prices are not such a cheerful proposition.

Michael Baker is director of research and Jean Lambert is manager of research projects for ICSC.

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