Description

Macro Thesis: The United States is over-stored and this will ultimately hurt the retail industry, particularly specialty retailers. The U.S. savings rate has been negative for the past few years. Credit card debt on an absolute basis is at an all time high and the average credit card debt to median household income is also at all time high. The average American’s consumption power is at best flat over the past few years due to rising healthcare, gas, food and education costs. The only major category that has experienced some deflation over the past few years has been apparel. At the same time, there was an inflated asset bubble, which many consumers borrowed heavily against and gave them the false sense of increased purchasing power. These are main reasons why retail has been able to expand so much. Now that housing bubble has burst, this will likely cause consumption to ratchet back. I believe 2008 will be a major inflection point for many of these retailers.

1. The median home in the U.S. at the end of 2004 was $220,000. Eight months later the average median home increased to a peak of $259,000. Home prices at that time were increasing at a CAGR of 16-17%. If we assume the average LTV was 20% or 5x leverage, this resulted in a huge boost to consumer spending considering the median U.S. household income is $45-$50k and that over 70% of American households make less than $75,000. It was not until 2007 that we started to see the carnage from easy financing, which resulted in inflated housing demand and thus an asset bubble. At the end of 2007, the median home price was $233,000, which is only a total increase of 5.9% over the past 3 years.
2. I looked at a diverse mix of 75 retailers, which included 30 specialty apparel retailers as well as the major shoe, sporting goods, department store, home improvement, electronics, etc. companies. The total square footage growth for these 75 companies combined was about 20% over the past 3 years. My best guess is that these companies in total will increase square footage at about 5-7% in 2008 since many of these leases were signed before the middle of 2007. I just came back from the ICR XChange conference—the mantra from practically every successful specialty retailer was that they are not economists and that since their sales have been good, they will continue to expand if their concepts have not yet reached what they believe to be maturity.
3. Mall-based rents over this 3-year time frame are cumulatively up around 9.1%--this is due annual rent step-ups of around 3%. There are other costs that go into building and running a store, which have all increased over this time frame. The only costs that are possibly down is the cost to build out the stores—i.e. what the general contractor is paid due to increased competition for jobs since there is a lack of supply of new homes being built.
4. Almost everything Americans consume in the United States is up over the past few years, which in total has exceeded income growth and thus the average American’s real income is flat at best over the past few years.

a) Healthcare Costs: The average household in America spends around $3,500 on healthcare or about 7% of the average household income. Healthcare costs are expected to increase 6-7% per annum.

b) Gas Prices: The average cost per gallon has risen from around $1.80 to $3.00 over the past 3 years—a total increase of about 67%. There has not been a major new discovery of oil since the 1970s. Demand, which exceeds supply, is expected to only increase over time as emerging markets continue to grow.

c) Food & Beverages Costs: These increased 4.8% in 2007, 2.2% in 2006 and 2.3% in 2005. A large part of the reason for the increase in these costs is due to the rise in energy prices, which should continue to increase over the long-run.

I believe the best way to play this macro thesis is to short a basket of these retailers or simply short the XRT. I identified several retailers that I believe are likely to have the greatest stock price declines over the next year or two. The criteria was based on valuation, square footage growth, current operating margins relative to their 10-year average, inventory levels, prepaid expense levels and sales per square foot.

The most attractive retailers to short in order of most to least attractive are:

1) JCG: While top-line growth (due to productivity levels at all-time highs) is above average, square footage growth is well below average; inventory relative to sales is 1.3% above average and prepaid expenses as a % of sales (4.0% v. 1.8% avg.) and on a per square foot basis are well above the industry; D&A as a % of sales is well below average to the tune of 0.9%; valuation is very expensive at 16x TTM EBIT and over 2x TTM Sales; operating margins are well above its 10-year average

2) UBRN: While its top-line growth is in-line with the industry, its square footage growth is well above average; new stores do not have the same productivity levels as old stores and as a result sales per square foot has declined a bit; there are no inventory issues; however, prepaid expenses as a % of sales is about 1.0% above normal, but this is off-set by D&A as a % of sales being 1.2% above average; the valuation is very expensive at about 23x TTM EBIT and 3x TTM Sales; at the same time operating margins are right in-line with its 10-year average

3) GES: While top-line growth (due to productivity levels at all-time highs) is above average, square footage growth is well below average; there are no inventory or prepaid issues; D&A is about 0.8% below average, which could mean free cash flow is less than reported earnings; valuation is pricey at 12x TTM EBIT and over 2x TTM Sales; operating margins of 18.6% are at all time highs and significantly above its 10-year average of 3.2%; Pre-tax ROA over the past 3 years is unimpressive and well below average at 7.1%

4) BKE: Both sales and square footage growth are well below average; the company has done a good job of raising sales per square foot and thus operating margins, which are now about 15% above its 10-year average; inventory relative to sales is about 1.5% above average while prepaid expenses relative to sales is about 0.9% above average; D&A as a % of sales is a bit below average; valuation is full at 8.5x TTM EBIT and 1.4x TTM Sales

5) LULU: Top-line and square footage growth due to its very small base is well above average; sales per square foot have grown immensely over the past few years from around $700 to almost $1,500 and are currently about 3x the industry average; inventory relative to sales is well above average (22.4% v. 15.4%) while D&A relative to sales is a bit below (0.3%) below the industry; valuation is extremely expensive at almost 100x TTM EBIT and over 13x TTM Sales

6) ULTA: Top-line and square footage growth is well above the industry average; inventory relative to sales is well above (25.2% v. 15.4% avg.) the industry average; there are no prepaid issues and D&A accurately reflects maintenance capex; the valuation is expensive at over 25x TTM EBIT and 1.1x TTM Sales; also, pre-tax ROA of 13.0% is a bit below average

7) ZUMZ: Top-line and square footage growth is well above the industry average; inventory relative to sales is well above (18.5% v. 15.4% avg.) the industry average; there are no prepaid issues and D&A accurately reflects maintenance capex; the valuation is expensive at 12x TTM EBIT especially considering current operating margins are about 25% above its 10-year average; also, pre-tax ROA of 12.0% is below the group average

8) PIR: Sales growth is negative with flattish square footage growth due to sales per square foot declining; inventory as a % of sales has been rising to a current 27.9%, which is well above the average specialty retailer’s 15.4%; prepaid expenses as a % of sales are 3.0%, which is well above the group average of 1.8% and is especially high considering the lack of new store openings; D&A as a % of sales is 2.9%, which is below the group average of 3.6%--another red flag that could point to sustainable free cash flow being less than reported earnings; the company loses money and trades at just under 0.4x sales; its pre-tax ROA over the past few years has been negative; even if it gets back to its average 10-year margin, which is highly doubtful, it would only trade at 5.5x EBIT on current sales

9) DKS: Top-line growth is well above the industry average; there do not appear to be any balance sheet issues; the valuation is expensive at over 12x TTM EBIT and 0.9x TTM Sales especially considering current operating margins are about 20% above its 10-year average; also, pre-tax ROA of 10.0% is below the group average

10) WMAR: There has been no sales or square footage growth over the past couple of years; inventory as a % of sales at 37.2% is relatively high compared to most “category killer” retailers; valuation is expensive at over 24x TTM EBIT; while TTM EBIT margins stand at 1.0%, it is unlikely that it will get back to its 10-year average operating margin of 4.6%, but if it does it will only put the stock at 5.4x EBIT; also, pre-tax ROA over the past few years has been a dismal 5.1%

11) RNT: Top-line growth has been in-line with the retail industry and a bit above that of its direct comp, RCII; inventory/square foot at $80.4 is much higher than RCII’s $61.8; prepaid expenses as a % of sales are relatively high (2.8% v. 2.1% for RCII); valuation is pretty full at 7.6x TTM EBIT and over 0.7x TTM Sales; note that if inventory were to be in-line with RCII levels, it would wipe out most if not all of its earnings; pre-tax ROA over the past few years has been a mediocre 10.2% versus 14.0% for RCII, which is about the same for the retail group

12) ACMR: Sales growth (below the group average) has grown slower than square footage growth due to sales per square foot declining by 13% over the past couple of years; there does not appear to be any balance sheet issues; valuation is pretty full at over 27x TTM EBIT; even though current operating margins of 1.2% are well below its 10-year average of 4.4%, the valuation would still be over 7x EBIT if it were able to achieve that

13) JOSB: Top-line and square footage growth is a bit better than the group; inventory relative to sales at 38.2% is massively above the group average of 15.4% and well above its closest comp (MW), which stands at 24.2%; while there are no prepaid issues, D&A relative to sales is a bit below normal; on the surface valuation at 5.5x TTM EBIT does not appear expensive, but it likely is given the huge potential inventory issues coupled with the fact that TTM EBIT margins of 13.6% are well above its 10-year average of 7.8%

14) PSUN: Square footage growth is greater than sales growth, which means that new stores are not as productive as the existing base; top-line growth is well below the industry average; sales per square foot has declined over the past few years; operating margins are -3.5%; it trades at 0.5x sales; while its 10-year average EBIT margins is at 11.0%, it would need to achieve at least a 7.5% margin on current sales v. -3.5% TTM to get burned shorting the stock here

15) GPS: Top-line and square footage growth are basically nothing—well below the group average; there are no inventory or prepaid issues, but D&A as a % of sales (and on a per square foot basis) appears to be well below the group average by about 0.7%; the valuation is pretty full at over 9x TTM EBIT; even though operating margins are about 25% below its 10-year average, even if they get back to those levels, the valuation would be about 7x EBIT—not screaming cheap

16) ARO: Top line and square footage growth is in-line with the industry; there are no inventory or prepaid issues; D&A on a per square foot basis as well as a % of sales is well below the industry average and thus free cash flow could be less than reported earnings; the valuation is expensive at about 9x TTM EBIT given that operating margins are about 20% above its 10-year average

17) TWB: Growing its top line and square footage slightly below the industry; it has no inventory or prepaid expense issues and D&A as a % of sales seems to accurately reflect maintenance capex; however, the valuation at about 10x TTM EBIT seems to be a bit expensive given its margins are only slightly below normal

18) CWTR: Top line and square footage growth is above the industry average, but it is not getting commensurate top-line growth relative to square footage growth, which likely means that new stores are not nearly as productive as its existing base; sales per square foot, which is still way above average has come down considerably; inventory relative to sales is above average; there are no problems with prepaid expenses and D&A seems to more than accurately reflect maintenance capex; however, valuation is at about 10x TTM EBIT; while operating margins are below normal a lot would have to happen to get sales per square foot and thus margins back up—and even the stock would only trade at 6.5x EBIT

The key thing to know is that retail is a highly fixed cost business and that at the end of the day it is all about how much a company can leverage each square foot. The retail industry continues to expand while the consumer will continue to ratchet back spending—this will not end well.

The other thing that could be a huge bonus to the short thesis, which I’m not counting on is China raising apparel prices. I first heard this second hand, but most recently from various companies at the ICR XChange conference. If this happens either of one of two things will transpire: a) Retailers eat the increase in costs, which hurt gross/operating margins and thus operating income; or b) Retailers pass on the increase in costs, which lowers demand and thus sales, which will hurt operating income.

Disclaimer: My firm and I may or may not be short any of these stocks. This is not a recommendation to buy or sell securities. Please do your own work and do not rely on this report for anything.

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