The inevitable death of brick & mortar retail has been in the news for years. Even if you don't watch TV, take a drive through any suburb and the misery is unavoidable. You will see malls that used to have big box anchor tenants and empty parking lots. If you drive closer, you might mistake the big empty cement buildings for the headquarters of a dictator who rules in some future dystopia. Everyone knows Amazon is the company that is transcending business in every sector it's tentacles touch. When I come home to my apartment at night, I am surprised when I DON'T see a package from Amazon Prime waiting for one of my fellow tenants. They could have ordered that package 24 hours ago, what kind of crazy person would take time out of their day to go to a store and buy clothes?
Moody's recently released a report highlighting the pressures ex-Amazon retailers are facing, citing "intense competition, erratic management, and limited financial flexibility." Traditional brick & mortar retailers are consistently experiencing declining same store sales, and many have been forced to take drastic action. So far this year, Macy's has closed 100 stores and laid off 6,200 workers while JCPenny has closed 140 stores. The low interest rate environment and yield hungry investors have allowed "zombie" companies to stay in business since it is so cheap to roll over debt. "Zombie" companies with their lingering inventory, make it tougher for the whole sector to profit. The equity is a bloodbath. Household names like Sears, JCrew, Rue21, Neiman Marcus debt securities have fallen to distressed levels. Everyone can understand these developments on an intuitive level, so a couple weeks ago ProShares announced the creation of "The ProShares UltraShort Brick and Mortar Retail Fund" which will look to use derivatives to generate daily returns of 2X or 3X the inverse of the index comprising the most at-risk US retailers, per Bloomberg. If you're worried about how that sort of scheme will work you are not alone. Leveraged short ETFs arriving to the marketplace are often the buy signal for the very assets financiers have created these complicated instruments to bet against.
Time for the "vultures" to come out. Most of the time, securities become distressed because they can't refinance once a maturity comes due. I mentioned plenty of retail credits have fallen to distressed levels, and at this point, many may be a bargain for distressed debt investors. Brick & mortar retail firms aren't profitless internet start-ups or a hot biotech company that may or may not have a cure for cancer in 10 years after 37,652 FDA approvals. They have real merchandise with real, actual, tangible value - even if that value is a lot less than it used to be. We aren't talking about Radio Shack selling walkie talkies and portable DVD players, consumers will always want fashionable clothes right? Some have real estate that once divorced from the business has value as well (even if the structures look like something out of Orwell's 1984 right now). In 2016, eCommerce accounted for just 8.1% of total retail sales - is Amazon really going to capture 100% market share? That seems unlikely. Retail debt is offering you the truest form of value in a market environment where there is none to be had. Distressed debt tends to be uncorrelated with the overall market. Most investors don't have the skill set, time horizon, or flexibility of mandate to evaluate the collateral value or recovery rate of distressed debt. They can't wait around for the debt restructuring or Chapter 11 to be resolved. They need to sell due to this factor, often for an additional discount. Savvy distressed debt investors will be able to calculate the asset/collateral values, withstand the j -factor risk, then lock in a margin of safety in regards to intrinsic versus market value. Investors can also play the capital structure game. Term loans often have liens against assets like intellectual property and working capital. If a term loan has greater collateral protection than secured debt - long/short trades can make sense (they can also mitigate carry costs). In any case, the collateral behind the high yielding/distressed securities is how investors are protected in these deep value scenarios. Retail debt appears to be approaching levels where buying makes sense.
I also believe there is upside besides looking at a dead carcass and seeing how much the organs are worth. These companies have real assets and household name recognition. If they are cheap, private equity investors could step in as a buyer as well. It is not much more difficult to imagine than private equity leveraged buyouts in the past with struggling energy or food and beverage companies. Those were certainly profitable ventures. Top tier operators like 3G Capital known for creating efficiencies, could squeeze value out of operations or identify niche markets where these brick and mortal firms can succeed. I could be wrong, but Amazon can't dominate absolutely everything can it? Brick & mortar firms could also reinvent themselves to lure consumers back into the stores. No one likes to waste an hour of their day driving to and from the mall to pick up a shirt or some socks, but they will gladly spend precious time on an "experience." After all, movie theaters seem to have outlived their usefulness but SuperLux/Luxury theaters that come with fine dining, wait staff, and chic decor still seem to attract consumers on Friday nights. I have even heard of a former video rental store (remember those?) that added a bar for young people to come hang out at and experience "nostalgia." If retailers can discover ways to lure consumers back (apart from 70% off, everything must go discount events) it may provide an avenue for recovery. Finally, eCommerce firms could easily be in a bubble. Isn't the notion that fundamentals and profitability don't matter usually a warning sign? "This time is different" rarely ever is. Admittedly, this is speculation on future developments that may not happen - but it is upside nonetheless. I am sure Amazon and eCommerce will continue to gain market share and flourish, but the negative news and impending doom is already priced in. Investors are likely already protected by the collateral behind these struggling retailer's debt securities; the upside is just the cherry on top.
Moody's recently released a report highlighting the pressures ex-Amazon retailers are facing, citing "intense competition, erratic management, and limited financial flexibility." Traditional brick & mortar retailers are consistently experiencing declining same store sales, and many have been forced to take drastic action. So far this year, Macy's has closed 100 stores and laid off 6,200 workers while JCPenny has closed 140 stores. The low interest rate environment and yield hungry investors have allowed "zombie" companies to stay in business since it is so cheap to roll over debt. "Zombie" companies with their lingering inventory, make it tougher for the whole sector to profit. The equity is a bloodbath. Household names like Sears, JCrew, Rue21, Neiman Marcus debt securities have fallen to distressed levels. Everyone can understand these developments on an intuitive level, so a couple weeks ago ProShares announced the creation of "The ProShares UltraShort Brick and Mortar Retail Fund" which will look to use derivatives to generate daily returns of 2X or 3X the inverse of the index comprising the most at-risk US retailers, per Bloomberg. If you're worried about how that sort of scheme will work you are not alone. Leveraged short ETFs arriving to the marketplace are often the buy signal for the very assets financiers have created these complicated instruments to bet against.
Time for the "vultures" to come out. Most of the time, securities become distressed because they can't refinance once a maturity comes due. I mentioned plenty of retail credits have fallen to distressed levels, and at this point, many may be a bargain for distressed debt investors. Brick & mortar retail firms aren't profitless internet start-ups or a hot biotech company that may or may not have a cure for cancer in 10 years after 37,652 FDA approvals. They have real merchandise with real, actual, tangible value - even if that value is a lot less than it used to be. We aren't talking about Radio Shack selling walkie talkies and portable DVD players, consumers will always want fashionable clothes right? Some have real estate that once divorced from the business has value as well (even if the structures look like something out of Orwell's 1984 right now). In 2016, eCommerce accounted for just 8.1% of total retail sales - is Amazon really going to capture 100% market share? That seems unlikely. Retail debt is offering you the truest form of value in a market environment where there is none to be had. Distressed debt tends to be uncorrelated with the overall market. Most investors don't have the skill set, time horizon, or flexibility of mandate to evaluate the collateral value or recovery rate of distressed debt. They can't wait around for the debt restructuring or Chapter 11 to be resolved. They need to sell due to this factor, often for an additional discount. Savvy distressed debt investors will be able to calculate the asset/collateral values, withstand the j -factor risk, then lock in a margin of safety in regards to intrinsic versus market value. Investors can also play the capital structure game. Term loans often have liens against assets like intellectual property and working capital. If a term loan has greater collateral protection than secured debt - long/short trades can make sense (they can also mitigate carry costs). In any case, the collateral behind the high yielding/distressed securities is how investors are protected in these deep value scenarios. Retail debt appears to be approaching levels where buying makes sense.
I also believe there is upside besides looking at a dead carcass and seeing how much the organs are worth. These companies have real assets and household name recognition. If they are cheap, private equity investors could step in as a buyer as well. It is not much more difficult to imagine than private equity leveraged buyouts in the past with struggling energy or food and beverage companies. Those were certainly profitable ventures. Top tier operators like 3G Capital known for creating efficiencies, could squeeze value out of operations or identify niche markets where these brick and mortal firms can succeed. I could be wrong, but Amazon can't dominate absolutely everything can it? Brick & mortar firms could also reinvent themselves to lure consumers back into the stores. No one likes to waste an hour of their day driving to and from the mall to pick up a shirt or some socks, but they will gladly spend precious time on an "experience." After all, movie theaters seem to have outlived their usefulness but SuperLux/Luxury theaters that come with fine dining, wait staff, and chic decor still seem to attract consumers on Friday nights. I have even heard of a former video rental store (remember those?) that added a bar for young people to come hang out at and experience "nostalgia." If retailers can discover ways to lure consumers back (apart from 70% off, everything must go discount events) it may provide an avenue for recovery. Finally, eCommerce firms could easily be in a bubble. Isn't the notion that fundamentals and profitability don't matter usually a warning sign? "This time is different" rarely ever is. Admittedly, this is speculation on future developments that may not happen - but it is upside nonetheless. I am sure Amazon and eCommerce will continue to gain market share and flourish, but the negative news and impending doom is already priced in. Investors are likely already protected by the collateral behind these struggling retailer's debt securities; the upside is just the cherry on top.
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