Anything within a mile radius of a shopping mall is now considered toxic on Wall Street. Toys 'R' Us, an American toy retailer, plans to close over 180 stores this year (read: a quarter of its stores) after it filed bankruptcy on September of last year. The common stock of Macy's, a department store chain, is now trading at about $25 compared to $64 three years ago. The stock of Sears Holdings, owner of retail store brands such as Sears and Kmart, is now trading at $2 compared to $33 three years ago. And CBL & Associates, a real estate investment trust founded in 1961, is now trading at about $5, a decline of 75% from three years prior.
Wall Street’s ominous outlook for the retail sector and its effect on stock prices did not bypass the stock portfolio of yours truly. On July 2017, I bought 2,000 shares of Bon Ton Stores at a cost of $0.64 per share. The stock now trades at nine cents a share.
The investment thesis
I bought the stock in Bon Ton Stores for two reasons. First, I bought one dollar of the 2016 free cash flow for less than 50 cents. Compare that to the company's average free cash flow per share of $1.31 between 2016 and 2007 which was valued anywhere between 75 cents to $13. I thought it was a bargain.
The second reason was that I estimated that Bon Ton Stores had net tangible assets of about $5 per share. So, I assumed that in a case of bankruptcy there would be more than enough of a margin of safety to return capital. But I was utterly wrong. And the community at Seeking Alpha correctly brought to light my faulty analysis. I will skip the accounting related issue and get to the bottom line: while I assumed Bon Ton Stores had direct ownership in commercial real estate properties, the amount of real estate it owned was negligible. The company was leasing practically all of its stores.
"If you are in the market for cheap stocks, take a look at Bon Ton Stores, Inc." was the name of the article should you like to read more.
I was wrong to make the adjustment to the reported deficit equity of about $23 million or an equity deficit of $1.14 per share. And not only did I not purchase the stock at a discount to book value, I bought the stock at a hefty, unjustified premium.
What the community in Seeking Alpha also pointed out to me was that I failed to discuss Bon Ton Stores’ right side of the balance sheet. Similar to the effect that attractive women have on me - of shrinking my analytical and reasoning capabilities to that of a chimpanzee - I was lured by the company’s cash flow measures and had glanced to briefly at the company's liabilities.
Take adjusted EBITDA after capital expenditures as an illustration. For the five years prior to 2016, Bon Ton had over $82 million of adjusted EBITDA per year, while the average interest expense was $72 million. So I felt confident that the company could service its debt while gradually improving its operations.
And one did not need a forensic investigation to see that a simple improvement in operations could revamp the income statement dramatically. For example, the sales, general and administrative to gross profit ratio was 90% when I bought the stock. But over the prior decade the ratio ranged from 79% to 88% with an average of 85%.
I recently learned about the Bon Ton stores’ liabilities, not out of a genuine curiosity, but as a major force. In mid-December of last year, the company failed to make a $14 million interest payment to a group of second-lien secured notes, according to its 8-k filing. And in less than 48 hours, the quoted price of the stock by declined by 70%, from about $0.50 to $0.15.
“According to the bankruptcy filing,” notes Thomas Onder of Stark & Stark, an attorney firm, “the debtor is seeking a strategic sponsor to invest. However, if it cannot find such a sponsor, then it intends to sell all of its assets.”
The right side of the balance sheet
It is an old adage that debt is not your friend. And, in the case of retail, it is a practically a natural law. Retail is an industry that requires constant capital expenditures to attract customers. Debt also stiffens innovation. And without excess cash flow, alongside a constant need to please Wall Street each quarter, Bon Ton Store’s ability to invest for the long term was questionable.
And I should have seen that.
But this is not an article about the use of debt, nor of the wolves of Wall Street, so let us go back to our topic of discussion. Bon Ton Stores has over $1.2 billion in outstanding debt (there is nothing outstanding about its debt, it is just business jargon, perhaps by genius marketers). There are about $700 million liabilities that are payable within one year, and this year, the company was going to refinance its maturing long term debt of about $500 million. The timing of the maturing long term debt could not be worse.
It should be obvious that, even at a quoted price of nine cents a share, now is not the time to invest in Bon Ton Stores. There is little chance the company will get out of bankruptcy without severely diluting or eliminating current shareholders. And the picture I tried to paint for you in the first paragraph is that there is even less of a chance that capital markets will view the retail sector and the shopping mall sector favorably any time soon.