Tuesday, July 17, 2012

Retail: Is It Different This Time?

Many large, recognizable retailers are trading as if their business models are dead. For example, among others, Staples, Best Buy, and Office Depot all trade at P/E's under 10 (in some cases, quite a bit under!) while the 45-year old RadioShack sells for barely more than its net current assets. Investors appear to have abandoned ship on the fear that Amazon is going to take all of these guys (and others) under. I'm much more pessimistic about our ability to make such predictions.

First, we're just not that good at making predictions, especially about the future. Anecdotal evidence of this has been discussed repeatedly on this site (e.g. here, here and here) but more importantly so has been the statistical record. It's why governments do a poor job picking successful industries, and it's part of the reason why countries that rely on free-market capitalism have higher standards of living than those with central planning. Back to the subject at hand, it's also why value screens and things like the magic formula work; since we are so bad at predicting, you'd do much better than average just by buying what's cheap!

Second, even if we can predict which companies are stronger and which are at risk, how do we know how the economics of the situation will play out? There are no patents in this industry, which allows everyone to copy whatever works. For example, a company with purchasing power like Best Buy can offer more goods online than it does in stores (matching Amazon) and in-store pickup (besting Amazon), while a company with local economies of scale like Staples can offer same-day delivery (besting Amazon).

As more sales go online, the cost of retail space may fall, allowing bricks and mortar retailers to pass on the pain to retail landlords. Already, we see lease rates have fallen. For example, appliance and electronics retailer hhgregg has been profitably increasing its store count and raving about the economics of the lease rates it is currently able to pick up (in large part thanks to the exit of Circuit City). At the same time, Best Buy sees a 20% IRR on its small-format stores, suggesting RadioShack's problems are more internal (i.e. they can be fixed) vs external.

At the same time, Amazon has been enjoying a sales tax advantage over its bricks and mortar brethren. But it increasingly looks as if that advantage may be going away. Many states are in the process of implementing sales taxes on goods purchased online, which would put the retailers back on a level playing field. We also have to be wary of falling prey to The Halo Effect, the term (and title of the book) used by Phil Rosenzweig in describing business delusions. When share prices fall, investors and the media tend to see the negatives far more than they do the positives. But why is a company like Staples more likely to crumble in the face of the Amazon threat today than, say, two years ago when its share price was double what it is today? (Hint: It isn't! We're just more scared now because its price is lower, but when sentiment is negative and prices are lower is precisely when you are better compensated for taking on risk.)

Finally, for those of you who think bricks and mortar is dead, consider Amazon's next step. The company is apparently opening its first store soon! Clearly, even Amazon thinks there's a future in bricks and mortar.

Don't get me wrong; I'm not saying these and other retailers don't face challenges. But they've faced challenges before. There have been unemployment crises, consumer leverage crises, terrorist crises, tech-bubble financing for competitors and other challenges all in the last 15 years. All of these have required changes to business models to better suit customer needs; we're hard-pressed to know whether these changes will improve or hurt each of these businesses' performance in the long-term. As such, we may be better off accepting that we just can't predict what will happen, and therefore we would probably do well to buy these companies when they are very cheap.

Disclosure: Author owns a few retailers, as discussed on the Stock Ideas page

1 comment:

Anonymous said...

If you kiss as many frogs as you apparently do, you'll collect a football team of princes.

Parading each one around gives the illusion of investment management acumen. But your record indicates otherwise.