Retail Carnage (Part 3) – Sorry Wall Street, Balance Sheets Do Matter

Can you name a retailer than has gone out of business without having any debt on their balance sheet? The common characteristic of the recent retailing bankruptcy announcements is highly leveraged balance sheets. In more cases than not, private equity firms took over the companies, loaded them up with debt, and the interest payments became too much to handle as sales and profits declined due to excessive competition and the “race to the bottom” in terms of discounting full price merchandise. Recent examples include Sports Authority (2006 private equity deal), Limited Stores (2010 private equity deal), Payless Shoes (2012 private equity deal), and J Crew (2011 private equity deal), which has been fighting to avoid bankruptcy recently.

It may seem overly simplistic to simply equate lots of debt with bankruptcy and vice versa, but in today’s investment world where folks opt to trade exchange traded funds and computerized algorithms treat all retail stocks as if they are identical, it seems clear that strong balance sheets are being undervalued by investors.

Put another way, if a retailing company has no debt and generates positive free cash flow, it should not trade at a similar valuation to a competitor with lots of debt. The challenge for companies with strong balance sheets is not survival, but rather growth (or in many cases merely maintaining their existing market share).

To illustrate how Wall Street appears to be getting it wrong with regard to balance sheet analysis (or lack of interest), consider two retail stocks that recently reported first quarter results below analyst expectations and saw their stocks crater; Express (EXPR) and Francesca’s (FRAN).

$6.68 per share, 78.5 million shares = $525 million equity value
No debt, $191 million cash onhand = $334 million enterprise value
2016 financials: $2.19B revenue, EBITDA $187M, free cash flow $88M
Valuation: 2x EV/EBITDA, 6x FCF

$10.46 per share, 36.8 million shares = $385 million equity value
No debt, $48 million cash onhand = $337 million enterprise value
2016 financials: $487M revenue, EBITDA $87M, free cash flow $50M
Valuation: 4x EV/EBITDA, 8x FCF

These two companies are in no danger of going bankrupt. Will they have to fight hard to compete for shoppers’ dollars given how crowded the apparel and accessories space is in the U.S. right now? Absolutely. But both of them are going to be around for a long, long time.

Let’s contrast Express and Francesca’s with a couple of other retailers with debt and see if Wall Street is segmenting the sector in a rational way. Consider Barnes and Noble (BKS) and JC Penney (JCP):

Barnes and Noble:
$6.68 per share, 72 million shares = $485 million equity value
$180 million net debt = $665 million enterprise value
2016 financials: $3.95B revenue, EBITDA $150M, free cash flow $11M
Valuation: 4.5x EV/EBITDA, 44x FCF

JC Penney:
$4.75 per share, 313 million shares = $1.5 billion equity value
$3.7 billion net debt = $5.2 billion enterprise value
2016 financials: $12.5B revenue, EBITDA $938M, free cash flow ($93M)
Valuation: 5.5x EV/EBITDA, No FCF

If you look at the stock charts, you will see that the public equity markets are saying that these four companies are essentially the same. However, it is not a hard argument to make that both a traditional department store and a retailer of all things “Amazonable” (physical books, toys, etc), with quite a bit of debt, are in a worse competitive position than a chain of women’s boutiques and an apparel brand focused on a 20-30 year old customer that now gets 25% of its sales from e-commerce (up from zero 10 years ago), both of which are debt-free. And yet the latter two are cheaper on a valuation basis and the stocks of all four look like they are headed for the graveyard in the same vehicle.

I know it does not fit with the media-driven narrative in retail right now, but balance sheets matter. It is short-sighted to simply categorize all bricks and mortar retailers as dead and call it a day. Can you name companies that go out of business with no debt? Other than a select few examples when a company does something illegal and gets shut down by the government or a regulator, or can’t come up with enough cash to pay a large jury award, I cannot think of any. At some point, investors will take notice (I think, anyway… there are no sure things in the investing world!).

Full Disclosure: Long shares of EXPR and FRAN at the time of writing, but positions may change at any time.

7 thoughts on “Retail Carnage (Part 3) – Sorry Wall Street, Balance Sheets Do Matter”

  1. I believe Circuit City was a retailer that had “no debt” that went bankrupt. The company had no term loans or public debt but did have a bank credit line (which virtually all retailers have). Please correct me if I’m wrong. Bob Rodriquez had invested in it.
    BTW I don’t think that this exception disproves the rule. Peter Lynch had often said you can’t go bankrupt without debt. And that’s a good rule of thumb (despite exceptions).

  2. We value the insight and the rationale is cogent. Yet is it not prudent to consider outstanding lease obligations as debt as it pertains to retail?

  3. Express is not debt free. It has leases for all it’s stores right? Must be a few hundred million dollars worth of lease payments…

    Express comp sales dropped -10%. It’s not being eaten by amazon, but other fashion retail, zara, uniqlo, handm, topshop.

    For Barns and Noble and JCP – don’t you think you should normalise FCF rather than just use last 12 months…average the next 3-5 years…

  4. Hgg somehow managed to go bankrupt without debt, but to be fair they weren’t overcapitalized like the names you own

  5. We ask whether including lease obligations in the debt calculation of a retail entity is not only prudent, but germane to the analysis?

  6. One thing that could be missing is operating leases. If you PV the minimum operating leases to capitalize them on the balance sheet then FRAN and EXPR do have “obligations/debt”?

  7. I don’t consider leases to be debt, although I am certainly aware that other investors do adjust their leverage ratio to treat leases as debt and then excludes the rent from their EBITDA calculations. Since rent is an operating expense, I prefer to include it as such when calculating cash flow (and therefore not treating leases as debt). But obviously that is a personal preference.

    I also think treating all contractual obligations as debt muddies the picture even more since that philosophy shows up in other areas. If a company leases their corporate offices, one would then want to be consistent and treat those lease obligations as debt as well.

    Then there are your employees. If you fire them, you have to pay out severance. Should potential severance payments for all of your employees also be counted as debt? After all, just like you would have to pay to exit a lease, you have to pay to fire an employee. And so on and so forth. Besides, companies terminate leases quite frequently and it is a negotiation like anything else (landlords will often make it easier for tenants to exit a long-term lease if they know they can increase the rent materially for a new tenant). So the actual lease contractual obligation is rarely what the actual liability winds up being in a lease termination situation. Heck, some old anchor stores actually get pay by their landlord to exit a lease, for this very reason (they are paying a few dollars per foot). In that case, the lease would actually be an asset, not a liability.

    All in all, there are so many factors that I think treating leases as debt is a slippery slope and overcomplicates the analysis..

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