Teeny-bopper fashion retailer Aeropostale made headlines last week when it filed for Chapter 11 bankruptcy, had its stock delisted from the NYSE, and announced a plan to close 154 out of 800 stores – all after a disastrous $136.9 million net loss in 2015.
This morning, Gap Stores reported lousy sales and plans to close stores to deal with what it called a “tepid macro environment for apparel retail” while admitting that changes it made to its product designs and selections have been slow to catch on. Gap stock plunged 10% after the announcement.
And last month, Sears’ slow-motion death march continued with an announcement that the company is closing 70 more Sears and K-Mart stores.
The retail industry is in crisis. Buffeted by structural changes such as the explosion of ecommerce, weak consumers and an increasingly selective consumer base, there’s been an epidemic of mall-based retailer bankruptcies lately (Sports Authority, RadioShack, Aeropostale, American Apparel, Pacific Sunwear…) and it’s only going to get worse. Thanks to heavy borrowings by their private equity owners (in some cases to pay dividends to reduce or eliminate their investments in these companies), most mall-based retailers that were taken private are likely to default on their bonds when they reach their maturity dates over the next couple of years…
When that happens, these six companies will be the first to go.
And you’ll be able to make a sizeable profit – if you do this.
The Slow Bleed In The Retail Industry Is About to Turn Fatal
The corporate credit cycle is at least two years from bottoming. Unlike previous default cycles, which occurred in a normal interest rate environment, this default cycle is delayed by low interest rates that let borrowers (particularly those owned by private equity firms that have a huge incentive to delay default as long as possible to prolong their management fees) delay restructurings and bankruptcies longer than in earlier cycles. The fact that so many energy companies filed for bankruptcy so quickly shows the severity of the energy price collapse, but other industries like retail are bleeding more slowly.
However, that trickle is now becoming a steady stream.
|A Bankruptcy Timeline
- February 2015: Cache Inc., women’s dress retailer, files Chapter 11.
- February 2015: RadioShack files Chapter 11.
- April 2015: Frederick’s of Hollywood files Chapter 11.
- June 2015: Anna’s Linens files Chapter 11.
- September 2015: Quiksilver, surfwear retailer, files Chapter 11. In January 2016, the company emerges from bankruptcy; it is now controlled by private equity firm Oaktree Capital.
- October 2015: American Apparel files Chapter 11, after years of losses.
- January 2016: Wet Seal, teen fashion retailer, files chapter 11.
- February 2016: Hancock Fabrics files Chapter 11 for the second time, closing 70 of its stores and liquidating inventory at the other 185.
- March 2016: Sports Authority files Chapter 11, saying it would close 140 of its 450 stores.
- April 2016: Pacific Sunwear of California files Chapter 11.
- April 2016: Vestis Retail Group, the operator of sporting goods retailers Eastern Mountain Sports, Bob’s Stores, and Sport Chalet files Chapter 11, closing all 56 stores.
- May 2016: Aeropostale files Chapter 11.
The retail industry is experiencing a slow death spiral with mall-based retailers melting away before our eyes like the Wicked Witch of the West. The following companies’ bonds are trading at distressed levels and are waiting for their maturity dates over the next several years to default:
- J. Crew
- Rue 21
- Claire’s Stores
- Nine West Holdings
- Men’s Wearhouse
Unless their private equity sponsors step up and repurchase their bonds, these companies are toast. With the exception of Gymboree, which just tendered for $40 million of bonds at 52% of par (which included a large tender premium), none of these sponsors have stepped up to do so, suggesting they lost confidence in the businesses and are just milking them for fees. (I’ve discussed the opportunistic behavior of the private equity market here.)
The fate of the retail industry is closely tied to the junk bond market. And just as investors jumping back into equities to chase the recent rally are likely to get burned, those investing billions of dollars in the junk bond market are also tempting fate. There is $1.2 trillion of high yield debt maturing between now and 2020 according to Standard & Poor’s. Nearly 60% of this debt was issued between 2012 and 2014 when the average yield on high yield debt was 6.2%. The average yield rose to 8% at the end of 2014 and passed 10% early in 2016 before dropping back recently to roughly 7.7%, but it remains elevated for the weakest credits. There is $280 billion of debt rated B- or lower maturing through 2020 with most coming due (or meeting its maker) in 2019 and 2020, so the day of reckoning may be delayed for a while.
But when it comes, it will come with a vengeance.
Weak sectors with the largest amounts of debt maturing through 2020 include media and entertainment ($220 bn), oil and gas exploration and production ($112 bn), retail and restaurants ($81 bn), financial institutions ($99 bn), and metals, mining and steel ($44.3 bn).
It will be very surprising if the U.S. economy does not experience a recession (or worse) between now and 2020, and a recession would accelerate the demise of many of these companies. The high yield market benefitted from unusually low interest rates since the financial crisis, but those conditions are coming to an end not because of the Fed’s actions but because the market has repriced risk.
By 2020, you can expect most of these private-equity-owned retail stores to be bankrupt and closed – and malls across America to see higher vacancies and lower revenues.
Beware The High-Yield Market (But Profit from The Fall)
Successful investors will identify specific companies that can weather the storm: companies with adequate margins of safety to survive a prolonged or sharp economic downturn. And anyone who thinks that a troubled high yield bond market is not a problem for Corporate America is making a serious error.
Investing in ETFs, mutual funds and other broad-based vehicles over the next several years is unlikely to generate satisfactory risk-adjusted returns and could end up blowing up in investors’ faces, particularly since liquidity conditions in the bond market markets are simply awful.
Investors should avoid the fixed income markets until further notice. The Fed has destroyed bonds as an asset class. The biggest bond funds in the world are generating terrible nominal returns. When those returns are adjusted for inflation and the risks taken to generate them (derivatives, leverage, etc.), they are even worse. When they are adjusted for the fact that the currencies in which they are denominated are being actively devalued by central bank policies, they are nothing short of catastrophic for investors. Remember – just because the dollar is strong versus other fiat currencies does not change the fact that the Fed is destroying its value in absolute terms.
Investors need to earn at least a high single digit return to maintain their buying power in constant currency terms. There is virtually no opportunity for them to do so in the fixed income markets except in specific situations such as beaten down high yield bonds such as Sprint Corp. NRG Energy, Toys R Us and fallen angels (investment grade bonds downgraded to junk status) that involve a meaningful amount of risk. (I’ve recommended a fairly low-risk way to play the fallen angels market here.)
While there are a number of individual bonds that are attractive investments for those with patient capital, but the overall market remains a falling knife. In particular, investors should avoid high yield bond ETFs (JNK and HYG), as well as bank loan ETFs and mutual funds, which will continue to underperform as the corporate bond markets remain distressed for the foreseeable future.
Market conditions will further deteriorate as companies confront the need to refinance bonds in an environment where their cost of capital rose exponentially due to the sharp drop in their bond prices. This will spread the pain beyond the troubled energy and basic industry sectors to the rest of the market.
If you own bonds of any of the dying retail companies above – J. Crew, Claire’s, or any of the rest – it goes without saying that you should get rid of them now.
And in order to profit, I suggest that you buy long-dated puts on any one of several mall REITs: Simon Property Group Inc (NYSE: SPG) and General Growth Properties Inc (NYSE: GGP) would both be good choices. Malls are going to be seeing many of their tenants go bust over the next couple of years.