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

First It Was Bricks and Mortar Clothing Stores, But Now The Manufacturers Are Dying Too?

Put me in the camp that thinks the death of bricks and mortar retail stores is being greatly exaggerated. It is true that e-commerce is here to stay, but people seem to forget that most of the online clothing and accessories shopping is done on store sites that have a physical presence. The notion that Amazon private label clothes are going to render great American brands useless seems a bit far-fetched to me. So yes, there are retail stocks out there that look mispriced to me, but today I want to point out something else going on in the market that seems odd to me; clothing manufacturers are falling in sympathy because their goods are stocked in the stores that investors feel will be closed.

So let me get this straight… we aren’t going to buy shirts, pants, shoes, and underwear in an actual store, in fact, we aren’t going to buy them at all?! Is the Internet going to make it such that we never leave the house and therefore won’t require clothing? We’ll just order a pizza from Domino’s by tweeting and chill on the couch watching Netflix?

When I see the stocks of companies like Ralph Lauren, PVH, UnderArmour, and VFC Corp trading at multi-year lows it makes me think that Wall Street is getting this all wrong. Some of these names are less well known; PVH sells Van Heusen, Tommy Hilfiger, Calvin Klein, Izod, and Speedo, while VF owns North Face, Lee, Wrangler, Timberland, and Vans, among others, but let’s be honest, these companies might see their distribution channels evolve but they aren’t going away.

Below are some charts of the names I am digging into. Long-term I bet there are some great investments in the sector.


Full Disclosure: Long RL and UA at the time of writing but positions may change at any time

This Is How Amazon Will Become America’s Most Valuable Company

In 2014 I invested in (AMZN), much to the bewilderment of many of my clients. Even though the stock had fallen from more than $400 to below $300 per share, the consensus view was that the company was a money-losing unfocused endeavor that prioritized innovation over financial considerations. In many minds, there was no way to justify Amazon’s market value, so $280 per share was pretty much just as crazy as $400 per share.

Fast forward 30 months and Amazon shares trade in the mid 700’s. The company is reporting GAAP profits and still growing 20% per year. Prior skeptics missed several things, but at the core they did not account for the fact that Amazon sees no boundaries in terms of areas in which it will compete. The company was losing money in the accounting world, but in reality certain businesses were making money and those profits were being used to subsidize growth initiatives in other areas, some of which would fail and others that would succeed but not turn a profit on their own until years later.

We often hear growth investors focusing on a company’s total addressable market, or “TAM,” when trying to figure out how high a stock could go over a 5 or 10 year period when growth is more important to management than short-term profitability. Many Amazon investors try to gauge the company’s TAM by looking at the total retail market, and assuming e-commerce ultimately represents X percent of retail spending, and Amazon gets Y percent of that e-commerce market. That method of analysis would work for most companies, but not Amazon. The problem is that it implied that we know what categories will have an e-commerce component and that the e-commerce penetration of each category will remain somewhat consistent (such that we can predict what it will be).

Why is that problematic? Watch this video, unveiled today by Amazon:

You see, Amazon is not a traditional company. It is creating new businesses that don’t exist and it is re-imagining business models, like the convenience store. There is really no way to know what businesses Amazon will get into in the future. All we really know is that they are more willing than any other company on Earth to venture into something new that may or may not seem to make sense. This is why I believe within the next five years Amazon will become the most valuable U.S. company. There is nothing stopping them from growing because they never limit themselves.

The “Amazon Go” store you saw in the video (see the related Seattle Times article here) will open in 2017 in Seattle, about 10 miles from my house. I will eagerly await its arrival and share my initial experience when it opens. As for the stock, as the price warrants I will reduce my position over time (I already have sold some), but it is probably the only stock I have ever owned that I will continue to hold at least some of my shares almost no matter how high it goes. As long as I cannot predict where Amazon’s growth will take it in the future, it will be hard for me to confidently say the company is overvalued.

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

Will People Continue To Buy Clothes In Stores?

It is always interesting to me when Wall Street takes a few select situations and uses them to make dramatic conclusions about how the world will change forever. If you have read much about consumer spending in recent months you might come to a few conclusions, such as:

  1. Millennials are the only consumer group that brands should care about because they now outnumber baby boomers
  2. Millennials don’t spend money on clothes
  3. Instead Millennials spend money on travel, eating out, live experiences, and consumer electronics

I want to focus on where consumers are spending money because I think the idea that retail shopping is dead due in large part to a de-emphasis on clothing and accessory purchases is presenting excellent investment opportunities right now. Many leading department store chains as well as specialty retailers focused on apparel and accessories have been crushed in the public markets. They are trading at equity valuations that imply their businesses are in permanent decline due to a combination of shopper preference changes and increasing market share for online-only retailers. Even though the bricks and mortar companies have spent billions of dollars building out their online capabilities to complement their store networks, investors largely do not believe these investments will show solid returns.

First, I find it odd that investors do not want anything to do with the apparel and accessories category right now. Are we going to somehow stop wearing clothes? If not, are there technological advances in the space so great that wearing clothes will no longer result in them wearing out and needing to be replaced? The view that there is an irreversible trend toward spending materially less on clothing and related products appears suspect to me.

If you agree, then it makes sense to continue down the road and examine other supposed reasons why retail is supposedly “uninvestible” today. For instance, I hear many people point to the fact that Amazon is going to surpass Macy’s in clothing sales in the United States. Even if this is true, should we conclude that Macy’s is therefore doomed? If I think about it, it seems logical that Amazon will surpass many retailers in various categories. After all, Amazon allows any company to list their products on their site. Conversely, Macy’s has a limit to how many items they can sell, as both their stores and distribution centers have finite capacity. Isn’t this therefore an apples and oranges comparison? Honestly, I would be concerned if Amazon could not sell more clothing than Macy’s given their vastly different business models.

Macy’s stock has dropped from $73 to $33 per share in the last 12 months, bringing its equity value down to $10 billion. To give you a sense as to how negative investors view the company’s prospects, it has been widely reported that the Macy’s flagship store in New York’s Herald Square (which they own) is worth at least $3 billion. Add two more valuable stores in Chicago and San Francisco and there might be $6 or $7 billion of real estate value in just three of Macy’s 800+ store base across the country. This discrepancy tells me two things; 1) there is a large margin of safety in Macy’s stock, and 2) investors don’t think very much of the company’s retail business despite more than $25 billion in (very profitable) annual sales. Another interesting fact is that Macy’s stock currently yields 4.5%, which is higher than the yield on Macy’s corporate bonds that mature in 2023 (about 4.1%). Typically investors accept lower income payouts on equities in return for more capital appreciation potential. And in case you were wondering, Macy’s is more than adequately covering the dividend with free cash flow.

There are many other examples of retail stocks that I believe are being mispriced today. Some have inherent real estate value due to owned stores vs leased stores. Others have high dividend yields that actually point to undervalued stocks rather than distressed operations. Others have no dividend or owned real estate, but instead have real growth opportunities ahead of them and simultaneously are trading on public markets as if they are shrinking in size. Because the opportunities vary in shape and size, I recently began buying a basket of five names that I find particularly attractive as a way to spread the risk around (retail will always be an extremely competitive business) but make a macro bet on the apparel space continuing to operate quite profitably. There are many values to be found if you, like me, believe that clothing and accessories is a retail category that will remain in style for decades to come.

Full Disclosure: Long Macy’s and many other retailers at the time of writing, but positions may change at any time

Whole Foods Market: 2015 Update

It has now been about 18 months since I began accumulating shares of Whole Foods Market (WFM) in the high 30’s. Since that time the stock briefly had a huge move back into the 50’s before losing steam again. Same-store sales have decelerated but my investment thesis remains unchanged; just because competitors are copying WFM’s model and seeing success does not mean that the company cannot continue to be the leader in the healthy food space. Investors were not pleased with WFM’s quarterly earnings report last night, but the stock is finding some support around $30 and might be forming a bottom.

So how bad are things really? Well, if you only look at the stock you might conclude the company is all but dead. For instance, traditional supermarket chain Kroger (KR) now fetches a higher relative valuation (cash flow multiple) than WFM, despite the fact that they have more than 2,600 stores nationwide compared with 431 for Whole Foods. Yes, investors think Kroger will deliver better financial results going forward. I don’t suggest taking that bet.

The financial media has concluded that WFM’s troubles are due to people shunning their stores for the likes of Wal-Mart, Target, Costco, and smaller, regional WFM copycats since all of those places now sell organic food. While this may be true to some extent (especially with local WFM wannabe stores — not many Whole Foods shoppers frequent their neighborhood Wal-Mart), there are other explanations that are ignored because they are not as obvious and do not make for interesting headlines.

A big one is the fact that Whole Foods is cannibalizing itself by continuing to open new stores at a rapid pace (32 in the just-completed fiscal year). In Seattle, where I live, there are now 7 Whole Foods stores, with several more in development. Over the last 6 years WFM has increased their store count by 50%. As soon as a new store opens that is 10 minutes away, people are going to stop traveling to the one that is 20 or 30 minutes away.

Interestingly, the company provides information about its store performance based on the age of the store. If the media was 100% right and people were simply switching from Whole Foods to Target or Kroger, sales at all WFM stores would suffer equally. But look at the data for fiscal year 2015:

Store Age       SSS

<5 years         +7.6%

5-11 years       +1.5%

>11 years        +1.1%

ALL                 +2.5%

The older the store, the worse the sales growth. This makes sense, right? If there has been a store in your neighborhood for a decade, chances are you will already be shopping there if you are at all interested in doing so. It’s very hard to boost sales at older stores, especially considering that Whole Foods stores already sell far more food per square foot of space than any other grocer.

And when they open new stores those stores do well for many years, at the expense of the older stores. Existing WFM shoppers will migrate to the closer location (hurting older store sales) and shoppers that had no interest in driving longer distances just to shop there might check it out now that it is more convenient to do so.

Notice that none of this has anything to do with the fact that Safeway now sells Annie’s fruit snacks.

Accordingly, the investment thesis for WFM must incorporate the fact that growing same store sales for the company’s existing base of 431 stores is going to be very hard. In fact, I am assuming that they cannot post sales gains above inflation, which implies flat traffic growth for all stores after they have been open for a few years. So why invest?

First of all, the company has 431 stores vs over 2,600 for Kroger, so it is entirely plausible that Whole Foods ultimately reaches their 1,200 store goal in the U.S. And secondly, the company’s stores are massively profitable even if sales do not grow. For all of the heat the company has gotten lately, fiscal 2015 same store sales actually grew 2.5% and operating cash flow totaled more than $1.1 billion. That’s more than $2.6 million of cash flow per store. For comparison, Kroger does about $1.6 million per store, and their stores are bigger.

At $30 per share, Whole Foods stock trades at less than 8 times EBITDA and less than 14 times existing store free cash flow, both below their less impressive competitors. Such a price would only be justified if the company had minimal growth ahead of it.

Lastly, I cannot conclude without commenting on some of the odd analyst questions from last night’s quarterly conference call. More specifically, the investment community is criticizing the company’s decision to borrow money (they have never had any debt before) to buy back stock aggressively over the next few quarters.

Normally, companies are mocked for buying back stock as it hits all-time highs and then halting the purchases when things turn sour. Despite the fact that WFM did not start buying back any stock until last year (after it dropped dramatically) and now is accelerating those purchases (as it is hitting levels not seen since 2011), everyone just seems to want to pile on. Here is the first question from the conference call:

“Thanks for taking my question. So my one question has to do with share buybacks. I just wanted to understand the rationale for taking on debt and buying back shares right now maybe instead of waiting until maybe comp trends stabilized. So if you could maybe help us with your thought process.”

I was shocked at this question. Whole Foods has no debt, more than a half a billion of cash in the bank and stores that generate over $1 billion of cash flow per year, so they are in pristine financial shape. The stock is hitting 4-year lows and trades at a discount to traditional supermarkets despite being far better in terms of sales and profits. And the analyst wants them to wait until business gets better before buying back stock?

It should be obvious why they are doing this. Because they know if they can improve the business at all going forward the stock is going to go up a lot. Buy low, sell high, right? In fact, if they took Oppenheimer’s advice and waited until the stock was $50 before doing any repurchases, they would probably get mocked for doing so. This just tells me how negative the sentiment is for Whole Foods Market right now.

I may have been early last year with the stock in the $37 area, but since I invest with a five year horizon I am happy to average down and wait for the water to warm up. Right now the company is getting absolutely no credit for what they have built, how successful it continues to be even today, or any future growth opportunities that exist. It is the epitomy of a contrarian, long-term investment.

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

New Amazon Disclosures Reinvigorate Bull Case For Investors

Amazon (AMZN) is a fascinating company for many reasons and their latest investor relations move has gotten the markets excited about their stock once again (it’s up 57 points today alone as I write this). Bulls and bears on the shares have long had a disagreement about the company. Shareholders argued that Jeff Bezos and Co. were purposely “losing money” in order to invest heavily in growth and attain massive scale. Bears insisted that the spending was required to keep their customers coming back, and that if the company started to show profits the business would suffer dramatically. Regardless of which camp you are in, one thing is clear; Amazon chooses growth over profitability in the short term if it thinks they can be successful.

So when the company announced that it would break out the financial results of its Amazon Web Services (AWS) business segment for the first time in its nine-year history starting in 2015, the consensus view was that the division would show losses. After all, if Amazon embraces short term losses in exchange for growth, and AWS is its fastest growing business, why would you think otherwise? So imagine the surprise last evening when Amazon announced that AWS is profitable, and not just a little bit. Operating margins for AWS during the first quarter of 2015 were 17%. Add back an estimate of depreciation expense and EBITDA margins are likely approaching 50%. And the stock price is rocketing higher on the news.

All of the sudden it is possible that Amazon does not hate reporting profits (some have speculated that income tax avoidance is a motivating factor). Instead, maybe they are being sincere and simply invest capital when they think they have a good reason, regardless of whether it results in short-term GAAP profits. And maybe the thesis that Amazon’s business model does not allow for profits is incorrect. That is surely what investors today are thinking. Given their corporate philosophy, there is no reason Amazon should be running AWS at a large profit, but they are. Why? Perhaps they have built a very good business. Simple enough.

The implications for the stock are important. We now have evidence that AWS is probably worth the $60 billion or so that the bulls have long thought. At the lows of the last year (below $300 per share), Amazon’s total equity value was only a little more than double that figure ($130 billion). The bears on the stock will probably stick to their guns that the current share price (approaching $450) is irrational, but if you actually run the numbers, it is not that hard to value Amazon in a range of $200-$250 billion based solely on what we know today, given that non-AWS annual revenue will approach $100 billion this year and AWS alone can account for 25-30% of that valuation. The stock is getting close to my personal fair value target, but is not quite there yet. And given that Amazon could very well surprise investors more going forward (they don’t exactly set the bar very high), I am not in a big rush to sell.

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