Wal-Mart Just Declared War On Amazon

amazon-versus-walmart-780x439On January 7th, I posted my first article about Wal-Mart. I posted another on March 23rd. You can read these here and here. Wal-Mart has performed well this year. It is up 19.6% YTD. The market is up 7.1% YTD.

Last week it was announced that Wal-Mart purchased Jet.com for $3.3 billion. What is Jet.com, you ask? It’s a 1-year-old online shopping site selling groceries, furniture, and small appliances. It has some pricing gimmicks, but it’s basically the same old business model: an online marketplace where third-parties source the products and sell directly to consumers.

Wal-Mart’s E-commerce

Wal-Mart’s e-commerce has been a hot topic among analysts for the last 18 months or so. I wrote about their online business in my first two posts. Wal-Mart was expected to spend $1.1 billion this year and $1.3 billion next year on e-commerce. Online sales were expected to grow 20-30% a year which would be consistent with Amazon’s growth. However, last year they fell short of expectations by only growing online sales by 12%. In Q1, they only grew online sales by 7%. Is buying Jet.com the answer? In short, No. I was very supportive of WMT’s e-commerce strategy and investments. I thought they were doing a good job. However, buying Jet.com is a key long-term strategic move for the company and I cannot support it.

Store Productivity

Boosting store productivity of an existing retail store is very difficult. You have to create strategies, goals and initiatives that flow throughout the entire business. Most importantly, the employees that are directly interacting with customers must understand and believe that they are the backbone of the business. No one did this better than Frank Blake at Home Depot in 2010. The company had serious productivity issues and he executed one of the best retail turnarounds ever. (I discussed this in my previous article here.) The reason I mention this again is because we are seeing WMT shift away from these proven strategies. At the beginning of the year, Wal-Mart boosted wages for all employees. This worked very well because it improved customer service and Wal-Mart employees purchased more merchandise when they shopped at Wal-Mart.. The other strategies that WMT put in place were to invest in inventory management systems and close underperforming stores. Both of these were good. Finally, they shifted capex dollars to boost the buyback which has been accretive to shareholder value.

Now they are heading a completely different direction. Instead of focusing on improving the customer experience, they are going after a zero margin business. No one is going to stop shopping on Amazon and start shopping on Jet.com because their dish soap is $0.02 cheaper. That isn’t going to happen. If Wal-Mart tries to cost cut Amazon, they will lose.

Now there are two directions that Wal-Mart can go. 1) Keep Jet.com separate from Wal-Mart.com and try to grow it as fast as possible. 2) Integrate Jet.com into Wal-Mart.com and have a Wal-Mart.com powered by Jet model. I don’t know what they plan to do but either one will cost a lot more than the $3.3 billion they already paid.

Merging Businesses and Cultures

Mergers are extremely difficult. Combining two existing businesses and maximizing synergies is complex and time consuming. It requires excellent planning and perfect execution. The fact is, 83% of mergers fail to increase shareholder returns. Most of the time they don’t work. This acquisition will probably not work out well for existing shareholders. Although $3.3 billion is not a lot of money to Wal-Mart. This is just the beginning. They will probably spend another $3 billion in the next two years merging the businesses.

The capital isn’t the only problem. All companies have limited time and attention. Where they spend that time and attention drives shareholder value. Wal-Mart will be spending an immense amount of time and attention on this merger. Time they could be spending on improving their customer experience. Companies get in trouble when they spend 90% of their time on 10% of the business. This is what WMT is doing and this is a zero margin business. The core business is doing very well posting 1.5% comps and 6.5% comps for neighborhood stores. I fear the company will not appreciate how well this piece of the business doing and not give it enough attention going forward.

Merging Cultures

The Wal-Mart and Jet.com cultures could not be more different. Jet.com has made many moves that sacrifice profit for growth. Wal-Mart is the opposite, they continue to look for ways to boost the bottom line (buybacks, closing stores ect.). Jet.com does not make money and won’t as long as they push for transaction and user growth. Jet.com’s goal is to undercut Amazon’s price which means they are going to have a very difficult time boosting margins. I really don’t know how Wal-Mart will merge these cultures. They are complete opposites.

Current Valuation

Wal-Mart’s valuation does not look as compelling as it did when I posted the article last January. The stock is up about 20% since then so that is part of it. Analyst estimates have slightly fallen in the last eight months. Wal-Mart is expected to make $4.91 in FY2019. We know that historically it has traded with a 15 P/E. This gets us to a valuation of about $73.50 which is where the stock is today. I expect revenue growth to accelerate after the Jet.com deal but I think it will hurt EPS.

The bull case is that the stock will demand a higher valuation with the Jet.com acquistion. I wouldn’t be surprised if the stock does get a higher valuation based off of the deal even though I don’t like it. It wouldn’t shock me if the stock trades at a 17 or 18 P/E which would push the stock closer to $80.

My Portfolio

Wal-Mart is a large position for me. I bought the stock last November and I have done very well with it. However, I want to own great businesses at reasonable prices. A business that is at war with Amazon sounds like a miserable business. I plan on holding Wal-Mart through November for tax purposes. The Jet.com deal will take months to close and I don’t believe the core Wal-Mart business will be affected in the next 12 months. Looking out over the next 10 years, Wal-Mart is going to be in a expensive fight with Amazon.

I currently hold 35% cash in my portfolio. I have only slightly underperformed the market by 28 basis points through July 31st. Owning companies like Wal-Mart (Up 19.6% YTD), Loews (Up 8.4% YTD), Nexpoint Residential (Up 59% YTD), and Post Properties (Up 12.1% YTD) has helped me. Post Properties was purchased last week by Mid-America Apartments for about $72.50 a share. That deal will close in a few months.

There is a good probability that I will sell my Wal-Mart position before the end of the year. This will take me to close to 50% cash. I continue to look for value one company at a time. It is not easy to find great businesses that are trading with reasonable valuations. I am remaining patient and disciplined. Don’t follow the herd. I am prepared to underperform the market in the short term in order to achieve long term outperformance. Charlie Munger says that envy is the worst human emotion. It is 100% destructive. Being envious that others are getting richer faster than you will do nothing for you. When there is an opportunity, I will be ready.

Disclosure


Long WMT

 

 

 

NexPoint Residential – Demographics Driving Growth

Nexpoint480x270

A couple weeks ago, I published a post about Post Properties here. I have received questions about my investment thesis. I explained in the post that I believe the massive amount of student loan debt will delay Millennials purchasing homes for an extended period of time. However, the growing student loan debt is just one macro factor that is driving renter demand. In addition to the student loan debt, there are large demographic shifts happening in the U.S. I believe these shifts will continue and will persist for a very long period of time. Most of this post will cover the demographic shifts that I am seeing. The changes in demographics drew my attention towards apartment real estate investment trusts. I believe NexPoint is in the right market to capitalize on the new environment and will be a great business going forward.

NexPoint Residential Trust, Inc. is a real estate investment trust (REIT). The company is focused on multifamily investments primarily located in the Southeastern and Southwestern U.S. The company’s investment objectives are to maximize the cash flow and value of properties owned, acquire properties with cash flow growth potential, provide quarterly cash distributions and achieve long-term capital appreciation for its stockholders through targeted management and a capex value-add program. The company owns approximately 39 properties representing over 13,000 units in over eight states.

Rental Demand


Today there are 43 million Americans living in rental housing. This is up 9 million people in the last decade. This has been the largest 10 year increase ever. 37% of American’s are now living in rental housing which is the highest proportion since 1964. Many economists have blamed the financial crisis for these statics. However, I believe demographic shifts are having a bigger impact than anyone realizes. The Millennial generation has increased the amount adults in their 20’s. This is the period in life when renting housing is most common. Not only are there a lot of 20 somethings in the U.S, but also, they are getting married and having kids much later than previous generations. Delaying these events is pushing back the point in time when they might purchase a home. The number of renters would actually be higher today if the financial crisis had not happen because it forced many renters to move into their parents/friends houses. Most of these renters are still living with parents/friends. In combination, these trends are showing up in homeownership rates.Homeownership

These trends have boosted the number of renters in all age, income, and household type categories. Interestingly enough, renter demand isn’t as strong from Millennials as you might think. The largest increase over the last ten years was a 4.3 million boost coming from renters in their 50’s and 60’s. Millennials only added 1 million renters. Households 40 and older make up the majority of renters.

Demand for Mid Cost Rentals

There is a huge unmet need in rental housing. Over the last ten years, the supply of mid cost ($400-$800) rentals increased 12%. However, there was a 31% increase in rental households demanding these rentals. From 2001 to 2014, rent prices increased 7% while household incomes fell 9%. These trends have increased the number of cost-burdened (paying more than 30 of income in rent) renters to 49% of the rental population, this is a record. Today 26% of renters are severely burdened (paying more than half of their income in rent.) This is also a record. There is growing evidence that households lacking stable, decent-quality housing are more vulnerable to health problems and developmental delays among children. It is expected that demographics alone will be responsible for an additional 1.3 million renters to be cost burdened over the next decade. This indicates about 55% of rental households will be cost burdened. The unmet demand for mid cost rentals is a large problem.

Growth Demographics

As mentioned, the growth in rental households is not coming from where you might think. Millennials only added 1 million rental households. In the last decade, the number of adults aged 20-29 increased 11%. However, renter households from this age group only increased 2%. This demonstrates the phenomenon of Millennials continuing to live in their parents/friends homes.Demographic Growth

As shown, there was massive growth in rentership from the 30-49 age range.  On net, less than 2 percent of the 30-49 households made the transition from renting to owning over the decade. By comparison, more than 11 percent of baby-boomer households became homeowners when they were at a similar stage of life in 1984–1994. The largest increase in rental household came from baby boomers at 4.3 million driven by the decrease in homeownership. These large rentership rates from baby boomers are likely to persist. As people age, the probability of them making the rent-to-own transition decreases while the probability of own-to-rent increases. As more baby boomers make the own-to-rent transition, the unmet demand for rental housing could grow even further.

Forecast of Future Demand

Demand going forward is expected to be strong. Half of the Millennial generation are still in their teens and many will become renters in the next ten years. It is projected that 12 million millennials will be added to the rental population over the next ten years.

Another trend that will boost rental demand is strong immigration. Minorities are expected to account for three quarters of household growth over the next decade. There is a large gap between white and minority ownership rates. The probability of minorities renting is much higher. Therefore, strong immigration will translate into more demand for rental housing.

The other trend that we will likely see is the continuation of the own-to-rent transition from baby boomers. As many will reach 70 in the next ten years, many will transition to renting. This will accommodate their need for accessibility. I expect this transition to keep pressure on homeownership rates over the next ten years.

Rental Supply


There is currently a large lack of supply of low and mid cost apartments. Historically, newer apartments would age and the rent would filter down to supply the low and mid cost markets. However, there has not been enough apartments filter down into these cost markets to satisfy demand.

Costs of Development

Developers face a variety of regulatory and financing obstacles that limit their ability to add significantly to the lower-mid cost stock. Local zoning regulations often restrict the area available for multifamily development, especially in suburbs, which can increase the competition for available sites and raise land costs. Many regulations and zoning reviews are resulting in per-unit construction cost increases. It has made it almost impossible to build a new multifamily apartment complex that the median renter ($875) can afford. Most developers are focused on the upper end of the market which is causing the gap between supply and demand of low-mid cost rental housing to get wider.

Long-Term Supply Issue

Today 80% of newly constructed rentals are multifamily apartment buildings with 50 or more units. The median cost of these apartments is $1290 which does nothing to address the problem. This means that downward filtering of higher cost rentals will have to account for the supply of mid-low cost rentals. In the last decade, downward filtering boosted supply by 11%. The only problem is, because mid-low cost units are older, all of these gains were offset by rentals that were permanently removed from the supply because they had to be demolished. Therefore, only 8% were added in the below $400 range and there was just a 12% increase to the $400-$800 range. A 12% increase does almost nothing when there is 31% increase in demand for rentals in the $400-$800 range. This problem continues to get worse.

Market Conditions


Since 2011, rents have increased at an average pace of 2.7% a year. However, in the last 12 months they increased at a faster 3.6%. With overall inflation at just 0.4 percent, the real increase in rents in the preceding 24 months was larger than in any other two year period since 1987.

Rent

Vacancy 

The national vacancy rate sits at 6.7% its lowest rate in 30 years.

Vacancy

In the last five years, there has been a 1 million unit reduction in vacancy. Over 750,000 of the million were units priced below $800. Today, vacancy rates of units priced below $800 is only 3.9%. This is the lowest it has ever been. You should expect continued pressure on rising rent and falling vacancy rates in the coming years. Much of the future growth will be from minorities and senior households who typically have lower incomes.

NexPoint Residential


NexPoint owns multifamily properties in the Southeastern and Southwestern U.S. The great part is they offer Class B apartments in the $500-900 range. Right where the demand is greatest.

Organic Growth

NXRT has shown many quarters in a row with exceptional organic growth. The growth is driven by their rehab capex spending and the strong rental market. They are on pace to have about $30 million in capex for 2016. As of Q2’16, they have about $42 million in-progress rehab projects. Over the last four quarters, NXRT has achieved 12.2% same store NOI growth. This is double its peer average at 6%. Thier occupancy rate also outperforms peers at 94.8% vs. 94% for peers.

The company has averaged a capex ROIC of 21.2%. Assuming this continues into 2017, investors can expect $5.8 million in incremental NOI. This translates into $0.28 in FFO bringing estimated FFO to $1.73 for FY’17. At $1.73, NXRT only trades at about 11x FFO. Its peers trade closer to 17x.

Management

The management group has done very well and they have a lot of skin in the game. All of the top direct holders are in the management group. Combined they hold 4.25 million shares or 20% of the company. James Dondero is the President of NexPoint Residential. He is also Co-Founder and President of Highland Capital Management. On top of the 20% owned by management, Highland Capital owns 1.65 million shares or 8.22% of the company. All together, between management and Highland, they own 28% of NXRT and continue to buy more.

Financial Overview

NXRT Financials

Summary

NexPoint is a very underfollowed company that trades at a very reasonable valuation. The metric worth paying attention to is Funds from Operations (FFO). This is calculated as net income available to common shareholders determined in accordance with GAAP, excluding gains (or losses) from extraordinary items and sales of depreciable property, plus depreciation of real estate assets, and after adjustment for unconsolidated partnerships and joint ventures all determined on a consistent basis in accordance with GAAP.

Returning Cash to Shareholders

NXRT has a nice 4.29% dividend yield. This is the lowest it has yielded since the stock became public so I wouldn’t be surprised if they decide to raise it in the next few quarters.

Debt

The balance sheet is quite levered. The debt/equity ratio is about 3x. However, they are becoming less levered every quarter and I don’t see any reason why this trend won’t continue with the demand I see.

NXRT Debt

This chart above shows how different NXRT’s business is from other REIT’s. They have more debt than their peers but their debt agreements are much more favorable because they are variable. With interest rates continuing to stay low, they are not having to pay much interest on their debt. Monetary policy from the Fed will have a large impact on the cash flow of the business. We know the Fed wants to raise interest rates and I believe there is a good chance they will in September if they economic data remains decent. On June 6th, NXRT entered into a credit facility of $200M with terms 1 month LIBOR + 2.2%. Today, they have $258M in variable rate debt. Even if they Fed raises rates, LIBOR will likely not be greatly affected. Bottom line is, if interest rates in the U.S rise quickly, their debt agreements could swing from being a tailwind to a headwind. I cannot predict where interest rates are going. I have no idea and I am not going to waste my time trying to guess. Therefore, I will monitor relevant interest rates but focus on their business.

Valuation

NXRT valuation

I am trying to get away from doing rigid valuations. Investing is an art not a science. I just put this one together quickly. I don’t want to put much emphasis on it. It does indicate that there is value in the stock even if it grows at 3% a year. NXRT is growing at 20% so far in 2016. I believe NXRT can grow at 10% or more a year for many years considering the demand for apartments they offer.

Each quarter, management includes a NAV calculation in their financial supplement. Below is the NAV calculation from Q2.NXRT NAV

If you look towards the bottom right you can see the est. NAV is between $19.44 and $24.78. The midpoint is $22.11 or 12.8% above current market prices. I find it hard to believe that NXRT continues to trade at a large discount to NAV. I believe this is an opportunity for investors.

Bottom Line

NexPoint is a terrific business. Demand for their units is incredible. It could take decades before today’s Class A apartments filter down to satisfy demand. I believe we are going to continue to see NexPoint acquire properties and grow NOI. Management owns 20% of the shares giving them plenty of incentive to perform. I look forward to watching this company grow in the future.

Disclosure


Long NXRT