It did not take a genius back in 1994 to realize that Jeff Bezos’s Amazon would some day imperil bricks-and-mortar retailers.
What did require genius back then was to answer these questions: What would it take to turn e-commerce’s promise (for consumers) and peril (for retailers) into a meaningful threat to traditional retailers? When would that threat create an opportunity to profit from the collapse of those retailers? How should investors bet on that collapse?
In 2017 it is easier to come up with some short answers: Provide consumers with wide product variety — for example, in 2015 Amazon increased by 87% the number of apparel and accessory products on its website when it sold $16.3 billion worth of apparel, lower prices, quicker delivery, and excellent service; Maybe 2016 but it’s just getting started; and seek out short candidates among debt-laden retailers and commercial mortgages or buy Amazon stock. (I have no financial interest in the stocks mentioned in this post).
What prompted this line of thinking was my March 2017 visit to Laguna Beach, Calif. for an escape from the cold Boston weather. I took some bad advice and visited Newport Beach — spending a few hours in a huge shopping mall there called Fashion Island — all of which I found disappointing.
I was overwhelmed by the massive — and likely very costly — apparel retailer spaces leased by Macy’s, Nordstrom, and many others. As I strolled through the floors I was struck by the utter absence of potential or actual customers.
And that set me on a search for data to evaluate whether my guess that big financial trouble was ahead for these companies was just an isolated hunch or a meaningful trend.
Here are four reasons to think it is meaningful trend:
- Four-fold increase in likely store closures this year. According to Bloomberg, Credit Suisse analyst Christian Buss estimates that there will be 8,640 retail store closings in 2017, up 232% from roughly 2,000 in 2016. If Buss is right, 2017 could surpass the previous peak of 6,200 in 2008. Examples abound, Payless (the shoe chain) “filed for bankruptcy and announced plans to shutter hundreds of locations. Ralph Lauren said it will close its flagship Fifth Avenue Polo store; and the [Apax Partners-owned] teen-apparel retailer Rue21 — which has about 1,000 stores — is preparing to file for bankruptcy as soon as this month, according to Bloomberg.
- 10% of U.S. retail space expected to close or be converted this year. “Over 10% percent of U.S. retail space, or nearly 1 billion square feet, may need to be closed, converted to other uses or renegotiated for lower rent in coming years,” CoStar Group told Bloomberg.
- Glut of lower “class” malls. One analyst, Cowen’s Oliver Chen, says that high-end malls continue to perform well. But so-called C- and D-class shopping centers — which account for 30% of the 1,200 total malls — are in the most trouble.
- Retailer’s inability to counter Amazon’s e-commerce dominance. E-Marketer reports that Amazon took 53% of all e-ecommerce growth in 2016 with the remaining 47% shared by the rest of the industry.
One problem with my thesis is that I was surprised to find that mall operators are profitable. Here are two examples:
- General Growth Properties (GGP) has recovered from its 2008 woes to become a shrinking REIT that owns and operates 126 retail properties in the U.S. with revenues that have declined at a 1.9% annual rate in the last three years while sporting a 34% operating margin, according to Morningstar.
- Simon Property Group is the largest mall owner and operator REIT with revenues that have grown at a 6.2% annual rate in the last three years while sporting a 50% operating margin, according to Morningstar:
And the one that owns Fashion Island is Irvine Company, a privately held company that “since 1864, has been one of California’s largest landowners, evolving from a ranching and farming operation to one of the premier real estate investment companies and master planners in America.”
REIT analysts remain bullish. Robert Schulz, a credit analyst at Standard & Poor’s told Dow Jones, “Well positioned retail REITs, when faced with the prospect of taking back space from weak tenants that are shrinking their physical store footprint, will manage repositioning successfully, partly because they have the financial resources to do so.”
However, Dow Jones wrote, “malls in weaker locations that face more competition could suffer from department store closures if the departures trigger a domino effect, allowing tenants to demand lower rents or vacate entirely.”
If 2017 is likely to feature record levels of store closings and REITS are not endangered, how could an investor profit from it?
Here are three possibilities.
1. Short endangered retailers
Other small retailers, HHGregg, Gordmans Stores, and Gander Mountain all “entered bankruptcy this year. RadioShack, meanwhile, filed for Chapter 11 for the second time in two years,” noted Bloomberg.
Investors might consider whether companies such as Sears Holdings — with $1.5 billion in negative free cash flow and stock that’s down 92% from $131, its 2007 high, Macy’s and J.C. Penney which are “shutting hundreds of locations combined,” according to Bloomberg, will be able to continue to restructure without filing for bankruptcy.
To help make that decision, investors should only borrow shares with the hope of repaying the share-loan by buying them back in the open market if they think that a bankruptcy filing is very likely.
It looks like many investors are betting on a further decline in Sears — 76.4% of its float was sold short as of March 2017, according to Morningstar.
2. Bet on a decline in the Commercial Mortgage Backed Securities (CMBS) ETF
The iShares CMBS ETF tracks fixed income securities that are backed by loans on things like office buildings, retail properties, and hotels. If you believe that those retail properties are going to default on their mortgages, this index could decline — but because the index tracks office buildings and hotels, this is hardly a pure play.
In other words, you might need to do what the protagonists in The Big Short did — hire Goldman Sachs to construct for you a vehicle to bet specifically on a rise in defaults on loans to operators of apparel retail stores.
3. Buy Amazon Stock
Amazon is run by the world’s second wealthiest person, Jeff Bezos. As I wrote in my book, Disciplined Growth Strategies, he is one of a few CEOs who offer investors a rare and valuable bundle of skills.
Bezos founded the company and took it public, it’s over $100 billion in revenue, it’s growing at over 20% a year, he attracts and motivates top talent to toil relentlessly on providing a great customer experience, and he keeps investing in new growth opportunities.