Mall Tour 2017 (Part III)

August 27, 2017 10:40 PM


Ever since the first Sears catalog was published in 1888 (the Amazon.com of its day), pundits have called for the death of retail establishments. It’s easy to see why they would think that such a thing was happening—namely stores around them were closing in rapid succession. Of course, these successive waves of retail disruption (the appearance of Woolworth’s, SS Kresge, K-Mart, Wal-Mart, the advent of malls, big box stores, the birth of suburbia, online shopping, etc.) have occurred and only served to make American retail stronger and more versatile. Only two decades ago, the mere mention of a Wal-Mart coming to a town would lead to near riots as disparate groups from local retailers to unions would unite to protest. Now, Wal-Mart itself is struggling against online retail. Despite more than a century of change, disruption and repeated waves of retailer bankruptcies, the only constant is that consumer spending has increased each decade. In the end, consumers want stuff, they just want different stuff; delivered in different ways. Those who can figure out where retail is going, are set to earn excessive profits.

I started this whole adventure (Mall Tour 1, Mall Tour 2) to see what I could learn about the direction that retail is going. While it is obvious that online shopping will control a growing percentage of the pie when it comes to retail, there will be many niches in the world of bricks and mortar that also thrive—despite or possibly because of online. If you look back twenty years, Wal-Mart’s assault on the retail industry only abated when retailers stopped competing on price, and started competing on quality, selection and service instead. If online shopping will further broaden the powers of selection and service, where are the remaining niches?

I recently read One Buck At A Time the story of Dollar Tree Inc, by Macon Brock, the co-founder of the chain. I was struck by his tenacity to drive costs lower, but also to find unique products that would retail for a dollar, while costing the company a good deal less when bought in massive quantities. What is even more interesting, is that Brock had started his empire by growing a chain of mall-based toy stores, only to have the advent of big box toy retailers like Toys R Us gain the upper hand in his industry. Rather than compete directly against the big box retailers, he admitted defeat, sold out and looked for a retail concept that would not be held hostage by the box stores. It taught him that most stores cannot compete against a larger selection, and a lower cost structure. Dollar Tree does neither—all its wares are available on the internet, but no one is going to pay for shipping an item worth only $1.00. Even better, almost all wares are impulse buys, with the convenience of basic household consumables as the draw for customers. This really struck me, as Dollar Tree is a retail concept that is more than just surviving—in fact, it’s thriving against internet options. What else will survive?

one buck at a time

That’s what I have been wondering for the past few weeks. Along the way, I’ve spent a good deal of time exploring different retail concepts. I went to the local antiques flea market. Business is healthy. These are one-of-a-kind bulky items. Despite well recognized international systems for grading and assessing wear, purchasers want to see the goods themselves in person. Next door, the local food court was humming with local produce, local prepared foods, ethnic foods. You can produce and ship from online, but you miss out on the experience of sampling dozens of products in an hour. As we moved further along in this old warehouse, we saw vintage used goods—also doing quite well. Vintage sizes aren’t always comparable with modern clothing sizes—you really do need to try them on. Here’s an epiphany, there’s a whole class of goods that can be sold online, but sell better in person. Moreover, these goods are retailed by local individuals who are perceptive to local tastes and can adapt rapidly to changes in their local community. The whole “local” movement is alive and well. The internet cannot compete with that.

What about those who cannot access the internet? This may sound stranger than you would have thought, given the proliferation of smart phones, but 7% of the population is unbanked and another 20% of the population is underbanked. Another 3% of the population is illegal. These percentages overlap, but you have many people who cannot or will not be able to order online. When you have tens of millions of customers, you have a huge addressable market that many of us largely ignore—yet by sheer size, these people represent a massive customer base. Those providing goods and services to this group will survive and thrive, especially as the economy bifurcates between those who have access to credit and those who do not.

Despite my belief in a mass-extinction event for retail and commercial real estate, I want to be clear that there will be winners. Dollar Tree is a winner, but it is all grown up. What’s the upside there? The key will be discovering the next generation of winners. I sure as hell am not setting up as an antique vendor, though many of these local retailers are more than prospering. I want actual companies to invest in. Who are the winners that are; largely immune to the internet or even supported by it? That are built for the next generation of consumer tastes? That are already at a scale so that we can invest? There is a huge wave of disruption coming. Those who can figure out the winners, will make lots of money.

To be continued…

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Mall Tour 2017 (Part II)

July 5, 2017 1:51 PM


Malls are bearing the brunt of changes in retail, but they’re only the canary in the coal mine. Let’s start with a simple premise; commercial real estate (CRE) will change more in the next decade than it has in the past hundred years. Anyone who thinks they can fully foresee how it will evolve is lying to you. The only certainty is that highly leveraged real estate investors and lenders will be obliterated as current models evolve faster than anticipated.

In the past, retail was retail, warehouse was warehouse and office was office—the same for all other CRE classes. There was some cross-over, but the main commercial real estate components stayed segmented for the most part. Now, with big box stores, the lowest hanging fruit for online shopping to knock off, going to dodo-land, there will be hundreds of millions of feet of well-located space suddenly becoming available. People act as if there are enough Ulta Beauty and Dick’s Sporting Goods to go around. However, you cannot fill all of this space with the few big box retail concepts still expanding—especially as many stalwarts are themselves shrinking.

mall rats

As a result, a huge game of musical chairs is about to take place. Why pay $20/ft for mid-rise office space, if you can now move into an abandoned Sports Authority for $5/ft. Sure, it doesn’t come with windows, but employees like open plan space and there’s plenty of parking. Besides, with the rental savings, you can offer your staff an in-house fitness facility and cafeteria for free. Does your mega-church need a larger space? There’s probably a former Sears or Kmart that perfectly accommodates you at $3/ft. Have an assisted living facility with an expiring lease? Why not move it to an abandoned JC Penney—the geriatrics will feel right at home, as they’re the only ones still shopping there.  

Go onto any real estate website and you will find out that huge plan space is nearly free. No one knows what the hell to do with it and the waves of bankruptcy in big box are just starting. As online evolves, these waves will engulf other segments of retail as well.

Type Macy’s into Loopnet.com and look at how many millions of feet of old Macy’s are available for under $10/ft to purchase. Retail’s problems are about to become everyone’s problems in CRE. When the old Macy’s rents for $2/ft, what happens to everyone else’s rents? EXACTLY!!! What happens if a CRE owner is leveraged at 60% (currently considered conservative) and leasing at $15/ft when the old HHGregg across the street is offered for rent at $3/ft? An office owner can lower his rents a few dollars, but at the new price deck, he cannot cover his interest cost, much less his other operating expenses. What happens to a suddenly emptying mid-rise office building? It has higher operating expenses than the box store due to full-time security and cleaning—maybe it’s a zero—in that future market rents no longer cover the operating expenses of the asset, much less offer a return on investment. I know, crazy—that’s how musical chairs works when demand contracts and the supply stays the same.

What happens to the guys who lent against these assets? Kaplooey!!!

retail per capita

America currently has more feet of retail space per capita than any other country. For that matter, America has more feet of office and other CRE types per capita as well. A decade of low interest rates has made this problem substantially worse. Think of the two malls that I spoke about in the last piece—they weren’t done in by the internet, they were done in by a tripling of retail space in a cities that are barely growing. These cities simply ran out of shoppers for all of this space. Now the mall is empty—heck the strip retail is only partly filled in. The next step is that rents will drop—dramatically. The owners of each asset, the mall and the strip center will go bust. Neither has a cap structure that is designed for dramatically lower rents. Neither has an org structure designed for carving up this space for the sorts of eclectic tenants that will eventually absorb it over the next few decades.

CRE has had it so good for the past 35 years, that most owners have never seen a down cycle. Sure, Dallas had too much supply in the early ‘90’s. Silicon Valley over-expanded in the early ‘00’s. It took a few years for it to be absorbed. Anyone who had capital during the bust made a fortune. This time may really be different. There’s too much supply. Short of blowing it up, it will be with us for years into the future. Without dramatic economic or population growth, some of it may NEVER be absorbed.

As an investor, this is all interesting to understand, but you don’t fully comprehend it until you have visited a few dozen of these facilities and seen how owners are trying to cope with the problem. In Miami, space is constricted. In Texas, there’s more CRE than I’ve ever seen. They keep putting it up—even if there isn’t demand currently. For three decades, they’ve always been able to fill it over time. For the first time ever, they can’t seem to fill it—in fact, demand is now declining. It is now obvious; there will be a whole lot of pain for CRE owners and lenders. Of course, someone’s pain can be someone’s gain. To be continued…

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Mall Tour 2017

June 25, 2017 7:19 PM


For the past few years, most retailers have struggled. Of course, it’s easy to blame Amazon.com, but it is only one of many causes. At the same time, for us hedgies living in major cities with luxury malls, there is confusion about the problem itself—my mall is crowded and people are shopping. After having debated with friends endlessly on what the real root of the problem is, I decided it was time to actually go investigate. Every city has its own story and the local mall is the nexus of that story. In my mind, the only way to get real answers was a 4-day, 1,500 mile meandering road-trip through the lower mid-west, where we planned to hit as many malls and take as many meetings with facility managers and brokers as we could organize along the way. Besides, when an asset class like mall real estate is down 90% in a few years’ time, a different viewpoint can create huge upside.

The overriding question was: is retail suffering because of Amazon.com cannibalizing store-fronts or are rising health care costs, with stagnant wage growth, what’s really cannibalizing disposable spending power in middle-America? Is shopping still America’s pastime or do we prefer food and “experiences” instead? Every industry evolves. Why hasn’t the mall changed in the past three decades—it’s still the same cinema, crappy food court and undifferentiated retailers that I knew when I was a teen—where’s the fun in that? Other countries are perfecting “shoppertainment,” why hasn’t America? In summary, what is the real issue with retail?

malls 2

When you scroll through http://deadmalls.com there is a certain eeriness about a million square feet of empty space. However, the images don’t, in any way, prepare you for an almost-dead mall on its last gasps. As we wandered one facility with the head of leasing, we could look straight ahead at a thousand feet of almost vacant space, dimly lit from sky-lights as none of the lighting fixtures still worked—the air conditioner had long ago failed and it was 95 degrees inside this mall. However, there was one light that drew us forward. As we approached, we heard music and sure enough, it was the Victoria’s Secret that time forgot (corporate probably forgot it too). In a mall with only 7 tenants and even fewer shoppers, Victoria’s Secret was still jamming out. No customers, but 2 girls tending shop, blasting music and throwing light into a dark hallway.

As we rounded another corner, we heard the unmistakable sound of a Zumba Class at 100 decibels. As we drew nearer, we saw the first mall visitors in almost an hour—what looked like an instructor with a half dozen middle-aged women trying to do exercises that they were hopelessly unfit to accomplish.

I turned to the leasing agent;

Me: Any idea how much they pay in rent?

Him: Actually, I think they’re squatting in here. I don’t show any record of them being a tenant.

Me: Is anyone going to make them pay rent?

Him: Why bother, at least it brings people to the mall...

empty malls

With no security or cleaning staff, who's watering the plants?

 

All of this segwayed into the meeting with the leasing agent afterwards.

Me: Can I meet the facility manager when we’re done chatting?

Him: Funny story; actually, she quit a few months back. Unfortunately, the owner only told me last week that I am now in charge of managing this mall. I’m doing my best, but I live an hour away, so I can only come here a few times a week.

Me: So who’s been locking up at the end of the day lately?

Him: Hmmm…. Honestly, I’m not sure. That’s a pretty good question.

Me: Would anyone notice if they never locked the doors?

Him: Probably not…

Of course, you cannot quite put this into context until you realize that I was sitting there in a nearly pitch black food court, in 95 degree heat, with only a beam of light from the sky-light above to guide the conversation—yet despite the odds, one vendor still remained at the food court—ironically it was the sushi place.

mall gumballs

I wonder what decade these gumballs are from?? I didn't know they could turn brown.

 

While the tour was entertaining, what I really wanted to know was; why did this place, surrounded by a thriving community somehow fail? This is where the story actually deviates from the usual narrative.

This mall was in a community of about 100,000 people. A decade ago, this had been a thriving mall. Then, a new major highway was placed about 5 miles west of the mall, which diverted regional traffic away from the mall. Even worse, a massive open air retailing complex was built alongside the new highway, siphoning shoppers from the mall. In a town that was big enough to support one large shopping complex, the newer one with better access from the highway had ultimately won out. However, this mall was still muddling forward with a handful of national tenants who hadn’t quite thrown in the towel, despite no lighting, air conditioning or adult supervision at the mall. It lead to a real epiphany; malls die a slow strange death—not the cataclysmic collapse depicted by most analysts.

empty malls 3

We saw a similar situation on the following day at another mall about 100 miles away. In this situation, a new retailing facility had been built closer to the local university to compete with the mall. This facility had stolen a number of the key tenants from the mall. At the time, it looked like this mall would also surrender to the newer facility in the better location. Instead, the mall was sold to new owners who; injected substantial capital to remodel the mall, offered discounted rent to retain existing tenants and had put up a fight to the death with the newer facility. Now, nearly a decade later, neither facility was full and both were desperately fighting it out for the minds of tenants and shoppers in a winner-take-all battle, a veritable retailing Battle of Verdun in the north of Texas—where even the winner will be a loser for having spent so much capital to win the booby prize of top retail destination in a town of about 125,000 people. Even worse, with no clear winner, new retailing concepts were hesitant to guess wrong in their expansion plans and simply chose to pass this town by when expanding—further sapping the strength of both facilities.

In fact, we continued to see similar stories as we ventured north. Retail may not be dead; instead there may simply be too much retail (both property and competing concepts) fighting it out for too few customers. This is further compounded by too much cheap capital developing more retail as a result of ultra-low interest rates. Naturally, there will be losers in this process—in fact; the losses have only just begun. There will also be huge winners.

To Be Continued…

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Amazing Tequila (Part II)

May 10, 2017 7:57 PM


I tend to travel a lot. No matter where I am, I try the local beer. If I like it, I often seek out the local brewer. You’d be amazed at how often you can get a brewery tour—at pretty much any hour of the day—any day of the week. If the owner or head brewer is proud of what he’s producing, he’s going to want to show it off and then share plenty of it with you afterwards.

Apparently, the same rules apply with Tequila and my new friend Guillermo Erickson Sauza, from Fortaleza Tequila was more than willing to share. The Sauza family has been producing tequila for 5 generations and it shows. However, I wasn’t interested in exploring the eponymous industrial scale production facility which was sold by the Sauza family in 1976. Instead, I wanted to see the artisanal Fortaleza facility, where tequila is still made in the traditional way.

With that in mind, here’s a crash course in Tequila making;

agave field

 

You start by harvesting the agave from the fields. Note the town of Tequila in the distance.

 

tequila pinas

 

The leaves of the agave plant are removed so that all that remains is the fleshy stem (pina) that has the maximum quantity of sugar.

 

tequila 1

Then, processing starts. The pina is slowly baked in an oven to break down the complex sugars into simpler fructose. The pinas are then mashed (see the millstone in the back of the collection tank). Using water, the fructose is washed out of the fibrous plant material through hard work resulting in an agave juice. (Notice how small the facility is).

 

tequila 2

After the fiber has been thoroughly washed of sugars, it is left on a rack to allow all the agave juice to drip back into the collection tank. Machines can accomplish the same task in much less time, but you end up with overwashed material and unwanted flavors.

tequila fermentation

The extracted agave juice is then fermented into a wort or mosto with low alcohol content.

fermentation foam

The foam on top means it's working!!

distillation

After it has been fermented, it is distilled.

aging

At this stage, silver tequila can be bottled directly and tequila destined to become reposado or anejo is pumped into casks to age.

tequila fortaleza

Here is the finished product. Having drunk my way westwards across Mexico for nearly three weeks, I can say that this is the finest tequila I've had. Clearly, others agree as it continues to win all the tequila awards. Unfortunately, all the stores in Miami are sold out--trust me, I've been calling around.

Let's just say that Guillermo has it all figured out and it sounds like his annual sales growth is off the charts. This is the sort of business that I would be interested in owning part of--too bad he doesn't need any capital for his growth. He already has it all; a few dozen hectares of agave fields, a massive estate on a hill overlooking his fields, his own tequila production facility and a tequila cave bar for escaping the heat of a Mexican afternoon.

guillermo

Guillermo sitting to the right, watching the preparations for our afternoon drinks.

 

Premium tequila has minimal penetration into the US and sales are growing nearly 50% a year. Clearly there's an opportunity for me here. Unfortunately, the hunt for the right opportunity goes on...

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Amazing Tequila (Part I)

May 8, 2017 11:48 PM


For most of my life, tequila was something I gagged on at 4am, because some asshole thought it would be “fun to do shots.” Yet, throughout my many recent trips to Mexico, I experienced faint hints of what quality tequila tasted like. I quickly learned to avoid the mass produced commercial product out there and instead sampled small batch brands—often led forward by those who claimed to be experts in the craft. I liked what I tried, but I knew that nothing would do justice except a proper education in Tequila itself. As I was already organizing a Mexican road-trip with friends, I figured, we all might as well go 500km out of the way and explore both tequilas—the city and the libation. Besides, with overall US tequila consumption growing 10% a year and premium consumption growing nearly 50% a year, maybe there was an angle for a bunch of drunken portfolio managers to explore.

Tequila itself is unique, as it is one of the very few alcohols to take the name of the city it is produced in, instead of a region. After many a fraternity night essentially doused in the stuff, I assumed that the city would be set up for drunken tourism—a Bourbon street in the highlands of Mexico. Let’s just say it wasn’t what I was expecting. There are some tourist accoutrements, but in reality, this is a sleepy sixteenth century village of about 25,000 people—most of whom are in some way or another, tied to the tequila industry. Then again, given how remote the city is, it shouldn’t be a surprise that the tourists making the journey are true tequila aficionados—not the rowdy fraternity boys I expected to find.

downtown tequila

The leisurely town square in Tequila

 

After a leisurely lunch, we made our way to La Cata, Tequila’s best (and only) tasting room to get educated by a true expert, Clayton Szczech. While I can describe the dozens of varieties we sampled, that won’t do justice to the unique flavors—besides, by glass number 5, I sort of lost track of what I was drinking. What I do remember is our talk about the tequila industry itself.

Tequila comes from blue agave plants, primarily from the state of Jalisco and a handful of surrounding areas (the appellation). Production from other regions is considered mezcal. This limited growing region has created unique problems for producers. To start with, the plant takes 7-10 years to mature and will rot if not harvested at maturity. Since only the inner stem is used, it must be replanted after harvest and the wait until harvest begins again. With demand growing rapidly, this has led to perpetual cycles of boom and bust—just imagine how hard it is to predict demand for a product a decade into the future. Meanwhile, the cycles can last for many years due to the time it takes for a crop to mature. When we arrived in Tequila, the price, at 13 pesos per kilo was on the upswing—having been at half a peso per kilo just a few years earlier. Then again, that bust was epic and caused by a peak price of nearly 40 pesos per kilo (adjusted for exchange rates) back in 2000.

tequila truck

Truck full of agave waiting to unload

 

In all commodities, the cure for high prices is high prices. In the early 2000’s, farmers raced to plant agave, dreaming of heady profits, only to have most of their agave rot on their fields around 2010 since the glut was so extreme that it didn’t even pay to harvest it. That experience even led farmers to tear up their young plants and now there is a growing shortage again. The magnitude of this boom and bust cycle is unique for an agricultural commodity. If wheat doubles, that’s a huge move. Agave is up nearly 25-fold in 3 years and no one expects the price to pull back until larger crops can be harvested around 2020. Agave has had an epic move. Who needs futures or leverage, if you can capture those sorts of moves with physical offtake agreements? In a country with high interest rates and a lack of access to capital, I’m sure there is a business here. As everyone attested, the big guys are calling the shots and screwing the farmers who need access to capital.

The big distillers have the luxury to use grower loans to lock in supply when it’s cheap. Alternatively, they can store semi-processed product for years in order to smooth out these cycles when the price is high—buying agave when it’s cheap and storing it by the millions of gallons for when the price appreciates. Of course, that’s why most of the tequila you drink tastes like diesel—it wasn’t meant to be stored semi-processed. To a bunch of hedgies, this sounds like a system that is ripe to be disrupted—fortunately, we all scheme best when inebriated…

la cata

La Cata Tequila Wall

 

As we went through La Cata's wall of tequila, another recurring question was; how do these brands intend to differentiate themselves in the market? Unlike the whiskey bars now popping up everywhere, there aren’t a lot of tequila bars in the US for sampling all the brands out there. Americans often have to buy a full bottle to try it—hence the tequila sales effort is focused on the bottle design—unlike with whiskey. We saw some real works of art—much of it hand-blown. Interestingly, while a lot of well-known global brands will tell you that they’re “super-premium,” once you try the good stuff, you realize that there is still plenty of room globally for a super-premium brand of tequila—the true high ground hasn’t yet been claimed. Unfortunately, grubstaking a young brand is too much like venture capital. While established liquor brands have insane returns on capital, most start-ups fail to be noticed and ultimately go bust. This was a business that we would leave to someone else.

After a week on a bus full of hedgies, the conversation naturally turned back to the usual talk of which industries are due to be disrupted, which companies we should target for activist campaigns and which of our friends has had a big score lately. We sipped a few more glasses of tequila and continued to think out an angle on the rapidly growing tequila industry.

Unfortunately, all that drinking got us hungry and we weren’t going to bed without some quality street tacos.

 

taco guy

If you are ever in Tequila, seek this hombre out. He's mastered the taco craft.

sacha with dog

RBC Portfolio Manager Sacha Imbert devouring tacos. Even the local dogs were amazed.

 

To be continued….

 

 

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