Are Retail Stocks The Next Subprime Meltdown?

A prescient group of investors piled up staggering profits
during the 2008 financial crisis by shorting the subprime
industry. Now, many investors say they see the same opportunity
in bricks-and-mortar retailing in the U.S., which has been
thrust into an accelerating pace of decline as it faces
competition from Internet and e-commerce giants like
Inc. (AMZN). The retail
industry’s decline is presenting what amounts to the next big
short for investors who excel in the art of short selling.

The Next Big Opportunity

Events seem to confirm that diagnosis. Right now, 18% of U.S.
retailers, twice as many as of the start of 2017, have bond
ratings of CCC or lower, placing them among the highest risk junk credits,
per a recent FT article. Additionally, at
least 19 major U.S. retailers have filed for bankruptcy
protection so far in 2017, per CNBC, with privately-held Toys “R” Us
Inc. as the latest high-profile casualty.

“We think the magnitude of this short could be bigger than
subprime,” Stephen Ketchum, founder and CEO of $13 billion
hedge fund Sound Point
Capital Management LP, said in a detailed FT story on the industry’s
crisis in July.

In his remarks to the FT, Ketchum likened online merchant Inc. (AMZN) to
an iceberg and retail to the Titanic. Neither he nor the FT
singled out specific retailers, but the shares of many big
names have taken on water during the past 12 months. These
companies’ future will be determined by how the shakeout
unfolds. In the past year, Macy’s Inc. (M) has fallen 43%; Kohl’s Corp.
(KSS), -2%; JCPenney Co.
Inc. (JCP), -61%; Target
Corp. (TGT), -15%; Sears
Holdings Corp. (SHLD),
-38%; and Nordstrom Inc. (JWN), -17%. Bucking the trend so far
is upscale jeweler Tiffany & Co. (TIF), up 29%.

Contrarian View

To be sure, some investors are finding a contrarian play in
retailing, a third FT article reports. Cole Smead, a
portfolio manager at $2.2 billion equity fund Smead Capital
Management, has accumulated shares of Target, which he sees as
attractively priced relative to free cash flow. This ratio
currently is 9.0, per Investopedia data. Meanwhile, other fund
managers mentioned by the FT have scooped up shares of Macy’s
and JCPenney, whose current price to free cash flow
ratios are 9.6 and 12.4, respectively. (For more, see also:
Retail Stocks Hammered By Amazon May Be Good Buys.)

Reasons to Short Retail

But stock investors face enormous risks in the retail space.
The dramatic rise in online shopping is just one problem
besetting traditional brick-and-mortar stores, and the shopping
malls in which many of them are located. The other is
overbuilding and overexpansion. “This created a bubble, and
like housing, that bubble now has burst,” is what Richard
Hayne, CEO of Urban Outfitters Inc. (URBN), said earlier this year, per
the FT. He went on to say that the vicious circle of store
closures and declining rents in retail malls is likely to
accelerate. With growing numbers of vacant storefronts,
shoppers have less reason to visit these malls, leading to yet
more store closures. Urban Outfitters, by the way, was removed
from the S&P 500 Index (SPX) earlier this year, due to
declining market
cap. Its share price has fallen 37% during the past 12

Earlier this year, Bank of America Merrill Lynch released a
report estimating that U.S. retail floor space has fallen 10%
since 2010, during which department store revenue fell by 18%,
per the FT. As evidence of the overbuilding cited by Richard
Hayne of Urban Outfitters, international accounting and
consulting firm PricewaterhouseCoopers calculates that the U.S.
has about 24 square feet of retail floor space per capita,
versus 11 for second-place Australia, and somewhere between
only 2 and 5 in Europe. also per the FT. In 2016, 82.6 million
square feet of retail floor space were lost in the U.S., an
eight-year high, and announced closures for 2017 already had
approached that number by mid-year, the FT adds.

Too Many Stores

Meanwhile, recent research by IHL Group, which serves the
retail and hospitality industries, indicates that the U.S.
actually will have more retail stores at the end of 2017 than
at the beginning, according to Forbes. More than offsetting
the number of closures announced by bankrupt electronics
retailer Radio Shack and various apparel stores is an
aggressive expansion binge led by discount and convenience
stores, most notably: Dollar General Corp. (DG); Dollar Tree Inc. (DLTR); 7-Eleven Inc., a division of
Japan-based Seven & I Holdings Ltd. (3382.Tokyo); and
Circle K, a division of Toronto-listed Alimentation Couche-Tard
Inc. (ATD.B). The locations being vacated by failing retailers
typically are not suitable for these growing store categories,
hence the increased number of empty storefronts even as the
number of stores increases, Forbes notes.

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