Impinj -a Boom-Bust Process in the Making

I have been wrong on many fronts with regards to the retail sector. I got it wrong with my short of Impinj, which appreciated over 50% since my article. I tend to invest first and investigate later, so as I was doing due diligence, I realized my argument was for a short on Impinj was weak for the precise reason that commenters had mentioned on my article: strained apparel retailers were willing to invest in a technology that could optimize their inventory. The commenters were right and I was wrong.

I do think in the longer run, Impinj might have to come to earth in regards to its valuation, and its continuing rise in inventory is worrisome. The company currently trades for 8X revenue and makes continuous losses. Inventory turnover has gone from 3.59 in 2015 to 1.96, draining cash. However, as I should have seen from my prior experience with boom-bust cycles, the company is able to fund its cash losses by issuing stock at inflated prices. This sets it up to be a reflexive boom-bust process that is capable of running for a long time.

Value bets on Retailers were Misguided

At the same time, my bet on retailers that were optimizing their inventory has also failed. I invested in Express (EXPR) and Buckle (BKE). The entire sector sold off massively on a bad report from Macy’s (M). This is not what I would expect to see at a bottom. In a bottoming sector, I would expect minor sell-offs on negative news and rallies on any news that’s mildly positive. I sold EXPR on the break below $8, and in hindsight, the move was fortuitous. BKE is showing more share price strength so I’m holding for now.

Bottom Fishing is a Dangerous Hobby

On a separate note, I have been reviewing my results, and I noticed a distressing tendency. I tend to invest in companies that I believe are bottoming well before they bottom. I tried many times to catch the bottom in 3D Systems (DDD), a stock which I got right on the long and short side, but I caught a falling knife multiple times, and missed the eventual bottom at around $6 a share (it now trades above $20).

Again I got caught in the oil patch, investing far too early in an oil turnaround, however when it eventually came, I was able to hold out long enough to make a profit.

So the lesson I take away from all this is that I ought to wait a lot longer than I feel like waiting for a turnaround in a sector. As Larry Livingston from Reminiscences of a Stock Operator might say, “If a man never made mistakes, he would own the world in a month. If he never learned from his mistakes, he wouldn’t own a blessed thing”.

The Path Forward for Retail

Retail should prove no different. If I feel that I should invest now, when multiples seem absurdly compressed, there are probably at least 2-3 more big moves downward that ought to come before the bottom.

This is a sector that is littered with the corpses of companies that failed to adapt. I was looking at the quarterly letters from Kerrisdale Capital in 2011 (the year they made 200% while the market was flat), and the following struck me:

It is clear that we need to be more careful investing in struggling retailers with same-store declines and deteriorating margins. Sometimes they turn around, but usually they don’t. The hidden leverage of operating leases continually catches us unaware.

Kerrisdale lost on two separate retailers that unexpectedly went BK. I would note that the most recent Kerrisdale letters, during the current retail crisis, have neglected to mention any retail investments.

Changes to FASB Will Mean Re-ratings of Several Retailers

The “hidden leverage” of operating leases is not going to stay hidden any longer. Changes to lease accounting are coming. This will mean all the leverage implicit in an operating lease is about to be made explicit. The explicit statement of the operating lease liability on the balance sheet is bound to end up with winners and losers. Retailers that have the worst terms (i.e. long term leases that were signed > 2 years ago when leasing rates were much stronger) will suffer when these liabilities are made explicit. Many of the retailers will go from showing net cash to showing net debt. Companies have until January 2018 to comply. I would imagine those with the worst positions will delay filing until the last minute.

Short Retail REITs – Federal Realty Trust (FRT)

Federal Realty Trust is a REIT focused on retail properties – generally strip malls in relatively affluent areas. It trades at 21X FFO, while commercial REIT peers trade at 16X FFO. While it has a low payout ratio (dividends are only 61% of FFO) and a low MCX ($16-17 million), it does have a need to refinance in the next twelve months because of rising interest costs and principal repayments. There are $210 million in principal due in the next 12 months, $280 million of dividends to be paid, $17-18 million in MCX, and only $434 million in FFO.

The CEO is very confident the company can refinance at a property level, and I think this is true, but I think the company ought to get worse interest rates going forward, given multiple hikes at the Fed, and the levered nature of the company. Moreover, I think lease rates will go down as all the retailers race to shut down stores. Finally, I think the growth engine of a REIT that has been powered entirely by retail sector strength will stall out, which ought to cause the company to trade in line with peers. Multiple re-rating would imply 20-25% downside from here, and any further weakness in leasing rates going forward ought to mean a further 10% or so decline. My target is $90-95 per share. I have momentum in my favor, and I will seek to limit losses if the stock spikes.

I am actively looking through all the REITs with real estate exposure that I can get my hands on. I think these are some of the best shorts in the current environment where bond proxies ought to suffer and a secular decline in retail ought to hurt renewal rates on the underlying leases.