Inflection Capital Management creates timely thought pieces on what we view are pressing investor questions of the moment. Below are some of our recent white papers.


Amazon 2H Slowdown

December 7th, 2018

 

US Housing

December 6th, 2018

 
 

US Housing Sitting Precariously

November 24th, 2018

 

A Deeper Look Into the Culpability for the Retail Apocalypse

 

 

Is the Media Sector Evolving or Devolving?

 

US Retail & Is It Investible?

 

The Amazon 2H’18 “slowdown” and loss of market share (above) capture.

  • Recent Q3 results & guidance for Q4 resulted in a material correction in the stock.

  • We believe that management “took their foot off the accelerator” in the 2H to “tighten-up.”

Why?

  1. Stronger-than-expected demand during 2017 created some less than ideal operational and customer issues that management wanted buttoned-up.

  2. Prime has reached such a high rate of penetration in the US, that management is now transitioning the business’ growth to “wallet-share” from “new wallets”. Growth from wallet-share is far more challenging and requires extremely strong execution. Consequently, management wanted to “tighten-up” its assets and execution. 

  3. Given Amazon’s high penetration in core markets, Amazon has to now source significant new areas of consumption such as experience and services. This likely entails a major acquisition. Given their learnings from the Whole Foods acquisition, management needs to set up the Amazon organization to more effectively integrate large acquisitions. 


The Fed Beige Book for December was published yesterday. Nearly every district reported a material softening in residential real estate. Moreover, most cited higher interest and mortgage rates as a contributor. This contrasts to the prior Beige Book in October where conditions were, on balance, favorable and where only three districts (Chicago, Dallas, and Kansas City) pointed to CONCERNS about rising interest rates. We suspect that the December Book should figure heavily in the Fed’s consideration of and communication on interest rates. We are leaning dovish.

Below are the district comments, October following by December.


Conclusions:

1) US housing is in a precarious place as it’s transitioning to improved affordability.

2) The Federal Reserve can not increase the Fed Funds rate more than 2X, otherwise it will render the existing housing stock significantly less affordable.

3) Increasing the Fed Funds rate by 3X, or more, would especially hurt the entry-level buyer. The industry desperately needs that buyer to enter the market to improve overall housing liquidity and turnover.

4) We are not Fed analysts or whisperers. We are reasonable people. We are fully confident that the Fed is aware of the above housing dynamics and the difficult issues of population demographics, affordability, and wealth distribution. We also believe that the Fed is reasonable and prudent. As such, we think that the Fed WILL NOT raise rates by more than 2X. We think that a prudent path is one hike in December, followed by another in the 2H’19, depending upon housing data.


Conclusions:

1) During 2016 and 2017 announced US retail store closings were over 9500 stores, resulting in the elimination of around 250k jobs; the 2017 announcements were 230% greater than 2016’s level. Additionally, despite robust consumer spending, overall US retail net profits fell more than 20% from 2014 to 2016, and return on assets have fallen a like amount. As a result, US retail has been an underperforming sector in the stock market. This presentation shows that the sector’s profit and performance pressures are the result of a confluence of adverse factors and not solely due to the popular allegation of unfair competition by Amazon. That popular view is anchored by a false belief that Amazon doesn’t make profits and that Wall Street doesn’t hold Amazon accountable for profits, as it does for conventional retailers.

2) The confluence of adverse factors affecting the industry include: 1) the industry went through the 2000s aggressively building new stores--over-building into the teeth of unfavorable shifts in demographics and income bifurcation. 2) Those shifts were exacerbated by a move in consumer demand to e-commerce. 3) e-commerce moved retailers into competition with more efficient competitors (such as Amazon) which were also not beholden to historic higher retail prices and margins. 4) Retailer websites and pricing-bots moved competition from a local-market level to a national level where prices were set by the lowest price in the marketplace. And 5) moving into these headwinds were a material number of retailers that had been bought-out by private equity in more benign times. Many of these private equity-owned retailers did not have the capacity to invest, the capability to evolve, and the stamina to withstand the headwinds.

3) These buy-outs took place during an unprecedented period of private equity fund raising that was coincident with substantial shifts in institutional investor asset allocations from public equity to private equity. These allocation changes were made with the expectation of higher returns from private equity over public equity. While the expectation for higher returns was justified based upon historic returns, there has been little academic or independent research on the systemic risks and potential externalities of such large allocation changes. As such, institutional consideration for the risks and externalities appears to be limited.


Conclusions:

The media sector is at an existential crossroads. Its content is going direct to the consumer and traditional distributors like cable and satellite will be bypassed. Savings from cutting out distributors will be passed on to the consumer and video content choice should rise, allowing consumers to watch to more TV shows and films. Consequently, audiences will continue to splinter and it will become more costly to attract an audience; industry revenue growth and margins will both deteriorate. 21st Century Fox and Disney have taken steps to produce more value for shareholders. However, that value will likely accumulate only at a low-double-digit annual rate. For the remainder of media, value is likely to fall as the companies don’t have a strategy to resolve their legacy dependencies.

The tech and telecom titans (AT&T, Apple, Amazon, etc.) that already have adjacent media business will likely only accumulate value from their core businesses, not from their media assets. This is because video packaging and distribution is becoming a profitless business—unless one has massive global scale. Additionally, there is little way for the other tech and telecom titans to buy Discovery, Viacom, AMC Networks, etc. and create meaningful shareholder value. All the needle-moving assets are now taken. In contrast, Netflix has reached such a large scale in subscribers and content-acquisition capability that its market value is likely to accumulate at a rate faster than low double digits.


Summary Points:

1) The US consumer’s financial situation is healthy and spending on discretionary goods has been on-trend in 2016 and through Q2’17.

2) There continues to be significant misunderstandings about the size of e-commerce penetration in the US and Amazon’s real share of e-commerce.  Both are significantly larger than is popularly believed when third party sales are included.  As such, Amazon’s impact to traditional retail continues to be more than what is expected.

3) The key attributes for retailers to maintain their market share continue to be: 1) having strong branded vendors which control their distribution (see Best Buy and Home Depot), 2) having a strong private brand program that offers consumers tremendous value (see Costco), and 3) having a treasure hunt (see Dollar Tree and Ross Stores).

4) ICM forecasts that apparel retail will suffer larger share losses in ’17 and ’18 than prior periods.  This will continue to wreak havoc on apparel vendors. 

5) Today, the strategy by most large retailers that sell discretionary goods (ex. Target and Kohls) is to wait-out the competition and accrue the market share as weaker retailers close stores and fail.  This strongly suggests that margins and returns are moving lower in the medium-term.  Next year will not be the “year of easy comparatives” during which there is a bounce-back in earnings. 

6) In the long-term, after the “rationalization” and stability in market share, the sector may see a nice recovery in margins and returns, and be investible again.  In the medium-term the industry is fraught with risks that need to be carefully navigated. 


When to Sell Amazon

Summary Points:

1)   The “sell AMZN” question has been so difficult to answer because AMZN is consistently entering new markets which have positive reinforcing effects on AMZN’s ecosystems.  Weighing the value of this optionality and an impressive market-penetration ability against AMZN’s ever-increasing market cap has, thus far, proven futile.

2)   Inflection Capital Management (ICM) has sought to better forecast Amazon’s opportunities by making a detailed analysis of Amazon’s markets, its penetration of those markets, and adding an additional level for optionality. 

3)   ICM’s approach to judging when to exit AMZN is to forecast when Amazon is likely to hit material, negative inflection points in its core businesses and when it will face a law of large numbers problem in total revenue growth.

4)   ICM forecasts that Amazon’s growth will materially slow after 2020 as its market  penetration reaches more than twice the current level.

5)   ICM looked at market history to find strong parallels to the Amazon story. The best precedent that we found was Walmart.  Walmart’s valuation multiple was relatively stable until 2003 when its core, general merchandise business hit the law of large numbers.  After that point, multiple compression led to a flat stock price despite Walmart’s solid earnings growth and 10% annual revenue growth.

6)   Based upon ICM’s market models, we expect Amazon’s domestic retail business to hit the “law of large numbers” during 2020. This would be the tell to SELL as multiple compression would likely offset all of Amazon’s earning’s growth going forward.