Retail Short Idea Q4 2021 - Alpha University

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PREPARED BY: Chris Stanford

DATE: 10/23/21

TOPIC: Shorting Retail Stocks

In the present climate, the professional investment community is progressively focused on inflation. The best-performing industries over the last year were the commodity and transportation sectors. The long inflation trade feels extremely overdone. Inflation will likely stay elevated relative to prior years. That said, the risk versus reward on the long side is horrific. Our preferred trade is identifying major retailers that are overly sensitive to global supply chain shortages. A lot of the large retailers are trading at all-time /multi-year highs.

Last year we saw a huge spike in retail sales post-pandemic. Most economists agree the trend is short-lived. The retail sales data has already normalized, yet the companies continue to trade at steep valuations. The industry as a whole looks cheap when you compare it to the other industries. For the most part, these companies are priced based on the deterioration of fundamentals. It’s no secret that E-Commerce players like Amazon make it difficult for middleman retailers to survive. Revenue growth rates have slowed dramatically. Additionally, margins have suffered as a result of the increasing competition.

SUPPLY CHAIN SHORTAGES

Major retailers are citing supply chain issues as the biggest concern for the upcoming quarter. Q4 is typically the best quarter across the industry. However, this year we are seeing shortages in things like Christmas trees, sweaters, cardboard, food, clothing, semiconductors, oil, and natural gas. Supply chain analysts anticipate this will extend far beyond the holiday season. Labor shortages are at the heart of this and they are going to take time to resolve.

ECONOMIC GROWTH SLOWING

Goldman Sachs is one of the various investment banks that recently lowered their year-end GDP forecasts. The explosive post-pandemic growth is not sustainable. GDP is likely to normalize toward the second quarter of 2022. U.S. retail sales are projected to drop by 2%, which would make it one of the worst years in over a decade. Inflation, labor shortages, and supply chain issues are starting to catch up with us. Our team is moderately optimistic about U.S. economic growth. However, the stocks in the retail industry are priced to perfection.

INABILITY TO ADAPT TO E-COMMERCE

The previous year’s consumer spending and retail sales figures were exceptional. Quarter-over-quarter growth was beyond anything we’ve seen in years. Retail stocks made a prodigious comeback during the pandemic, but the excitement has led to a wide discrepancy in stock prices from core fundamentals. Investors were avoiding these companies pre-pandemic for a reason. They have been struggling to operate in a world dominated by Amazon. Online E-commerce has made it really difficult for middleman retailers to survive. A major part of Amazon’s competitive advantage is faster shipment delivery times, and cheaper products. Competition from Amazon has compressed margins across the entire industry. Various retailers have been forced into bankruptcy. We argue that these fundamentals still trump the short-term excitement related to the previous year’s retail sales recovery.

OUR PLAYBOOK

Our team has identified a handful of retailers we believe to be overvalued. Over the past week, we started to get exposure across the industry. Our preferred vehicle is a combination of put options and short-call spreads. One of the most important aspects of any trade is timing. It’s important to recognize that this is not a one-week or one-month trade. I estimate that this idea will take at least three to four months to play out. The ideal structure is to sell a call spread or buy long-term puts that extend past January.

Major retailers are warning us of an upcoming global shipping crisis during the holiday season. Despite the fundamentals, investors are likely to continue to overvalue this industry until holiday season earnings come out. The size of our positions collectively will make up less than 5% of the portfolio. Although we are confident in our analysis, I’m not convinced that others will so easily change their opinions. The following companies are some of our upcoming/currently ongoing plays:

$M (Macy’s)- obviously does not have a business model that is compatible with the online e-commerce industry. Amazon and Walmart both posted record year-over-year sales. Macy’s did $18 billion in revenue last year, down 28% from the prior year. Yet the stock is up 50%. The company is valued at $8 Billion. That seems cheap until you dig into the net profit figure. They lost $3.9 billion on the bottom line. Additionally, we’ve seen the firm’s total shareholders equity decline rapidly to only $2.5 Billion. Friday, October 22nd our team bought a January 21st $27 put. Also, we bought the May 20, 2022, $27 puts. The stock was trading at around $26 at the time.

$DKS (Dick’s Sporting Goods)- Dick’s sporting goods is one of the better-positioned retailers. That said the average y/y sales growth is only 3%. Last year was one of the best years in a long time for a lot of retailers. Dicks only grew by 9%. Yet the stock is up over 750% from its 2020 low. It’s up about 150% from its 2017 highs. The company is currently valued at 11 Billion, and they have $2 billion in shareholders equity. Last year’s net profit was $500 million. The company is priced at roughly 22 times earnings. Normalized net profit is usually closer to $300 million. I think Dick’s is expensive when you consider the slow growth, and the overall industry trends in E-commerce. Friday, October 22nd our team bought a January 21st $120 puts. The stock was trading at around $125 at the time.

$TJX(TJX Companies): was one of the various retailers contemplating bankruptcy amid Covid. Fast forward a year and a half and now the stock is at all-time highs. $TJX is up 100% from covid lows. Currently, the company has a $77 Billion market cap and an 8% average sales growth rate. However, last year’s sales were down 22% year over year. Total revenue came out to $32 billion. Net income was only 90 million. Which means they had a 0.28% profit margin. Normalized net margins are roughly 6%. TJ Maxx is priced at 25 times earnings. They have $5 billion in shareholder’s equity and the stock is priced at 13 times book value. An ideal structure would be to sell at the money call spreads against TJ Max.

$NKE(Nike): is one of the retailers that benefited from the coronavirus. They grew sales by 18% last year to $44 billion. It was the best year they’ve had over the last 5 years. Nike has a 12% net margin which comes out to 5.7 billion. Priced at 45 times earnings and 27 times EBITDA. They are better positioned than the middleman retailers like TJ Maxx and Macy’s, but they are priced to perfection. The market is failing to reprice Nike based on upcoming supply chain issues. The stock is up over 60% from 2020 highs and is currently at all-time highs. I’m less bearish on Nike than some of the other retailers that I listed above. They have a good direct-to-consumer business. The other companies do not. Therefore we are looking to sell a spread after holiday season earnings are reported. Will also buy an intermediate period put.