What A Difference A Strong Holiday Season Makes: Retailing Stocks Back From The Dead

Back in the second quarter of 2017 I wrote a four-part series of posts on the bricks and mortar retailing sector (Part 1: department stores – DDS & KSS | Part 2: mall owners – SKT & SPG | Part 3: balance sheet strength | Part 4: possible LBOs – JWN, DDS, URBN) focused on how Wall Street was pricing many companies as if they were essentially finished as profitable businesses.

Here we are after a strong holiday shopping season where online and bricks and mortar stores shared in the cheer and investor sentiment has shifted dramatically. This is notable because the businesses are the same today as they were back in May and June.

While the mall operators are largely unchanged, aside from above-average dividend payouts, profitable retailers with strong balance sheets have been on a tear. For example, Kohl’s (KSS) is up nearly 100%, hitting $67 today on an analyst upgrade. Similarly, Urban Outfitters (URBN) has doubled from $17 to $34 and Dillards (DDS) has jumped nearly 50% from $48 to $70.

The Kohl’s situation is interesting because the stock is jumping $2 today after a Jefferies analyst raised his price target by a whopping 50% to $100 per share (from $66). If that sounds like a crazy number, it is. While I was positive on the company in the $35-$45 area, after a move into the 60’s it warrants a skeptical eye going forward.

I had been using a $60 fair value estimate, based on 6x EV/EBITDA and 10x free cash flow. After all, this is a department store chain that will report lower revenue in 2017 ($19.0 billion) than it had five years ago in 2012 ($19.3 billion) and I wanted to use conservative estimates. Profitable and stable off-mall retailer? Check. Solid balance sheet with lots of owned properties to offer a margin of safety? Check. Growth company that stands to take market share? Not so much.

Slow/no growth department stores (JCP, DDS, M, KSS) have traditionally traded for 6x EBITDA. Unless you believe KSS can grow their business materially, a $100 stock price seems overly aggressive at 9x EBITDA and 17x free cash flow.

Although retail sales will continue to rise in the low single digits thanks to inflation and population growth, department stores will likely still cede market share slowly over time to online channels, as well as new store concepts. That trend likely explains KSS’s flattish five-year sales performance.

After a huge run, investors now believe that these companies will survive and do decently well, which is a huge shift in sentiment from 6-12 months ago. I consider many of the stocks trading at/near a fair price today, especially considering that revenue growth will still be hard to come by. In addition, the odds are low that media headlines focusing on the Amazon  threat, dead malls across the country, and bricks and mortar bankruptcies are a permanent thing of the past. Like many trends in the financial markets, I suspect we will get another good entry point in traditional retailers down the line when sentiment shifts yet again.

As for riding KSS from $67 to $100, I will leave that bet for Jefferies to make, as the stock is far less attractive today from a risk-reward perspective than it was at $36 last year. Most of these stocks seems like contrarian, sentiment-timed intermediate term trading vehicles more than multi-year, buy-and-hold investments.

Full Disclosure: Long shares of AMZN common, DDS debt, JWN common, KSS common, and SKT common at the time of writing, but positions may change at any time.I have been selling down existing positions in KSS recently, although not every share has been sold yet.


AutoZone Three Months Later: Sentiment Shifts Dramatically Again

We are not quite three months from my last piece on AutoZone (AZO), which back in mid September was in the midst of a nasty stock price decline, and now investors seem to feel a lot better about the company’s business. Of course, this is bizarre because AZO is a very large player ($11 billion of annual revenue) in a very stable industry and should therefore be mostly insulated from stock market volatility and immense shifts in short-term investor sentiment.

Below is the five-year stock price chart of AZO I shared back in September when investors were overwhelmed with negativity:

And here is an updated version that shows the last 12 months:

Why exactly a company of this size, with no material change in its business outlook could trade for as low as $497 on August 15th and as high as $763 on December 5th shows just how much the current bull market has lost a sense of rationality. That is a 53% move, for a $20 billion market cap company, in a matter of months.

So how does this happen? My guess is that the markets today are mostly driven by index funds, exchange traded funds, hedge funds, and computerized algorithms. The fundamental bottom-up investors are dwindling in numbers by the day. It is not uncommon for me to meet people who are struck by the notion that I pick individual stocks. The market has been so strong for the last nine years that indexes are now considered to be the only wise investment. It is amazing how much views shift based on where we are in the market cycle. You didn’t have famous investors extolling the virtues of index funds from 2000-2008 (a nine-year period where the market had negative average annual returns), but now that the following nine years have produced +15% average annual returns, all of the sudden they are a “no-brainer” investment.

As someone who strongly believes in the cyclicality of the economy, financial markets, and investor sentiment, the AutoZone example is evidence that picking individual stocks is not silly and the markets are far from efficient. Moves like those in AZO in recent months make my job much more difficult in periods like this, when individual stock moves often make little or no sense based on fundamental research, but as long as opportunities continue to present themselves, I plan to maintain my role as an active manager of client assets. There will always be a place for index investing (for my clients it is mostly through their work retirement plan), but the ease at which it produces stellar returns will continue to ebb and flow with the market cycle.

As for AZO itself, it is hard to argue the shares are anything but fairly valued today. It will be hard for the company to grow their business (in unit terms) given the maturity of the U.S. economy and online competition, and the stock now trades for roughly 18x my estimate of normalized fee cash flow, versus just 12.5x when the shares fetched $500 each. That sounds about right to me.

Full Disclosure: Long shares of AutoZone at the time of writing (holdings have begun to be reduced recently and those trades will continue into 2018), but positions may change at any time

Is The CVS Health/Aetna Proposal Really Just About Amazon?

Financial journalists seem to have a pretty simple playbook these days. Most any retail-related corporate development is a direct result of Amazon (AMZN). Plain and simple. No questions asked.

Last night it was reported that CVS Health (CVS) has made a bid for health insurer Aetna (AET). Immediately the media closed the book on the strategic rationale for the deal; Amazon might soon start offering mail-order prescriptions and CVS needed to make a bold move to counter that attack.

If CVS is really most worried about Amazon stealing away its pharmacy customers, would the best counterattack to be buy the country’s third largest health insurance company? Does that make sense?

It seems to me that the best competitive move to help insulate you from losing prescription share to Amazon would be to buy a last mile delivery company and use it to offer same-day or next-day prescription delivery to the home. After all, it is not like Amazon has any scale in the drug wholesale business, considering that they have yet to even enter the business to start with! And even if they do get into the business, are they really going to be able to get better pricing for drugs than CVS can, with its existing network of 10,000 retail pharmacies?

I would suggest that the CVS bid for Aetna is more about extending their corporate strategy of becoming a vertically integrated healthcare services provider. You have to remember that CVS bought Caremark, a pharmacy benefits manager, or PBM, more than a decade ago. They started Minute Clinic, the largest retail walk-in clinic chain in 2000. They acquired Omnicare, a pharmacy specializing in nursing home services, in 2015. Becoming more than just a retail pharmacy chain has long been the entire idea behind the company. It also explains why reports say that CVS and Aetna have been talking for six months (this idea was not just thrown together quickly because Amazon is applying for pharmacy licenses).

Adding a health insurer to the mix was a logical extension of that. Competitor United Health took the opposite route, as an insurance company that added Optum Health, a PBM, later on. That strategy has been wonderfully successful and I suspect that CVS and United will dominate the integrated healthcare services business for years to come.

Of course, the narrative on Wall Street has nothing to do with any of this. CVS stock is getting crushed today and United Health is up three bucks. The one-year charts make it seem like these businesses have nothing to do with each other:

To me it is simply baffling that UNH trades for 21x 2017 earnings estimates and CVS commands just 12x. If CVS really does build out a UNH-like operation, with a small retail pharmacy division, I can’t fathom how that valuation gap won’t narrow over time. But the investor community right now just can’t get that bricks and mortar component (no matter how small it would be post-Aetna) out of their heads.

What is probably most interesting is that Amazon does not have a history of putting companies out of business when it enters new markets. Amazon started selling books online in 1994. It launched the Kindle e-reader in 2007. If any bricks and mortar retailer should have been gone by now, it would have to be Barnes and Noble. And yet they are still alive and kicking:

A lot of people thought that Best Buy was finished once Amazon started selling a huge selection of consumer electronics. After all, with thousands of reviews, great prices, and fast shipping, why bother going to a store to buy a TV or computer? And yet, here is a five-year chart of Best Buy stock:

All Best Buy had to do was offer price-matching and quick delivery to keep a lot of market share from people who like buying online. And then you will always have a subset of folks who like kicking the tires in-person and asking knowledgeable people questions about the products.

While Amazon’s reach and e-commerce infrastructure will seemingly allow it to always take a certain amount of market share, it does not typically spell death for competitors. This is especially true when Amazon can’t offer anything better than anyone else. Plenty of companies can offer good selection and good prices, and they are finally spending the money to handle the quick delivery too. And with physical stores, in some cases they even have a leg up on Amazon.

Jeff Bezos likes to say “your gross margin is our opportunity.” By that he just means that if you mark up your prices too much, for no good reason, Amazon will undercut you and take your market share. For that to work, margins have to be high in the first place. For books and consumer electronics, gross margins aren’t very high. For other areas like auto parts, where product markups are 100%, do-it-yourselfers will probably shift business away from bricks and mortar retailers and to Amazon for certain items.

In the case of pharmacies, we are not talking about huge markups, from which Amazon can really offer a significantly better deal. Sure drug prices are sky-high in many cases, but there are a lot of middlemen that split the profits. Manufacturers ship product to distributors, who stock the shelves at the pharmacies upon receiving orders, who resell to consumers. Amazon is starting from scratch and has none of those capabilities yet. If their plan is simply to buy drugs from wholesalers and ship them via Prime to their customers, there is not going to be a lot of margin to shave off in the process, nor will they be doing anything different than others.

That becomes even more true because they will not have scale at the outset to get better wholesale pricing from the suppliers. And if Amazon goes directly to the drug makers demands better prices, the drug companies will just say, “sorry, get your supply from the same places everybody else does.” They are not going to voluntarily give up margin when they don’t have to.

And then there is the whole issue of whether Amazon can partner up with the employers, PBMs, and insurers to get access to their customer bases. Is Wal-Mart or Target going to add Amazon to their preferred network for employer-sponsored prescriptions? If CVS buys Aetna, will they let Aetna members get their drugs through Amazon at the same prices they could through CVS retail or mail order? And what is stopping CVS from hiring drivers at $15 an hour to drive around their local neighborhood delivering prescriptions to people’s homes? Does Amazon really have any competitive advantages in this space, assuming they enter it in the future?

I guess they could buy Rite Aid and Express Scripts, to add pharmacies and a PBM, but even after they spend all that money and integrate those businesses, aren’t they just in the same boat as CVS and Walgreens? Sure they are players at that point, but how will they crush the competition?

This is why I am skeptical that Amazon will try to do everything, will succeed at everything, and will kill off legacy providers that have been doing this stuff for decades. When I see a powerhouse like CVS, which will only get stronger if it buys Aetna, trading at 12x earnings, with the rest of the market trading at 20x it just doesn’t make a whole lot of sense. As Warren Buffett would say, “in the short term the market is a voting machine, but in the long term it is a weighing machine.”

Full Disclosure: Long shares of Amazon and CVS Health at the time of writing, but positions may change at any time




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

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.


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).

$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.

Retail Carnage (Part 2) – Shopping Center Landlords Evolve Their Properties

Last week I discussed why I believe many of the traditional bricks and mortar retailers are mispriced based on cash flows, despite intense competition and the acknowledgement that U.S. retail is not a growth business. Interestingly, many of the big box stores own a lot of their own stores, so they have a built-in margin of safety due to the optionality of being real estate developers if the retail business dries up.

So the natural next step in the conversation is to look at the pure play real estate companies. From a valuation perspective the mall owners are the most interesting. For a while the owners of the best malls in the country (GGP, Simon, Macerich, Taubman) were maintaining their premium valuations (roughly 20x FFO, or funds from operations), while the secondary malls in smaller cities were getting beaten up pretty good (single digit multiples of cash flow and double-digit dividend yields). Lately the narrative has changed such that many are saying even the best malls in the country will struggle to fill space as more retailers prune their store portfolios.

In fact, one of the prominent investors featured in The Big Short, Steve Eisman, recently commented on CNBC that he was short Simon Property Group (SPG), widely considered the best high end mall operator in the country) because he didn’t think there was any such thing as a good mall anymore. The reasoning: he just “counts the boxes” sitting on his doorstep when he gets home from work.

As a result, the aforementioned “big 4” high end mall owners have seen their shares drop about 30% on average over the last year, which now sport mid teens FFO multiples. Interestingly, you would be hard pressed to find a transaction in which an “A” mall has been sold for those kinds of prices. Not only that, it was only 2015 when Simon offered to buy Macerich for $95.50 per share and the offer was rejected as being inadequate. Macerich’s current stock price: $59 per share. I have little doubt that if management reconsidered their willingness to sell, Simon would be willing to still do that deal today.

So why are the “A” mall owners so optimistic about their ability to navigate this retail environment, reimagine their properties, and continue to grow their profits over the long-term? After all, if they can succeed on that front, the stock are very likely good buys at ~15x annual FFO.

I can think of a few good reasons. One, location. They have some of the best locations in major cities across the country. Two, incomes and populations are still growing so it is not like they do not have the built-in consumer base to shop their centers. Three, development expertise. These mall companies are developers first and forefront. They are experts are designing destinations that people want to visit.

So while tastes change and maybe 2017 does not bring with it the same thirst for apparel stores that 1997 did, the landlord can adjust. They can bring in more restaurants, more concert venues, more hotels, more office space, more apartment buildings. Rather than having the mall be a place to come and buy clothes, it can be a mixed use destination that serves as a primary entertainment venue.

And don’t forget, interest rates are very low. Developers need funding to expand and/or reposition their properties and money is cheap. If a Sears or a JC Penney closes shop, the mall owner can take that 100,000 or 150,000 square foot box and the huge parking lot that sits next to it and build whatever it wants. The real estate is extremely valuable and any number of uses would make a lot of sense in a densely traversed area that everyone already knows about.

I urge you to read through the conference calls for these mall owners and see how they are thinking about their properties. Take a look at the types of redevelopment properties they are embarking on and decide for yourself if Steve Eisman is right and there is no such thing as a “good mall.” There is a lot of talk in the industry that we have 1,000 malls today and that number needs to come down. And I do not doubt that is true. But every big city can support a couple nice malls. Here in Seattle, for instance, there is Southcenter Mall (owned by Westfield) to the south, Northgate Mall (owned by Simon) to the north, and Bellevue Square (privately owned) to the west. All of these are higher end malls that have plenty of customer traffic. From I-5 you can see all of the building going on around Northgate Mall (including a new light rail stop at the mall itself). The Bellevue property is adding hundreds of residential units around the retail hub.

The financial results of these companies bear out the thesis that they can navigate the changing times. For instance, Simon is projected to earn FFO of $11.50 per share in 2017, which would be a record high level of profitability. Three years ago that figure was $9. Six years ago it was $7. These companies own the land and have access to cheap capital. They really can control their own destiny.

Some other assets are also being dragged down as everyone obsesses over enclosed mall properties, not just the smaller town focused “B” malls. Take outlet malls for instance. The “race to the bottom” in retail these days has made it such that the more you discount the better you do. Chains like Burlington and TJ Maxx and doing great even though they own hundreds of bricks and mortar retail stores. Why? Because consumers have been trained to seek out bargains because it does not take long to find them anymore. Who pays full price for stuff, many will ask.

In that environment, I would think that the open-air outlet malls would have staying power here in the U.S. But a company like Tanger (SKT) has seen its stock price drop from $41 to $26 in the last 10 months. Maybe I am missing something, but I would think that outlet malls will outlast most of their shopping center competitors. But today you can invest in Tanger at just 11x FFO and a dividend yield north of 5%. I would not be surprised if this was a unique opportunity for bargain shoppers, both at their properties and in the stock market.

For investors who are leery of the retailing sector and the threats from Amazon, etc, the real estate owners should be a less risky way to bet on the idea that human beings, even with their Amazon Prime and Netflix accounts, will still find plenty of time to go outside.

Retail Carnage (Part 1) – Perception vs Reality

As a value investor, it should not be surprising that I have been spending a lot of time on the retail and restaurant sector over the last year or so. The space has been pummeled by Wall Street in recent quarters, as the thesis gains steam that we have essentially reached “game over” for traditional businesses. We will buy all of our stuff from Amazon (AMZN) because it is the only rational choice when we are offered a vast selection, great prices, and fast delivery. The same goes for our dining habits; why not have our groceries and meals delivered too? That way we can binge on our favorite Netflix (NFLX) shows without ever being bothered to leave the house to run errands.

I am not going to tell you that these trends are not real. Heck, I am an Amazon Prime member who subscribes to Netflix. The only time I visit an actual pet store is when Amazon is temporarily sold out of the pet food I need. I get it.

I guess my background as a fundamental evaluator of stock prices, though, tells me that the simple “macro” call (which is to avoid investing in any business that is being “Amazoned”) is not automatically the right one. I have always followed the premise that stock prices are a function of the underlying cash flow of the business. As a result, as long as a public company is producing free cash flow, it has value. Accordingly, if the financial markets are mispricing the intrinsic value of that cash flow, there is an opportunity for investment gains. Just because the internet has changed the landscape in many sectors of the economy, it does not follow that the link between cash flow, company values, and investment returns has somehow been rendered obsolete.

But if you have been watching the stock action in these industries you can not help but realize that Wall Street is not really valuing these stocks on cash flows right now. Good luck trying to justify Amazon’s stock price with numbers. Instead, investors simply conclude (correctly, if you ask me) that they are going to take market share in any number of sectors and the end result will almost surely be a higher stock price years down the road. It is more of an “over/under” bet (the line being their existing business today) than it is a prediction about exact profit levels.

And the flip side is also true. Bricks and mortar retailers are being valued at some pretty insane levels in many cases, especially if you happen to have stores in malls. But you can justify that if you ignore the actual numbers and simply make a more general prediction that 5 or 10 years from now there will be no reason to visit a mall or open air shopping center.

For a while now I have been trying to pick and choose attractive investments in these sectors where the sentiment does not line up with the actual financial results of the businesses. It has been a frustrating endeavor with very mixed results. It has become clear to me than in many cases the stock prices are simply not going to line up with the underlying profits or asset values, unless the company takes a proactive role in narrowing the gap (e.g. through a sale or some sort of transaction that “proves” the values). As the market continues to underprice retail-related assets, I think we will see more and more companies take a proactive role, though movements on this front have been muted so far.

But until that happens, I have concluded that the better way to proceed is perhaps to focus on the companies that not only are generating profits over and above what their stock prices would indicate is possible or likely, but moreso on those that are paying a substantial percentage of those profits out in dividends. After all, if Wall Street does not believe the cash flow is sustainable, market participants may never price a public share at a fair price. However, if your investment thesis is that the profits will be there, and they are paid out to you on a quarterly basis, then the stock price itself becomes less important. Put another way, you do not necessarily needs others to agree with your investment thesis for it to be profitable. The commonly referenced Keynes quote applies here: “the market can remain irrational for longer than you can remain solvent.”

Let me give you two examples that show what I mean. Let’s venture into the lion’s den and look at two department stores; Dillards (DDS) and Kohl’s (KSS). I happen to think both are severely mispriced, but the financial community has concluded that these entities will not survive long-term as profit-producing businesses. Let me quickly throw out some bullet points for each to argue that while they might not be well-positioned competitively, their stocks are mispriced.

At $36 and change, Kohl’s shares trades at a market value of $6.3 billion (net of debt the enterprise value is a little less than $8.5 billion). Over the last five years the company has produced cumulative free cash flow of more than $5.2 billion. I estimate free cash flow in 2017 of roughly $1 billion.

Quite frankly, at 6x free cash flow, the equity at current prices is being priced as if the company’s profits are on a perpetual path of double-digit annual declines. And yet if we look at KSS’s revenue pattern over the last five years, it does not appear to be so bleak. In 2012 revenue was $19.28 billion. Estimates for this year are $18.49 billion. That is a 4% drop over a 5-year period. Hardly catastrophic. But I know… it’s a department store, how on earth could anyone invest in a department store in 2017? Well, because they are earning $1 billion a year and trade at 6 times that figure.

What is even more interesting is that there is a margin of safety even if revenue starts to decline at 5% a year instead of the recent path of 1% per year.  You see, Kohl’s owns more than half their stores outright. For more than 1/3 of their store base they also own the land underneath the building. On their balance sheet, the gross book value of the owned land and buildings stands at more than $9.1 billion (less than the current enterprise value). And real estate prices go up over time, so there is a good chance that the $9.1 billion figure is understated relative to current market value.

Next, let’s talk about Dillard’s. DDS is another department store chain but it is seen as being in even worse shape because they operate mostly as anchor boxes in enclosed malls. At $48 per share DDS carries a $1.5 billion market value ($2.0 billion enterprise value including net debt). Last year free cash flow was more than $400 million. This year I project $300 million. So again we have a company that trades at an insanely low multiple of annual free cash flow. It is even cheaper than Kohl’s, with the cumulative free cash flow of the last five years totaling more than $1.9 billion.

And again you would think the business was in free fall based on the price of the stock. But when you look closer you will see that five years ago annual revenue was $6.6 billion and this year it is on track to be $6.1 billion, so it will take a long time for DDS’s business to go away.

Dillards also owns a ton of its stores, even more than Kohl’s. Of the company’s 49.2 million square feet of selling space, they own 44.1 million. The gross book value of the land and buildings at the end of last year was just under $3.2 billion (vs a $2 billion enterprise value). And again, that number is probably too low. In fact, at current prices DDS stock trades at roughly $45 per share foot of owned real estate. To give you an idea of how low that is, Sears recently spun out more than 250 of its stores into a publicly traded company that the market is valuing at $75 per square foot. Obviously Dillards and Sears store space is similar given that they are both anchors in enclosed malls.

So what is an investor to do? Most right now are simply taking the position that stocks like Kohls and Dillards are “uninvestable” because surely department stores are going to vanish. And yet they keep producing hundreds of millions of dollars of free cash flow every year. Clearly that profit stream has value.

A year ago I would have said I preferred Dillards over Kohl’s because it appeared to be even more undervalued. But the market does not seem to care about actual values, and there is no indication that these companies will take steps to demonstrate their intrinsic value by going private or selling stakes in their owned real estate, or whatever other options there might be.

If you asked me the same question today I would choose Kohl’s because they pay a big dividend and that might be the only sure way of earning a return on my capital given the current sentiment in the market. In fact, KSS just raised their annual dividend by 10% to $2.20 per share. I am sure that many people saw that headline and thought it was crazy. How can Kohl’s raise their dividend? Aren’t they dead in the water? Others who simply see the dividend yield of 6% on their computer screens probably come to the conclusion that the payout ratio is unsustainable. After all, since when do retailers pay out a 6% dividend? In the past 3% was a high yield for a retailer and reserved only for bellwethers like Wal-Mart.

So why am I confident that Kohl’s can pay the 6% dividend? Because last year they paid out $358 million in dividends but earned free cash flow of $1.38 billion. They only paid out 26% of their earnings in dividends! In fact, they actually repurchased more stock ($557 million) than they paid out to shareholders. Needless to say, the dividend is safe. In fact, they will probably increase again next year. All of this is true because the stock price and the underlying cash flows of the business are out of whack.

The issue for Dillards investors is that they are choosing to buy back stock and not pay out a large dividend (they do have one, but it is a measly 0.5% annually). While buying back undervalued stock is accretive to investors, it will be tough for those investors to be happy if the stock price is perennially mispriced and the company does not take action to fix the problem. Absent a deal to take the company private or monetize their real estate, it is not clear how the stock price will ever be at a more rational level.

So I think dividends need to be placed higher on the importance scale within the retail sector than they ever have before. They allow investors to lock in some of their expected capital return without worrying about what the stock market claims their shares are worth. As they say, “money talks.”

Stay tuned next week for Part 2 of my Retail Carnage post. For that I will be focusing on the public real estate investment trusts that serve as the landlords for retailers, as they are also stuck in the market’s current disgust of anything related to bricks and mortar retail.

Full Disclosure: Long shares of Amazon and Kohl’s at the time of writing, but positions may change at any time