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 Amazon.com 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 Amazon.com 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%.
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: 7 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 months.
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.