Last Year Was Horrible In Retail, But This One Looks Worse
Bed Bath & Beyond is just the latest retailer heading into bankruptcy due to a secular change in how … [+] Americans shops. With interest rates rising and recession looming, we’re likely to see more companies in distress in the coming months.
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For most investors, 2022 was a year of ups and downs, but mostly downs. In its worst year since the Great Financial Crisis, the S&P 500 finished out the year down by almost 20%. It was even worse in the tech space, with the NASDAQ Composite down by 33%. By comparison, the 8.8% decline in the Dow Jones Industrial Average (DJIA) almost seems like good news.
Things were no better in the fixed income space, with one analysis calling 2022 the worst-ever year on record for US bond investors.
The Fed continued to push interest rates higher, finishing the year with a total increase of 425 basis points. Analysts predicted just a 75 bps rise last January. Following the December increase, the Fed funds rate is now at its highest since 2007.
Looking forward, most economists still predict a recession and expect it to hit either late this year or in early 2024. That makes for an environment in which the distressed securities opportunity set is growing substantially.
The biggest distressed company story right now is Bed Bath & Beyond BBBY (BBBY). Like most brick-and-mortar retailers, BBBY has been a victim of a secular change in how Americans shop. Retailing was always a tough business, but it got progressively more difficult for most companies with the advent of the big box stores. Big box stores covered a vast range of product categories, had a lower inventory cost, and thus offered more attractive pricing for customers. Then, Amazon AMZN and the convenience of online shopping burst onto the scene, snapping up further market share from the older legacy retailers.
The systemic problems affecting BBBY are no different from those faced by so many other chain retailers—they have lots of locations, but they don’t own the underlying real estate and have pricey lease obligations on those properties. For BBBY, those obligations entail more than 940 locations and over $1.7 billion of total lease liabilities. And like other traditional retailers, they are forced to compete with new entrants into the business that don’t have those kinds of fixed costs. A company like Amazon only has warehouses and distribution centers, not stores, so they can source their supply directly from manufacturers and, in many cases, don’t even have to buy the inventory until after the order is processed. Brick-and-mortar retailers simply can’t keep up, as their stores need to fill their space with expensive inventory, have a lower inventory turnover, and pay fixed monthly rent all along.
When recent results were released and it appeared that BBBY was heading toward bankruptcy, I once again studied their balance sheet. Their building leases alone amount to a $1.7 billion obligation on their balance sheet. That liability is balanced by “operating lease right of use assets,” which match the liability dollar for dollar. However, many investors may not realize that this line item isn’t a real asset. It’s an intangible set up for accounting purposes to offset lease liabilities. The problem here is that, in the case of a liquidation, that asset will provide little value if anything to creditors.
Investors have lost billions of dollars investing in old line retailers, but there are still plenty of bankruptcies to come, and BBBY will certainly be one. Unfortunately for creditors, in retail bankruptcy land, there’s usually nothing there.
In the case of BBBY, they do have over $1 billion of inventory, but that’s not enough to cover their outstanding debt and even less so if it gets liquidated at any reasonable discount. Separately, their latest balance sheet shows over $1 billion of plant, property, and equipment. However, when you peel back the onion and read the footnotes, over 90% of that value comes from leasehold improvements, fixtures, and equipment, all of which will be virtually worthless in a bankruptcy liquidation scenario. If you add that to the intangible right-of-use asset, there might be nothing left at all for junior creditors, let alone shareholders.
When BBBY posted its third quarter results, losses were much greater than predicted just a week earlier. Same store sales declined by 32%, considerably more than analyst predictions of ~25%. BBBY actually lost $393 million or $3.65/share versus a predicted loss of $358.8 million ($2.23/share). Those quarterly losses include around $100 million listed as an impairment charge, which the company said was related to “certain store level assets.” The company recorded revenue of $1.26 billion ($80 million less than expected), a significant further decline from the $1.88 billion realized a year earlier, and also reported a negative operating cash flow of $307.6 million for the quarter.
Understandably, the company is squirming to find a way to stay afloat by drastically cutting costs wherever possible, including closing 150 stores, but bankruptcy seems inevitable.
Because of the publicity and the high-profile name, BBBY has become the latest meme stock. After closing at $1.30/share on Monday, January 9, the share price rebounded to $1.77 and even hit $5.24 on January 12 despite the awful news. But meme stock followers are speculators, not serious investors. Nevertheless, looking at the company’s list of investors shows numerous passive mutual funds and ETFs that don’t rely on fundamental analysis to make their investments. Major shareholders include BlackRock BLK , which owns 10% after selling off half of their position, Vanguard owns 7%, and State Street STT owns another 3%.
Passive ETFs and mutual funds are simply buying the names on their list. Part of it stems from a desire to keep their capital deployed, and they are just throwing money at everything out there because they don’t know what else to do. Sure, having sufficient capital to buy everything lets them grab onto winners that can help smooth out losses from the underperformers. Still, when a company like BBBY files for Chapter 11 and its stock eventually gets delisted, those big asset managers will become forced sellers of BBBY stock just like meme stock investors.
A bear market like we recently experienced, with the threat of recession looming, is a real test for any conventional investing strategies. The next few months will likely test investors further with a continued volatile ride for stocks. They are also likely to further challenge companies throughout the retail sector. Not just stores like BBBY and Party City, but also other businesses with the same core issues of too many locations with long-term lease obligations, declining customer counts, inflation, and a shift in consumer preferences. Examples would be AMC Entertainment, whose business has been disrupted by the onslaught of streaming platforms, and service businesses like Mister Car Wash.
As our economy goes through this cycle, interest rates continue to rise and a potential recession seems more likely, these secular trends can get worse. This leads us to expect considerably more distress in the coming months. It may be a real bloodbath for equity investors in the retail sector, but we anticipate other opportunities for investors with a mandate to invest either long or short and throughout the capital spectrum.
