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Specialty Retail: Ad Hoc Opportunity

Each specialty retail segment is not like the others; our analysts have scoured the industry’s credit offerings to find the best deals.

Philip Guziec, 01/31/2012

On Dec. 19, I sat down with some of Morningstar’s specialty retail analysts— Liang Feng, R.J. Hottovy, Joscelyn MacKay, and Peter Wahlstrom—to discuss the state of that sector and the credit offerings therein.

Morningstar launched corporate credit ratings in 2009 and now offers ratings on more than 700 of the largest corporate debt issuers in the world. In addition to credit ratings, Morningstar analysts also publish company reports, lists of bond investment recommendations, industry reports, and their opinions of new bond issues. In 2012, Morningstar plans to launch municipal-bond research as well.

Philip Guziec: Obviously, you can’t really look at specialty retail in aggregate—every subindustry is completely distinct—but that’s what generates investment opportunities. It looks like you’re pretty excited about home-improvement retailers. Can you give us the lay of the land in that industry, given what’s happened over the past five years?

Peter Wahlstrom: Over the past decade, Home Depot HD and Lowe’s LOW have basically doubled their square footage. These companies are now looking to improve their productivity and profitability within existing store walls. This makes sense in that you also have, with the housing downturn, fewer people spending on residential construction. Commercial construction is still a driver of the business, but these companies now want to encourage general merchandise, day-to-day traffic, and smaller repair/remodel projects. In the meantime, Home Depot and Lowe’s generated $75 billion and $50 billion in annualized revenue, respectively, while not spending a lot on new store capital expenditures, which lends to solid free cash flow.

Guziec: Which is why we’re excited from a debt perspective.

Wahlstrom: That is exactly right. Both of these companies do have fairly large share-buyback programs, and they also pay dividends that yield between 2%–2.5% currently. But we do think that there’s ample free-cash generation beyond those. And that’s why Joscelyn likes both of these companies at this point.

Joscelyn MacKay: We’ve been pretty bullish on Home Depot, from a credit perspective, for some time. We felt that the market was underappreciating the firm given its moderate leverage and very strong, stable free cash flow despite the heavy dividend and share-repurchase activity, especially relative to its peer, Lowe’s. In the spring, we had rated Home Depot one notch lower than Lowe’s, but we recently downgraded Lowe’s. We believed that the market was giving too much of a premium to Lowe’s bonds relative to Home Depot; we thought that gap should narrow, and this has proved true. We continue to like Home Depot given its strong, widemoat characteristics.

Lowe’s is a company that we felt was getting a little too much credit; we ended up downgrading the firm to A from A+ in November 2011. Right after that, the company announced an even-larger share-buyback program and decided to take its leverage target to 2.25 times from 1.8 times, which are the factors we discussed when we downgraded them. As a result, the bond spreads widened— but a bit too much, in our view. We think the market’s reaction is exaggerated. We did downgrade them, and we feel that their credit quality is weaker, but now Lowe’s bonds are trading closer to a BBB+ credit instead of an A credit.

Guziec: Thinking about it from a bond perspective, do we see an economic downside, or are we secure on the cash flows and these firms’ ability to support the bonds?

MacKay: Home Depot has maintained around 2 times lease-adjusted leverage for a number of quarters, all through the downturn and prior. The firm kept to that leverage target by watching EBITDA and being prudent with new debt issuance. Still, the risk for both companies is that they could change their leverage targets, and that would change our opinion on the bonds and where they should trade. To a lesser extent, there is also a risk that they could get caught flat-footed if there is a deep downturn, leading to a steep EBITDA decline, and not having the cash flow to pay down debt. But we see that as quite a low-risk proposition, considering their strong free-cash-flow generation, currently.

Guziec: So, there’s plenty of cushion, and we really like the debt. Let’s move to the office-products industry. Is there a different story there?

MacKay: There is. Office products tend to lag economic recoveries because of the industry’s ties to unemployment—unemployment impacts the retail side and the contract and delivery side of the office-products distribution business. We had thought there would be a nice, slow rebound early in 2011; when it became apparent that wasn’t going to be the case, the office-products distributors warned that they weren’t going to hit their projected numbers. Numbers continue to be soft for all three of the office-products distributors, but Staples SPLS is far and away the leader in this industry. We’ve noted that, particularly in their contract business, Staples sees gains with their corporate customers, while its two peers, Office Depot ODP and OfficeMax OMX, have seen declines.

Competition is very high in this industry, given that the products are very commoditylike. Nontraditional office-supply retailers, such as Amazon.com AMZN, Costco COST, and Wal-Mart WMT, have been exacerbating the industry’s competitiveness. They’re known as being low-price competitors, so it’s very easy for them to get into the game. Our argument here is that, in Staples’ case, it’s been going on for years, and we think that Staples, with its international presence and ability to leverage costs, can compete on price if it needs to. But being known as the office- supply superstore leader is benefiting the firm there.

Guziec: Is there anything you like in this space from a debt perspective?

MacKay: I would love to be able to recommend Staples from a debt perspective, but the firm will be reducing a great deal of their debt over the next couple of years. In 2008, Staples increased their leverage by about half a turn to acquire Corporate Express, which changed their international landscape. The company has been very up-front about getting back to pre-acquisition leverage levels, and they intend to pay debt as it comes due. So, with their only outstanding maturities being just a few years out, we don’t see upside to those bonds.

On the other hand, Office Depot and OfficeMax bonds are trading at pretty wide levels. We have them both rated at B–, which is the lowest rating before a potential default. We looked at these companies from a credit perspective and felt that an imminent-bankruptcy rating is not appropriate. We don’t believe they merit a CCC rating, given their very strong liquidity positions. They have a few maturities coming due in the next few years that we expect them to be able to cover through their revolver, and if not, with cash on hand. They have a free cash flow cushion of 1 times, which means that over the next few years, cash plus cash on the balance sheet can just about meet their contractual obligations, which include debt, capital lease obligations, and interest payments.

Guziec: At current spreads, are the bonds interesting?

MacKay: At current spreads, we find OfficeMax and Office Depot interesting. They’re yielding close to 10%, and as a debt holder, I think that you will get your money paid back. I think that would be very attractive for an investor, if you’re willing to deal with a little bit of risk.

Guziec: There are some interesting dynamics in consumer electronics.

R.J. Hottovy: I think some of the dynamics parallel what Joscelyn described with the office-products industry, but consumer electronics takes it one step further without having the contract side of the business to fall back on. Consumer electronics companies are facing competitive pressure from a lot of large mass merchants—Wal-Mart, Amazon, and Costco-who have taken considerable market share from Best Buy BBY, Radio Shack RSH, and GameStop GME the past few years.

We’re seeing other competitive pressures, too. Namely, a number of key consumer electronics vendors, whether it be Apple AAPL for consumer electronics, or AT&T T or Verizon VZ on the wireless side, are building out their own retail networks and becoming a lot less reliant on traditional specialty retailers to distribute their products. This gives the vendors a lot more negotiating power in and a lot more pricing power over these retailers.

Also, a number of high-margin products, such as entertainment media, are moving to digital distribution platforms. Wireless contracts are being moved to the vendors themselves or even distributed online through players like Amazon. It’s making the store space for consumer electronics retailers a lot less productive, and I don’t think that’s something that’s going to be easy to reverse. It plays into our longer-term thesis of margin compression in the consumer electronics retail industry.

Guziec: That sounds interesting and ugly.

Hottovy: It’s not a great space. At first glance the credit metrics are OK, since these are fairly solid cash generators, but that’s something that could quickly dry up. So, while they may look good on the surface, I think it’s important that we keep a market-weighted recommendation on the bonds for these retailers, given that the industry dynamics could change in a hurry and really zap these firms’ free cash flow potential. Guziec: Spreads are not wide enough to justify the risk?

MacKay: And not wide enough to recommend them at this point. GameStop is the third company in our credit coverage for now, but it is actually going to pay off all of its debt by the end of 2011 (final numbers weren’t available in time for this issue’s deadline), so we probably won’t be talking about it from a credit perspective soon.

Guziec: What about auto parts?

Liang Feng: In general, we like the auto-parts retail industry. Unlike many other specialty retail segments, auto-parts retail is countercyclical - during recessions, people are less likely to replace their existing vehicles, so the size of the old vehicle fleet has been increasing. Since people don’t want to buy new cars, they choose to go to the auto-parts retailers instead to purchase parts, or they can go to repair shops, which source many of their parts from the auto-parts retailers. As a result, auto-parts retailers have managed to grow profits tremendously over the past few years by growing their store bases and expanding their margins.

Additionally, unlike many other retail sectors, auto-part retailers are relatively insulated from online retail competition, because the majority of consumers prefer to go to the retail shops to get assistance from associates before purchasing.

Hottovy: In addition to that, a lot of the parts that auto-parts retailers sell are so specialized or technical that they aren’t carried by the mass merchants. You won’t see them at Wal-Mart; you won’t be able to purchase one on Amazon.

Feng: The three major players—O’Reilly ORLY, Advance Auto Parts AAP, and AutoZone AZO—essentially form a mini oligopoly, enjoying very high returns. Overall, we really like their position in the industry, because they continue to consolidate market share from smaller industry participants and generate quite a bit of free cash flow, which means they should be able to continue servicing their debt with relatively few problems. They are countercyclical, so if new car sales rise higher than the 14 million replacement rate, then we could see a reduction in the number of older vehicles on the road, and that could be a headwind. But since they’re consolidating the industry, taking market share from smaller players, and selling items that are nondiscretionary, we think their debt is relatively safe.

MacKay: The industry’s countercyclicality and other attractive dynamics have attracted bond investors in the past couple of years. Investors have felt safer owning these bonds in a recession, but the bonds trade at a level that’s too tight, in our opinion, and we do have some concerns over the next couple of years as the economy rebounds that the countercyclicality will work against auto-parts retailers. Mid-to-weak BBB credits—around where we have the auto-parts retailers rated—are trading around the mid-to-high 200 basis points area. Yet, the auto-parts retailers’ 10-year credits trade around the low 200 basis points area, which we think is way too tight for a BBB/BBB– credit.

Guziec: The businesses are in good situations, but they aren’t good bond investments.

MacKay: Investors have already gobbled up those bonds, making them not so attractive anymore.

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