AutoZone’s Numbers Don’t Suggest Amazon Will Replace Them Or Their Competitors

After a huge rally over the past five years, shares of auto parts retailer AutoZone (AZO) have taken a beating in recent months as investors fret over Amazon’s ability to become a full service parts supplier.

What is interesting, however, is that auto parts industry observers are far less optimistic about Amazon’s desire and ability to break into a business that often requires super fast delivery (far less than even two hours) and a huge selection of SKUs. Simply put, auto body shops suddenly dumping their relationship with AutoZone seems unlikely. In that case, AZO’s share price slump from $800 to $500 lately is probably unjustified.

There is little doubt that non-time sensitive auto-related purchases have a place in the online world. If you want to stock up on car air fresheners or get a new license plate holder, Amazon is a good place to look. But for more specialized needs, where price is not always the most important factor (getting your car back as soon as possible is), the distribution networks powering the large national auto parts retailers should still provide certainty, comfort, and value.

To see exactly how much AutoZone’s business has been impacted by Amazon, I looked back over the last 15 years to see the trend for the company’s sales per retail square foot. After all, if auto part sales are moving online in a material way, the average AutoZone retail store should be seeing sales declines. This would show up in sales per square foot since a store’s size is constant even if more stores are built.

Here is a graph of AutoZone’s sales per square foot since 2003:

Can you see Amazon’s impact in that graphic? When did they really accelerate their auto parts selection? Does it look like they are having the same chilling effect on AutoZone’s business as they are on, say, JC Penney? I just don’t see it.

For those expecting the impending doom of auto parts retailers like AZO, I think their death may be greatly exaggerated in Wall Street circles lately. In fact, it is notable to point out that over the last five years (when e-commerce growth has really started to disrupt traditional retailers), AutoZone’s revenue has grown from $9 billion to $11 billion, leading to an increase in free cash flow from $27 to $34 per share.

Full Disclosure: Long shares of AZO and AMZN at the time of writing, but positions may change at any time

Gilead Sciences Take First Step Towards Higher Valuation Multiple

It has been a tough couple of years for shareholders of Gilead Sciences (GILD), the leader in treating HIV and Hepatitis C, or HCV. After shocking the biotechnology world by buying little known Pharmasset in 2011 for $11 billion, which gave them what would be become the leading HCV treatment, Gilead’s stock soared as Sovaldi (and later iterations of the drug) set a record for the best drug launch in the history of the industry.

However, as Gilead effectively cured thousands of patients in short order, it became clear that their HCV franchise would peak, and then slowly decline over time. As profits peaked and turned down, so did GILD shares, beginning in 2015:

What happened next was a classic Wall Street (read: short term focused) reaction. The stock went from darling to dud because Gilead had nothing in their drug pipeline that could offset the loss of HCV revenue after those initial patients were cured. At the beginning of 2017, GILD stock fetched $72, or just 6 times trailing 12-month free cash flow. A free cash flow multiple of 15-20 is pretty normal for the pharma and biotech space, so investors were essentially saying that GILD was going to see its profits decline more than 50% permanently.

I started buying the stock in late 2016 because the situation seemed very similar to instances when quality drug companies come to the end of the patent life for one of their best selling medicines. Knowing that generic versions are coming, investors drastically cut the earnings multiple they are willing to pay, in case new drugs never come to pass.

Of course, this ignores the fact that the vast majority of the time those same companies take actions to limit the profit decline and eventually grow again. In my October 2016 quarterly letter to clients I wrote the following:

“The negative case for Gilead ignores the fact that corporations are very much like living creatures; they do not exist in a vacuum but rather can pull other levers and take actions to offset negative events. For instance, what happens if Gilead discovers new medications for other diseases? What if they siphon profits from their HCV drugs to acquire other companies in order to diversify their product pipeline? What if they use profits to repurchase their own stock, making each remaining share more valuable? Better yet, what if they do all three?

For example, Pfizer’s cholesterol drug Lipitor had sales of $9.6 billion in 2011. In 2012 sales fell by 60% after the patent expired and generic versions hit the market. To reflect this known reality, Pfizer stock closed out 2011 trading for $21 per share, or roughly 9x annual earnings. By 2015, Lipitor sales had plunged by nearly 90% but Pfizer’s annual earnings had only fallen by 5% as other products filled the void. Pfizer stock ended 2015 trading at $32, or 14x annual earnings.”

Today we learned that Gilead has agreed to acquire Kite Pharma (KITE) for $12 billion in what will likely be just their first step in a process to build a formidable oncology franchise. I would expect more deals like this, perhaps 1 or 2 over the next 12-24 months, to further diversify the company away from HIV and HCV.

If the transition is successful, investors will likely reward Gilead with a more normal valuation. The stock is only rising by 1% today, but over time there is no reason the valuation gap (compared with peers) will not close more dramatically. It will be a long time before Gilead gets back to peak profitability (2015 produced $13 per share of free cash flow), if they ever do, but let’s assume they can earn $10 per share in five years (versus perhaps $8 this year). Assign a reasonable 15 multiple to those earnings and Gilead shares would double from their current price.

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

Is the Enthusiasm for Charter Communications Getting Overdone?

Shares of cable operator Charter Communications (CHTR) have been on a roll lately, rising more than 50% during the last 12 months. You would think after such a big run that the company must have had a dramatic change of fortune, but really it is just a traditional cable company offering customers bundles of services while consolidating smaller regional competitors.

The story might sound a lot like Comcast (CMCSA) because they are pretty much in the same business. Comcast owns NBC Universal, so they have a content wing as well, but the two companies are the nation’s leading cable businesses in the United States, with nearly half of all U.S. households (~50 million residential customers cumulatively).

Investors would therefore likely conclude that Charter and Comcast were being afforded similar public market valuations, but you would be wrong. After Charter’s magnificent rise from $250 to nearly $400 per share (during which time Comcast shares have risen a more modest 20%), the smaller player now trades at a huge premium.

As the chart below shows, Charter fetches a 35% premium on EBITDA and a 60% premium on free cash flow:

It appears that merger chatter involving Charter may be behind a large part of the stock market move lately. Verizon (VZ) and Sprint (S) are both rumored to be eyeing a deal that would morph them into more than a cell phone provider, and perhaps adding wireless to the cable / internet / landline phone bundle would bring down costs and prove synergistic.

What investors seem to be missing, however, is that there is nothing unique about Charter’s business. The company still gets 40% of its revenue from cable video services, which are declining due to cord-cutting. The only strong business segment is broadband, which accounts for about 35% of revenue, but there is a limit there too. Population growth has slowed dramatically in the U.S. and offsetting cable losses by raising prices on internet service will only work for so long.

Charter has been an amazing investment since emerging from bankruptcy in 2009, but the stock appears very expensive. As more and more consumers move to streaming services for video content and drop their landline phones, cable companies are going to feel the squeeze. Perhaps that helps explain why a cable/wireless tie-up might make sense in the long run, but at nearly 12x EBITDA, there is very little margin for error in Charter stock. In contrast, Comcast appears to be a relative bargain.

Full Disclosure: Long shares of Verizon and Sprint debt at the time of writing, but positions may change at any time

 

Restaurant Bubble? Shake Shack Has Two Locations at One Mall

Once seen as a very strong industry riding the secular trend of Americans moving away from cooking at home, the restaurant sector is starting to feel growing pains. With U.S. population growth slowing and immigration becoming more difficult, same-store traffic declines are backing restaurant companies into a corner. The choice is simple: continue to open new units faster than your customer base is growing spending on food, or admit to investors that the growth they have come to expect is over.

High-flying fast casual burger chain Shake Shack (SHAK) has made the decision that, despite dozens of burger places popping up everywhere across the country, the name of the game remains growth. In fact, despite having fewer than 85 locations in the U.S. as of June 30th, the company now has two units open at the bustling King of Prussia mall outside Philadelphia.

Some bulls on the company will likely reference the Starbucks phenomenon whereby that chain purposely opens locations near each other in order to reduce the size of waiting lines during busy peak times. But this is different. Shake Shack has told its investors that it sees room for 450 locations in the U.S. alone. If your ultimate goal is to build 9 locations in every state, it probably does not make a lot of sense to have two in the same mall.

The bigger point has large implications for the industry. As more and more big box anchor stores close their mall locations (Sears, JC Penney, Macy’s, etc), landlords are trying to fill the spaces fast. And with so many bricks and mortar retailers struggling to compete in the e-commerce world, restaurants are an easy way to fill space.

It should not be hard to see the problem with this plan in the long run. With minimal population growth and declining mall traffic, over time there will be less of a need for restaurants at these locations, not more. And yet the industry continues to grow seats far faster than consumer spending. We are seeing the result already; less traffic per location, and thus less revenue and falling profits.

Shake Shack might be able to get away with overbuilding for a while, mainly because the chain started in New York and is brand new to most consumers as they expand across the country. But five years from now we are likely to look back and see that it was silly to have two Shake Shacks at King of Prussia (assuming mall trends continue in a similar trajectory).

As a long-time investor in the restaurant space, the current landscape is challenging. On one hand, Wall Street is giving many companies (not Shake Shack) meager valuations due to falling customer traffic. On the other hand, if the industry continues to build new locations for the sake of growth (and not due to demand exceeding supply), it will make it hard for any chain to post impressive financial returns.

How should investors approach these dynamics? Well, it looks like the franchising route might be the best way to limit downside risk. While lower sales will impact royalty streams for the franchisor, fixed cost deleveraging will impact the bottom line far more severely, and that will sting the franchisee first and foremost.

Shake Shack management would argue otherwise. In fact, during their latest conference call they bragged about having a second unit at King of Prussia mall. Essentially, they argue that it was a wise move as long as they sell more burgers cumulatively with a second location. After all, if the demand is there, why not book the sales?

However, this assumes that the demand will be steady and/or rising over time. Once Shake Shack loses its “newness” and more competing chains invade their turf targeting the same customers, we could very well see demand for their burgers fall considerably. Enough that two locations make little sense.

Full Disclosure: No position in Shake Shack, but positions may change at any time

Dillards Short Squeeze Makes LBO Less Likely Near-Term

It has been a little more than two months since my multi-part series on retailers highlighted the low valuations and negative sentiment on various companies, including department store chain Dillards (DDS).

In recent weeks the stock has soared, in part due to speculation that a massive short squeeze could be imminent. It looks like we are seeing signs of one right now, as the stock has moved from $48 in May to nearly $77 today.

Not only has the recent move narrowed the gap between market prices and intrinsic value, but it also greatly reduces the odds of a management-led buyout in the near-term. When the stock was in the 40’s, a $60 or $65 bid could very well have gotten done. But at current prices, offering a premium would very likely make a transaction less attractive. As a result, I would not be surprised to see the share price retreat after the current spike in short covering comes to a close.

Full Disclosure: Long Dillards debt securities at the time of writing, but positions may change at any time

Amazon and Kenmore: A Mismatch Made in Desperation

For years I have wondered why Sears chose not to sell Craftsman tools on Amazon’s web site. It just seemed like an obvious move to monetize a brand name they owned, given that their own stores are slowly disappearing due to customer disinterest. Earlier this year Sears sold the brand to Stanley Black and Decker to raise much-needed capital, and I suspect it is only a matter of time before the new owner utilizes Amazon to boost market share for the reputable Craftsman brand.

Yesterday the financial markets reacted quite strongly to the news that Sears will now sell Kenmore products on Amazon (the company still owns the Kenmore and Diehard brand names). Sears and Amazon rallied, while shares of competitors like Home Depot, Lowe’s, and Whirlpool fell sharply.

Unlike the Craftsman brand, which I believe resonates with most every demographic, Kenmore seems like an odd fit for Amazon. Clearly, Sears is feeling the pressure to stabilize its business and the country’s largest e-commerce retailer would seem to be a logical place to turn.

The problem is that the Kenmore brand has a loyal customer base, but those people are largely older, whose families have shopped at Sears for appliances for multiple generations and have come to trust the brand. In other words, the only customers Sears has left that shop in their physical stores, and more importantly, the last people who are going to consider buying a washer and dryer on Amazon.

Wall Street’s knee-jerk reaction (granted, most likely from computers, not humans) was to flee from the big box appliance retailers. This appears overdone because appliances only represent a small proportion of revenue at those chains, and they should be more Amazon-proof than many other bricks and mortar companies. The odds of this news materially impacting a Best Buy, Home Depot, or Lowe’s is minuscule, in my view. And the idea that the Kenmore brand is going to be reborn merely due to it being more prominent on Amazon’s site is wishful thinking. As a result, yesterday’s stock moves are likely to be short-lived, and they have provided investors with an opportunity.

Full Disclosure: Long shares of Amazon, Lowe’s, as well as Sears’s corporate bonds that mature in 2018, at the time of writing, but positions may change at any time.

 

Another AMD Comeback: Stock Says Most Certainly Yes, But I’m Skeptical

At first glance you might very well think Advanced Micro Devices (AMD) is having a hugely successful rebirth. Here is two-year chart of the semiconductor company’s stock price:

After so many fits and starts and promises over the last few decades, with little to show for it in the way of sustainable profitability, I had not really looked closely at the shares, even during this huge run recently. Then I read an article in the July issue of Fortune that spotlighted AMD’s bet on new chips that apparently has gotten investors’ attention.

For a company whose annual revenue in 2015 and 2016 ($3.99 billion and $4.27 billion, respectively) were the lowest out of any of the past ten years, AMD’s current market value of $13.5 billion (today’s share price: $14.39) seemed pretty lofty, but I wanted to dig deeper to see if progress is really being made. The numbers are pretty ugly:

The aforementioned revenue trend is poor:

And profitability is hard to come by. Here is free cash flow over the last decade:

Okay, “hard to come by” might be overly generous… AMD has not turned a material cash profit, after required capital expenditures, in any of the past 10 years. Looking at the two-year stock price chart again, it is hard to understand why the share are trading above $14 each.

Evidently, optimism about future products is high, despite some clear setbacks as noted in the Fortune piece. But I suspect the stock may be ahead of those rosy expectations. Including half a billion dollars of net debt, investors are currently valuing AMD at $14 billion. Revenue is expected to reach $5.3 billion in 2018 (sell side consensus estimate), which would get the company back to 2012-2014 sales levels.

So what is a best case for AMD? I decided to try and pinpoint a number in order to draw a final conclusion about the current stock market valuation. To do this I like to assume that most metrics get back to previous peak levels and see what kind of stock price I would get if things go right from here. Call it the “bull case” as many analysts do.

Using the last decade as my data set, I see that gross margins peaked in 2010 at 46%. R&D spending troughed at 19% in 2014. Corporate overhead troughed at 11% last year. Let’s plug in those expense levels (equating to EBITDA margins of 16%) and further assume that AMD can get annual revenue back to $6 billion (40% above 2016 levels and 12.5% above consensus estimates for next year). In that scenario annual EBITDA would come in at $960 million. Let’s call it a billion.

What multiple should we use on that $1 billion of EBITDA? Industry behemoth (and the competitor AMD has never been able to strongly challenge), Intel, trades at 7 times. If we give AMD the same valuation the equity would be worth $6.5 billion, or roughly $7 per share. Even if we are generous and assign a 10x EV/EBITDA multiple, we only get to $10 per share.

At over $14 per share, AMD stock currently reflects very optimistic assumptions about the company’s future growth, profitability, and valuation ($1.4 billion in annual EBITDA, at a 10 multiple, for instance). If the last decade is any indication, the odds are not great that they deliver. As a result, I am not touching the stock. In fact, for those who short overvalued and underwhelming businesses, it might be a solid candidate.

Full Disclosure: No position in AMD at the time of writing, but positions may change at any time

 

The Door Is Open For Somebody To Swoop In And Steal Whole Foods Market

It has been nearly three months since I wondered in writing whether anybody would step up and buy Whole Foods Market and a lot has happened since then. By now most people know that Amazon is in the driver’s seat with their $42 per share all-cash offer having been accepted by the WFM board of directors last month.

My assessment of the situation back in April was hit and miss. My estimate of fair value for the stock proved to be spot-on (“low 40’s”) but I dramatically underestimated Amazon’s interest in making a large acquisition. I pegged the odds of a deal at 40%, with the most likely buyers being a private equity firm or another grocery chain. Amazon must really like the idea of a Whole Foods combination, given that I do not believe it has ever offered $1 billion for another company, let alone the $13 billion Whole Foods will cost.

Today Whole Foods released its merger documents in preparation for the shareholder vote and the tidbits we learned were quite interesting. Specifically, four private equity firms and two grocery competitors reached out to the company, in addition to Amazon’s interest. Perhaps not surprisingly, Whole Foods focused on a deal with Amazon and never actually opened up the bidding to other interested parties. I suspect this is mainly because the company’s founder and CEO wants to keep his job and Jeff Bezos will let him.

In terms of where this deal heads from here, it was also noteworthy that Amazon’s initial offer was $41 per share and when Whole Foods countered at $45 Bezos and Co. made a best and final offer of $42. This is interesting because not only were they not really interested in increasing their bid, they also insisted that WFM keep quiet about the negotiations. Amazon even insisted on multiple occasions that they would walk away immediately if the deal was leaked or if other buyers were allowed to join the bidding.

Such a negotiating strategy clearly worked, but it does open up the possibility that a last minute competing bid could emerge. Imagine you are at a private equity firm, or another grocery chain who would be interested in partnering with PE to help fund a bid. Assuming you liked the idea of grabbing Whole Foods, the main reason not to would be the fact that Amazon has deep pockets and would likely be able to prevail most easily in a bidding war. But after reading the details of how this deal came about, it appears that Amazon might not be willing to raise their bid above $42 per share. In that case, as little as $43 or $44 might steal WFM away. You can bet that Jana Partners, the hedge fund whose 8% stake fueled the most recent takeover talk in the first place, would support taking the best offer possible.

Whole Foods stock closed today right at $42.00 per share, so there does not appear to be a high degree of confidence that another bid is coming. That may be true, but all it takes is one interested party who decided to take a shot at it. It could be a very quick turn of events (and relatively easy) if a single bid over $42 prompted Amazon to walk. I won’t bother placing odds on this happening given that I didn’t think Amazon would bid in the first place, but I don’t think it is a stretch to say that the details we learned today could sway another party who has been pondering making a higher offer. After all, they were never really allowed to bid in the first place.

Full Disclosure: Long shares of Amazon and Whole Foods Market at the time of writing, but positions may change at any time.

Retail Carnage (Part 4) – Are Controlling Families Starting Their Engines?

Last week we learned that the Nordstrom family, owners of roughly 30% of the large department store chain bearing their name, has begun the process of exploring a bid to take the retailer private. Given the public market environment for apparel and accessories retailers these days, this should not come as a shock to most Wall Street followers. Nordstrom has been a family business for many decades and spending valuable time and energy justifying to analysts and small shareholders why management is making large investments aimed at cementing their competitive position, or giving guidance about how strong or weak store traffic and same store sales have been in recent weeks, can only really be characterized as suboptimal for long-term stakeholders in the company.

Given Nordstrom’s strong relative position in the department store sector (only around 100 full line stores in higher end malls, and a growing off-price chain that caters to higher priced merchandise), I do not think it will be difficult for the Nordstrom family to find partners to help them take the retailer private. Whether they are willing to pay a price that the rest of the shareholder base will accept is another question entirely, but a  price starting with a “5” would probably get the job done.

Are there other retailers with large concentrations of family ownership that have probably mulled the going-private idea already and might be more inclined to take steps in that direction if the Nordstrom family succeeds? I certainly think so. Two names I would offer up are Dillards (DDS) and Urban Outfitters (URBN).

Both companies are far smaller than Nordstrom in terms of market value and therefore would be even easier deals to consummate. Three members of the Dillard family, directly owning roughly 13% of the equity, currently serve on the management team and have to be thinking that they too could benefit from a leveraged buyout transaction. The odds of department stores ever getting respect from public investors again are slim, in my view. Taking the company private, and owning all of that valuable real estate themselves, would be a very solid result for the family.

The Hayne family, founders of Urban, are less well known but they have retained a very large stake in the company, one that only grows as more and more shares have been repurchased with free cash flow in recent years. The Hayne family owns a near 30% stake and Urban’s balance sheet makes a deal even easier ($400 million of cash and no corporate debt). At $17 per share, the company sports an enterprise value of just $1.6 billion, versus $473 million of EBITDA in 2016 (free cash flow for the year was a impressive $271 million.

I think the odds are very low that none of these three retailers completed family-led LBO deals over the next 12-18 months. Two deals would seem very possible and a trifecta is even conceivable. After all, if the Nordstrom family is successful, the others are not going to want to balk and potentially look silly three to five years down the road.

Full Disclosure: Long Nordstrom equity and Dillards debt at the time of writing, but positions may change at any time

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).

Express:
$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

Francesca’s:
$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.