The game’s up for Game Group – but who’s next?

Video game retailer Game Group has called in the administrators. Sadly, it looks as though the company is finished, as a potential takeover bid has apparently been blocked by lenders. On Wednesday morning, the shares were suspended as Game’s board announced that it was “unable to assess the business’s financial position, and is of the opinion that there is no equity value left in the group.

Just like Woolworths, Game was a victim of changing high street economics. And retail is a tough business all over right now.

But that’s not the only reason for its demise. Controlling costs is vital in the retail industry, particularly now that the internet is stealing market share from the high street as a whole.

Game failed to control its costs tightly enough. And we wouldn’t be surprised if other distressed retailers end up sharing its fate. Here’s how you can spot a retailer on the brink.

The dangers of bricks and mortar retailing

Retail in general is tough right now. The weak economy means that consumers have less money to spend.

On top of that, there’s a major structural change happening, as the internet continues to take business away from the high street.

Game Group looks like it was caught in a perfect storm. Not only was the video games market going through a tough patch, but lots of games were being bought online, played on social networks or downloaded in the form of apps to mobile phones and tablet computers.

Game’s major problem was that it had too many costs – particularly store costs – that its internet rivals did not. Game had aggressively grown its store network during the last decade, which made things worse.

The fact is, store costs (especially rents and staff) are the biggest threat facing many of the country’s struggling retailers.

Why? Because lots of retailers don’t own their stores. They rent them. Come rain or shine, the rent has to be paid. Many stores are also subject to rental reviews where the rent keeps going up (a clause known as ‘upwards-only rental reviews’). This is the last thing you need as a retailer when your sales are going down.

These leases can be hard to get out of (although, faced with the prospect of some rent or no rent, you’d think that most landlords might opt to drop their rents or end up with a bill for business rates and other costs).

But how could you have seen these risks with Game Group? And which other companies face these problem?

How to spot the next retail casualty

‘Fixed-charge cover’ is a powerful and under-used calculation that can help identify signs of financial distress.

It looks at how many times a company’s profits can pay its rental and interest costs. These costs are known as fixed charges – they have to be paid.

You can work out fixed-charge cover by using just three numbers from a company’s annual report. The calculations for a selection of retailers are shown in the table below.

Company: Game Clinton HMV Topps
Operating profit (A) 43.2 2.2 28.4 18.2
Lease expense (B) 87.6 85.3 163.5 20.9
Profit before leases (A+B=C) 130.8 87.5 191.9 39.1
Interest (D) 5.7 2 4.8 4.8
Fixed charges (B+D)=E 93.3 87.3 168.3 25.7
Fixed-charge cover (x)=C/E 1.40 1.00 1.14 1.52

Company: Mothercare Next Tesco
Operating profit (A) 32.9 598.7 3,334
Lease expense (B) 68.2 204.5 1,064
Profit before leases (A+B=C) 101.1 803.2 4,448
Interest (D) 0.6 28.9 465
Fixed charges (B+D)=E 68.8 233.4 1,529
Fixed-charge cover (x)=C/E 1.47 3.44 2.91

As you can see, stronger retailers such as Tesco and Next have enough profit to comfortably pay all their fixed charges. This is not the case for some of their weaker peers. Clinton Cards and HMV look perilously close to the brink and surely can’t withstand much more pain.

We’d also be wary of businesses such as Topps Tiles and Mothercare whose fixed-charge covers are approaching the danger zone given the weakness of their revenues.

To be fair, the stock market has already worked this out – that’s why the share prices of these weaker companies are so low. However, next time you see a retailer that you think is cheap, look to see if it rents or owns its stores, and calculate its fixed-charge cover before you take the plunge.

The wider risks

The scenario with store rents could be equally applied to offices and other properties. It means that commercial property companies could have a lot to worry about. Given that these companies tend to have quite a lot of debt, the banks that lent them the money should be worried too.