"The Retail Bubble Has Burst" - Summarizing The Dark 4Q Earnings Commentary Of Retail CEOs

Amazon's willingness to sell almost any product imaginable at a loss, combined with a massive bubble in retail real estate square footage courtesy of decades of low interest rates seems to finally be catching up with the traditional bricks-and-mortar retailers of America. 

As evidence, Scott Krisiloff of Avondale Asset Management compiled the following sample of relatively downtrodden commentary from America's largest retail CEOs, all of who seem to be throwing in the towel on hopes of any near term upside for their industry:

Everything is not awesome, in fact, it's kind of awful

“Our industry is the midst of a seismic shift, and, of course, you read the headlines. In fact, many of you write the reports, we’re operating in an incredibly challenging environment. All across the retail industry, many of our competitors are aggressively rationalizing their assets. They are closing stores, exiting markets. They’re cutting costs just to keep their heads above water. We’ve not seen this number of distressed retailers since 2009 in the Great Recession.”   - Target CEO Brian Cornell

Cheap debt created a massive retail real estate bubble that is now bursting right before our eyes

“Retail square feet per capita in the United States is more than six times that of Europe or Japan. And this doesn’t count digital commerce. Our industry, not unlike the housing industry, saw too much square footage capacity added in the 90’s and early 2000’s. Thousands of new doors opened and rents soared; this created a bubble, and like housing, that bubble has now burst. We are seeing the results; doors shuttering and rents retreating. This trend will continue for the foreseeable future and may even accelerate.” —Urban Outfitters CEO Richard Hayne (Retail)

Profitability "race to the bottom" is on as brick-and-mortar stores make "investments" (a.k.a. "slashes prices") to drive volume

“We certainly view 2017 as a year of investment. In 2018, we’ll continue to transition as these different initiatives begin to mature. As we get into 2019 and beyond, we certainly expect stability and a return to growth…We’ve got to invest to grow. We’ve got to reimagine our stores. ” —Target CEO Brian Cornell (Retail)

 

“we plan to do what any good portfolio manager would. Invest resources in the most promising opportunities, diversify to lower risk, and increase liquidity…Our highest priority is where we’ve had the most recent success, digital” —Urban Outfitters CEO Richard Hayne (Retail)

Inflation may not be as strong as advertised

“Regarding deflation, overall, primarily in the US, we have seen deflation in the 1%, 1.5% range in February. Departments such as foods, sundries, frozen foods, liquor meat, dairy showed the most deflation on the foods and sundries side. On the non-food side consumer electronics continue to be deflationary, primarily in the TV category…The collective view is inflationary, or less deflationary, for the next few months and maybe a little inflationary, but it’s a crap shoot.” —Costco CFO Richard Galanti (Retail)

 

“we also have to acknowledge the ongoing challenges facing our industry. Our customers are facing a difficult retail environment due to deflation and increased competition. We view deflation as cyclical, inflation will come back at some point but while it’s here, it’s leading to some very real challenges for us and our retail customers.” —UNFI CEO Steven Spinner (Food Distributor)

Retail real estate glut + Market share loss to online = Disaster for REITs

“This would be fine if the increase in DTC sales were wholly additive, but they’re not. Digital shopping is partially replacing store shopping and thus is negatively impacting store traffic and store generated sales. Flat to negative store ‘comps’ are causing occupancy deleverage and eroding four-wall margins.” —Urban Outfitters CEO Richard Hayne (Retail)

But, chin up because this is all 'good news' as retail shares will tank and create opportunities for those on wall street who survive

“these inflection points come around every generation or so. And strong retailers endure, while others, well, they don’t. Pick your era defining change throughout history from downtown department stores to suburban malls, catalogs, e-commerce.” —Target CEO Brian Cornell (Retail)

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Meanwhile, as we pointed out earlier this week, the biggest losers in this retail melt down will inevitably be the investors in America's massively levered REIT companies. 

In fact, the latest note from one of the world's most vocal mega-bears, Horseman Capital's Russell Clark, perfectly summarized the slow-motion train wreck that is currently wreaking havoc on mall REITs in a note titled "Mall Rats":

“Intriguingly we have started to see volumes of real estate transactions for shopping malls fall. This means that the number of transactions to buy or sell properties is beginning to decline. Last time this happened, rents began to fall a year later.

His full note is below:

MALL RATS

Shopping mall REITS have been a fantastic investment over the years. Not only have they provided investors with large capital gains, they have also typically offered above market dividend yields. My interpretation of the REIT model is that the operator collects rents from a diverse number of retailers. This is then passed on to the end investors after costs and financing. The REIT manager reduces risk by diversifying the retailers paying rent, and by also spreading the risk geographically. If the REIT manager can acquire more real estate assets at a yield higher than what it needs to pay out as dividend yield, then the REIT can issue more shares and grow indefinitely. Mall REITs have generally done well, except during the financial crisis.

However, it seems to me that North America could well have too many shopping malls. On a per capita basis, the US has twice the space of Australia and 5 times that in the UK.

One source of REITs revenue growth comes from acquiring more malls. Intriguingly we have started to see volumes of real estate transactions for shopping malls fall. This means that the number of transactions to buy or sell properties is beginning to decline. Last time this happened, rents began to fall a year later. Perhaps it’s a sign that buyers believe rents have some downside risk?

Many people in the market are aware of the problems that the large department stores in the US are currently facing, and their resultant plans to retrench. This affects two of the largest shopping mall REITs that have the department stores as tenants. The reality is that the shopping mall REITs charge extremely low rents to the department stores. The large shopping malls use the department stores to lure traffic, and then make their money from higher rents charged to speciality retailers. Often the per square foot rent of the specialty retailer can be 30 times or higher that paid by the anchor tenant. Looking at the top 2 shopping mall operators, they disclose their top rent payers. Recent share prices performance of 8 shared tenants has been poor, and management commentary has seeming implied that they may also be looking to reduce store count.

It should also be pointed out that many tenants have a clause in their lease to reduce rents should an anchor close a store. Thus, even though the loss of rent due to an anchor closing is minimal, the knock-on effect of reduced rents from the remaining tenants is a serious concern for the REITs.

One of the other problems that shopping mall REITs face is that the size that the large department stores take up is more than 400 million square feet. The largest and most successfully specialty retailer is TJ Maxx which currently has 100 million square feet. It is difficult to see any single retailer quickly being able to fill the space made vacant by department store closures.

Back in the lead up to the financial crisis we found that the share prices of REITs and their tenants were very closely related. Recently we have seen tenants share price weaken again, but REITS remain relatively strong.

Investors are advised to exercise caution with the shopping mall REITs