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The Beatdown Continues
One of the most undervalued industries today is the retail industry, specifically clothing. Equity valuations across the sector are trading at multi-decade lows. Some companies are trading lower than they were during COVID-19. Even the major players are getting hit, with some down 50-75% YTD.
There’s a lot of reasons why retail companies are trading at these levels.
Recession risk: if a recession hits the consumer will pare back spending on non-discretionary items such as clothing. Costs such as leases are fixed and any reduction in sales will bite on the way down as the retail business model has significant fixed costs. There isn’t a lot of room to take out costs when your sales are down 25% as you still need to fill your stores with labor and corporate can only be slashed so much before you start hurting the brand.
Higher inventory levels: retailers have historically high inventory levels. Inventories are high as companies pulled inventories ahead of schedule to get ahead of the supply chain. If sales slowdown retailers will have to markdown their inventory and sell items at a loss. There could be large inventory impairments in the future, which is never a good look for the industry. In addition, higher inventories typically lead to lower merchandise margins and vice versa with low inventory levels. Model slightly lower merchandise margins and your upside gets blown out as the fixed costs typically stay fixed.
Inflation: if higher levels of inflation continue the consumer will be priced out of purchasing discretionary items such as clothing. In addition, retailers will be forced to pass on higher input costs to the consumer so they can protect their own merchandise margin. It is tough passing on higher costs to consumers as the consumer may be hesitant on purchasing a pair of jeans for $150 that they bought for $100 last month. From my experience, its pretty tough passing on higher costs immediately, so you get cut on the downside as commodities like cotton fly upwards before you can pass on the costs.
Higher interest rates: as interest rates move up investors increase their discount rate as their required rate of return increases. The required rate of return of holding a retail company has likely went from 10% to 15%, which has impacted valuations and expected free cash flows.
I think the way to play the retail industry is to buy the best companies out there. Don’t focus on the small and microcap retail companies that are trading at a significant discount to future free cash flow and brand value. Buy the high quality retail names with real brand equity as they are trading at a massive discount to their future free cash flows. I don’t think it makes sense to buy a small company like Tuesday Morning (TUEM) when you can buy Macy’s (M), which appears to be selling under the value of their significant base of owned real estate.
The entire retail industry is thrown out with the bathwater. Analysts are predicting quite the storm to be coming along to shatter expectations. There will probably be massive inventory write-offs and bankruptcies on the horizon. Just remember, not everyone in the space is going to go bust. If you are interested in the retail industry, you can be picky on what you invest in since every company is trading at a massive discount to future cash flows. Here’s how I am thinking about limiting risk in the space:
Purchase retailers with clean balance sheets. Don’t buy the levered ones here when you can buy the unlevered names that have control of their destiny. If merchandise margins fall, the names with a large cash pile will have an easier time surviving.
Looked at the owned assets such as land, headquarters and distribution facilities. There are a lot of retailers that own a significant amount of real estate. Buy the ones that own their facilities and figure out the value of those facilities. I know a few off hand where their owned real estate is approaching the value of their current enterprise value (hint Macy’s and Abercrombie).
Buy actual brands that have equity power. You get to be real picky here. When everything is getting sold off, go for the biggest, baddest and meanest brands. Invest in something with brand equity that a third party, such a private equity, would value. Think of Victoria’s Secret Pink brand.
Remember that you are buying cash flows for the next decade, not the next few quarters. Analysts get tripped up when there is a recession and tend to forget most of the value of a company is generated in year 2-10 and not the first two years.
I recently read this article titled Here comes a 'flurry' of retail bankruptcies, former retail CEO warns. In the article Mark Cohen, a former CEO of Sears Canada, warns that there will be a wave of bankruptcies in the first quarter of 2023 for retail companies. Later in the article, former CEO of Gap and J. Crew, Mickey Drexler says, “I have never — maybe I don’t remember — seen as much discounting with as much merchandise with higher precents off.”
Valuations are at dirt cheap prices, industry veterans are crying wolf and sell side analysts are downgrading big names. If you want to be a contrarian in a discounted industry the time is now. Buying assets that no one else wants to touch typically results in strong future results.
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