One of the investment themes that we’ve talked about in the past is the proliferation of technology and how it is changing enterprise and consumer behavior. In our last blog, Millennials’ Preferences Are Disrupting Music Business, we wrote specifically about changes in the music industry and how Live Nation may be positioned to benefit.
Beyond the music industry, technology and changes in consumer behavior are affecting retailers, as people shop more online and less in traditional brick-and-mortar stores. Websites and mobile apps—the portals to online shopping with their convenience, accessibility and high-touch features—are drawing greater crowds and changing the economics and business models of retailers and mall owners.
In our alternative strategy, our ability to take long and short positions across asset classes allows us to seek to generate returns from positive and negative trends. Below, we offer an example of how we structured a long/short trade in the debt securities of Neiman Marcus to create a position that we believe offers significant upside potential with limited downside, or what we term an “asymmetric return profile.”
But first, some background.
Neiman Marcus and the Migration to Online Shopping
Neiman Marcus is a high-end retailer of apparel and footwear. Over the past few years, an increasing percentage of apparel and footwear sales are being done online. Further, apparel and footwear account for a significantly greater share of merchandise sold online (Exhibit 1).
As of 12/31/16.
Neiman Marcus has been affected by this trend: Their reported same-store sales have declined. These sales figures include online sales, as well as sales from brick-and-mortar stores that have been open for more than a year. Moreover, sales in their brick and mortar stores (estimated as same-store sales excluding Internet sales) have actually been negative (Exhibit 2).
As of 9/30/16.
There’s an additional factor adversely affecting Neiman’s fundamentals. The company generates a relatively high share of its sales online, when compared to its closest competitors, but its Internet business is not as healthy as it appears. The company’s growth in Internet sales is slower than the growth rate for its industry category, indicating a loss of market share. Additionally, Neiman Marcus appears to be losing share not only to exclusively digital retailers such as Amazon, but also to the online arms of its major brick-and-mortar competitors (Exhibit 3).
As of 12/31/16.
Making the Investment: Structuring a Trade with an Asymmetric Return Profile
One obvious way to capitalize on this investment idea is to simply short-sell Neiman’s securities outright. However, in this case, the high coupons on Neiman’s bonds would make short-selling them expensive, because the short seller would have to pay a high coupon while waiting for a default.
In Neiman’s case, we pursued a more efficient trade that offsets the cost of short-selling and, in our view, maintains substantial upside potential while limiting downside. The trade comprises two simultaneous positions—long and short—in two different parts of the company’s capital structure: We assumed a long position in the company’s term loan while taking a short position in one of the company’s secured corporate bonds through a credit default swap (CDS).
Here is why this trade, in our assessment, bears an asymmetric risk/return profile that we believe is significantly tilted toward the upside and also highly efficient:
1. The term loan that we assumed a long position in has far superior collateral to the secured bond that we short-sold (Exhibit 4).
This term loan has a lien on two of Neiman’s most valuable assets: its intellectual property (including its strong, recognizable brands and Internet assets) and working capital (consisting primarily of store inventory, which is highly liquid and easy to value). The loan also shares a lien on Neiman’s real estate with which the secured bond we short-sold through a CDS does also.
On the other hand, Neiman’s real estate, which is the secured bond’s only collateral, is one of the company’s least attractive assets. Most of Neiman’s real estate is leased and therefore less valuable than it would have been if Neiman had owned all its real estate outright. The real estate would likely be worth less if divorced from Neiman’s brands, which are not pledged to the bondholders. Finally, the value of retailers’ real estate is, in general, negatively affected by customers’ migration online.
As of 12/31/16.
We believe our long position benefits from a superior collateral package relative to our short position. Since collateral is what determines recovery value in the event of a default, in our view, the term loan is likely to substantially outperform the secured bond in a default. (When a bond defaults, an investor who has a short position in that bond through a CDS receives the difference between the recovery value of the bond and par. The lower the recovery value—the higher the payoff of the CDS upon default.)
2. Our long position in the term loan can help defray the carrying cost of our short position.
As long investors in Neiman’s term loan, we are entitled to receive interest payments that we can use to pay the cost of the short position we assumed in the corporate bond (i.e., the cost of the credit default swap can be thought of as similar to the premium payments on an insurance contract). Essentially, this cost—known as carry—is now defrayed through our coupons from the loan. These proceeds make for a more efficient trade and reduce the expenditures we would need to bear in the intervening time waiting for the possibility of a default (Exhibit 5).
As of 12/31/16.
*The London Interbank Offered Rate (LIBOR) is the average interest rate estimated by leading banks in London that they would be charged if borrowing from other banks. It is a primary benchmark for short- term interest rates around the world.
Conclusion: Capitalizing on Changes in Consumer Behavior
Part of our philosophy is that change leads to disruption and ultimately to opportunity. Consumers’ migration to online shopping is an example of such a change. Identifying the investment opportunity is only half the battle, but the way an actual trade is structured and executed can also have a significant impact on an investor’s total return.
In the case of Neiman Marcus, we paired a short position in a bond with a long position in a term loan to potentially benefit from an anticipated decline in the bond’s value while offsetting the cost of the short position. As consumers embrace online shopping in growing numbers, we can be patient and wait for the impact to be felt.
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