Retailing and Moats

Few retailers benefit from an enduring economic moat because many goods stocked on their shelves reside at their competitors. Seemingly the only thing to distinguish their goods is the price. Hence in retail, the widest and best moat is found around the business that consistently offers the lowest price. As Charlie Munger observes, “retail is a very tough business. [Warren and I] realized that we were wrong. Practically every great chain-store operation that has been around long enough eventually gets in trouble and is hard to fix. The dominant retailer in one twenty-year period is not necessarily the dominant retailer in the next.”*

Though only fools would dare position themselves contrary to Munger, it is striking, when one surveys the American retail space, how many retailers appear to thrive. Of course, Circuit City and Linen ‘n Things have recently taken the fall, but the majority still remain, even amid this dire economic environment. Yet, when I survey the survivors, it is hard to discern any economic moat, much less a wide one. The washing machines at Lowe’s, at Sears, and at Best Buy appear virtually indistinguishable; the same Dockers line the walls of Sears, Kohls, and JCPenney. Yet, more of our family’s dollars find their way to Target than any other, even though Wal-Mart often offers better prices. Are we doubly fools, or does Target offer something which its competitors do not?

Looking at the numbers, Target has 351,000 employees, which produce 64.95 billion in sales, at a gross margin of 28.6% and an operating margin of 6.78%. Sears is likely their most similar competitor—in inventory, assets, and sales—and it has 324,000 employees, producing 46.77 billion in sales, at a gross margin of 27.05% and an operating margin of 1.31%. Wal-Mart, with its gargantuan 405 billion in sales, brings a lower gross margin of 24.52% and an operating margin of 5.6%. (So that’s what we should mean when we say we will make it up on volume.)

With these numbers, Target’s excellent margins leap from the page—an observation which seemingly runs contrary to our opening thesis: that offering the lowest price produces the best competitive advantages in retailing. So the question is: how can Target sell the same stuff for higher prices than its competitors?

My hypothesis is that Target offers a unique shopping experience, one which many women in their 20s, 30s and 40s particularly love. I say women largely based on my own idiosyncratic anecdotal evidence. For one, my wife and her sisters craft their weekends and shopping needs around a weekly excursion to Target, and it is indeed an excursion, because most of the trip involves just walking around, picking over shoes, accessories, clothes, baby gear, towels, sheets, and household décor. For all of these items, I have never seen any of them make a purchase from Wal-Mart or Sears. And of course, once you’re in the door, the convenience brings household goods and groceries into your cart.

Perhaps more interesting and illustrative is a simple Google search for “I love Target” or “Why I love Target.” Compared to competitors, the fan base is quite remarkable. “Target Brand Boxed Riesling is packaged in such an irresistibly cute green box that I could not resist it.” “Tonight I popped in Target after teaching a Kindermusik class… I ran across these shoes [picture].” “This is why I love Target… I want to kiss the person who designed them and make out with the person that decided to only charge me $30! LOVE IT! [link]” Sure, such banter is fun, spontaneous, and whimsical, and not too much should be drawn from it. But it does strike me that Target has established a shopping experience, shared by many, that compels sales of superfluous goods at profitable prices.

Fans talk about wide, uncrowded aisles, the shoe designers, the lighting, the employees. The reasons are multiple, but the passion is earnest. When thinking about the prospects of Target’s moat, it is hard to interpret the competitive advantage expressed by this passion. But certainly something is there that other retailers are missing.

Disclosure: I, or persons whose accounts I manage, own debt of Sears Holdings at the time of this writing.

* Schroeder, Alice.  The Snowball: Warren Buffett and the Business of Life (Random House, 2008): 332.

Follow Thy Neighbor (if he’s Buffett)

Today we take a third lesson from Dr. Cialdini and his book Influence: Science and Practice (2nd Ed., HarperCollins, 1988). In the first lesson, we observed the mental mistakes that can follow from perceptual contrast; in the second, we saw how our penchant for unflagging commitment may push us to fall in love with our worst investments.

A third form of influence that can be detrimental to investment performance is social proof. That is, when “we determine what is correct by finding out what other people think is correct” (110). In general, social proof looks sensible; if one doesn’t know what to do, presumably someone else does, so he should follow another’s cue. As Cialdini notes, “as a rule, we will make fewer mistakes by acting in accord with social evidence than by acting contrary to it” (111). Applied to public security markets, social proof entails respecting the market price of a given instrument. What more social proof do you need than the current market-clearing price? The market has spoken. That’s what the business is worth.

Yet, a fairly basic problem lurks here. Out there in the world some actors know what they are doing, but other prominent actors clearly do not (e.g., Lehman, AIG, Madoff). Of course, it is not easy to discern which is which, but it is clear that if we could follow the savvy smarts and disregard the duds, we would be better off (in life and in investing). For example, if we pay particular attention to how Tiger Woods prepares for and plays golf, we’ll do better than if we follow Wide Moat. And we can confirm this because their results consistently diverge over time. Likewise for investing, if we follow the footsteps of Buffett and train our minds to be like his, we will do better than if we were to follow the Beardstown Ladies. While the principle of social proof pushes us to follow any and all leaders, the truth is that we just need to find and follow a good leader.

Of course, in the markets, this assumes that there are better and worse investors, and that we have some tools to reliably differentiate them. Further, it suggests that the successful investor must have the chutzpah to invest contrary to the majority of market participants when they are wrong.

So how does one resist the tendency to join the crowd? For one, the valuation of a given business should take place, as far as possible, before reading news articles, research reports, and blogs. If one can value a business independently, the hooks of social proof will likely not snare him. Second, one must find a way to reliably distinguish the best investors from the crowd–I give my vote to demonstrated, audited, and long-term results. And third, one must not take the consensus view on a security to be decisive. Given our interest in Sears, it is surprising to us that Sears is the most hated stock whose market cap exceeds $250 million. Of course, today’s consensus may ultimately be correct; crowds can be right. But until the cash flow numbers show even greater deterioration, we’re going to stick with our positions.

Disclosure: I, or persons whose accounts I manage, own debt of Sears Holdings at the time of this writing.

Analyzing Sears and Bonds

Yesterday we briefly compared the equity of Sears Holdings to its outstanding “junk” bonds and found that an investor with a short time horizon (say 2-3 years) may find comparable or superior value in the bonds when compared to its equity. To be clear, we don’t mean to suggest that Sears bonds are without risk. One only needs to look to Circuit City, or Linens n Things to see that today’s retail environment is increasingly difficult. And we are assured that more retailers will seek bankuptcy as they watch American consumers begin to cultivate the lost art of saving.

Today, we will take some time to evaluate the risk of Sears bonds in greater detail. Though sophisticated bond analysis tools abound (some more useless than others), relative simplicity will rule this day. Benjamin Graham, in his widely acclaimed The Intelligent Investor, highlights a variety of criteria relevant for bond analysis. First, and most important, is “the number of times that total interest charges have been covered by available earnings for some years in the past” (148). Either the analyst should concentrate on the average multiple of interest coverage over the past seven years, or she can use the multiple of interest coverage in the “poorest” year. Graham concludes that, before income taxes, a retailer must have—at minimum—produced average earnings at least five times the interest charges, or at least four times the earnings of the poorest year.

A second test for bonds is the size of the business. Third, the analyst should assess the ratio of the equity’s market price to the business’ total outstanding indebtedness. And lastly, the analyst should discern the values of the assets on the debtor’s balance sheet.

In the case of Sears Holdings, it appears that its debt does not pass Graham’s first test. According to Sears’ most recent press release, interest expense for the fiscal year ending Jan 31, 2009 was around $272 million. Yesterday, we found Sears average annual FCF to be 1.03 billion; the ratio then is 3.8, below Graham’s 5x threshold.

The second criterion is fine, and the third as well, with Sears’ equity priced in the market at 4.3 billion (as of 3/5/09), compared to 2.9 billion in total long term indebtedness. The fourth criterion is quite interesting in Sears’ case. Given its wealth of real estate assets, its valuable brands, and its ownership stake in Kmart, Lands’ End, and Sears Canada, the balance sheet far understates its true value. For example, Bruce Berkowitz, manager of the Fairholme Fund, conservatively values Sears’ real estate at $90 per share, a valuation he has made using tax records and fairly detailed site analysis. By itself, the value of Sears’ real estate, largely hidden from the balance sheet, should provide the debt holder with an additional margin of safety.

All told, the analyst can see where Sears’ perceived weakness lies—its earnings power in its current state appears too meager. Given its assets however, combined with its cash balance of 1.3 billion, and the 3.5 billion available on its line of credit, some of the risk diminishes.  Diminished enough at least for this investor to seek the proffered returns.

Disclosure: I, or persons whose accounts I manage, own debt of Sears Holdings at the time of this writing.

Holding Sears

Inspired by Warren Buffett’s recent forays into the fixed income and preferred stocks, I have spent more time looking through quotes in the bond market. And some very interesting anomalies you will find. Take, for instance, the 5.375 senior notes of AIG (cusip: 02635PRT2), due 10/01/2012, rated BAA1 (“investment grade”) by Moody’s and BB+ by S&P, trading at 44 cents on the dollar, with a yield to maturity of nearly 33%, and a spread over Treasuries of more than 3100 basis points. Let’s just say the rating agencies and the market have a slightly different view of AIG’s situation.

Now, for the retail investor, there are numerous mines in this market and plenty of ways to lose a leg. But one particularly interesting case is Sears Holdings, the fourth largest retailer in the United States. As of today (3/4/09), the market prices the equity of Sears Holdings at around 4.5 billion and over 50% of that equity is held by Eddie Lampert’s ESL Investments and ESL Investors. According to the press release accompanying their annual report, “total debt as of January 31, 2009 was $2.9 billion, down from $3.0 billion as of February 2, 2008.” Excluding $665 million of capital lease obligations and $559 million of non-recourse borrowings from Sears Canada and Orchard Supply Hardware, Sears Holdings has borrowings of $1.7 billion. Most of that debt derives from Sears Holdings wholly owned financing subsidiary—Sears Roebuck Acceptance Corp—whose outstanding notes total 1.25 billion (and will total less than 950 million by May 2009). These Sears Roebuck bonds currently carry a ‘junk’ rating of BA2 from Moody’s and BB from S&P and currently trade at yields to maturity of 20-25%.

So, the question is: with these facts, which is a better buy—the equity or the bonds? Now a fuller evaluation of Sears Holdings would likely push the analyst into considering the value of Sears’ real estate, its automotive serving business, its appliance serving business, Kmart, Lands’ End, its Sears Canada stake, and the value of its prominent brands—Kenmore, Craftsman, and Diehard. Yet, rather than valuing these assets separately, today let’s focus on Sears Holdings as an operating business, which, according to Morningstar’s data, has had an average annual free cash flow (FCF) of 1.03 billion over the last five years.*

Thinking most simplistically, what looks like the better buy? Equity priced at 4.5x average, levered FCF, or the bonds priced to yield 25%? If we think of FCF as an owners’ return on equity, the (levered) equity yields 22%. In this admittedly simplistic analysis, the bond holder looks to get better returns than the equity holder at current prices, and gets the added safety of having a superior claim if Sears were forced into liquidation or bankruptcy.

Disclosure: I, or persons whose accounts I manage, own debt of Sears Holdings at the time of this writing.

*For Sears, it is important to note that its FCF far exceeds reported earnings because its annual depreciation is much higher than its capital expenditures. Many analysts point to this disparity and conclude that Sears is failing to sufficiently invest in its stores’ appearance and layout.  It remains to be seen whether the stores do need more capital expenditures to generate sufficient sales, but Chairman Eddie Lampert is aware of the criticism, observing in his recent letter to shareholders that “there has been significant expansion over the past five years in big box retail square footage and significant capital expenditures by our competitors, primarily for opening new stores, but also to refresh and expand their existing store base and infrastructure. At Sears Holdings, our investment principle is guided by the belief that capital invested in any area of our business deserves a reasonable return on that investment. If that return is not forthcoming, significant investments in the business will destroy value rather than create value for shareholders.”

Buffett the Bondsman Revisited

Warren Buffett’s annual letter to shareholders arrived this past Saturday morning with the anticipated fanfare and has produced its usual industry of commentary. Ever since Berkshire’s 13-F became public (2/17/09), I have been thinking increasingly about whether current economic conditions should alter my investment strategy and return expectations. As we observed yesterday, Graham and Dodd seem to suggest that such changes are unnecessary, if our current holdings were acquired with reasonable expectations and a significant margin of safety. Yet, in Buffett’s letter, he discusses selling some equities (presumably purchased with the requisite margin of safety) in order to purchase fixed income securities:

“On the plus side last year, we made purchases totaling $14.5 billion in fixed-income securities issued by Wrigley, Goldman Sachs and General Electric. We very much like these commitments, which carry high current yields that, in themselves, make the investments more than satisfactory. But in each of these three purchases, we also acquired a substantial equity participation as a bonus. To fund these large purchases, I had to sell portions of some holdings that I would have preferred to keep (primarily Johnson & Johnson, Procter &Gamble and ConocoPhillips). However, I have pledged – to you, the rating agencies and myself – to always run Berkshire with more than ample cash. We never want to count on the kindness of strangers in order to meet tomorrow’s obligations. When forced to choose, I will not trade even a night’s sleep for the chance of extra profits.”

Of these three equities, I am most familiar with JNJ, a favorite of many value investors (including Prem Watsa and John Hussman). Joe Ponzio at F Wall Street has analyzed JNJ and given it an intrinsic value (using a discounted cash flow analysis) of $83.10. With future cash flows discounted at 15% and a 25% margin of safety, Ponzio would be willing to purchase JNJ below $62.33.

Though personally I find this valuation a bit high, it does show that JNJ has a significant likelihood of returning the investor at least 15% per annum. For Buffett to sell JNJ for his fixed income securities, I would contend that he either sees greater return potential in them, or a greater margin of safety for a similar rate of return. The conclusion then presses upon me—a 15% return in equities may not be sufficient in this market. If that’s true, then perhaps the appropriate strategic response is to increase the discount rate in my DCF evaluations, and/or increase my desired margin of safety.

Of course, we can still find wide moat businesses whose current prices look like bargains even with these heightened standards, but the list is shorter. Ebay makes the new list, but likely not the Washington Post Company.

Lastly, Buffett’s moves have inspired me to look further up the capital structure. In the past decade, corporate bonds rarely looked attractive relative to the projected returns for their equity. Now, however, one can find a few better risk-adjusted returns in the corporate bond market. Tomorrow we’ll look at one potential opportunity by comparing the equity of Sears Holdings with its outstanding bonds.

Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway, eBay, Fairfax Financial Holdings, and debt of Sears Holdings at the time of this writing.