<DAILY DOUBLE>
Monday, July 12, 1999
REX Stores Corp.
(NYSE: RSC)
Phone: 937-276-3931
Website: http://www.rexstore.com
Price (7/9/99): $37 3/8
HOW DID IT DOUBLE?
Sexy REX was not -- until April, when this consumer electronics retailer announced it had started selling audio and video equipment on Amazon.com's (Nasdaq: AMZN) auction site.
While that venture won't have a major impact on the company's business anytime soon, it alerted investors to this value-oriented retailer's value price and improving story.
Like its big city rivals Best Buy (NYSE: BBY) and Circuit City (NYSE: CC), REX endured a tough FY97 (fiscal year ends in January), as falling average selling prices for PCs and uninspiring consumer electronics offerings crunched earnings. Yet, the closely managed REX remained nicely profitable throughout this rough stretch.
Getting out of the tough PC business, though a smart move, dampened revenues. More recently, liquidation sales by erstwhile small town competitors Sun TV (Nasdaq: SNTVQ) and Campo (OTC: CMPOQ) have also hurt revenues. Indeed, sales at stores open for at least six full quarters plunged 17.5% in FY97 and 10.5% in FY98 only to come in flat last year. That's why the stock looked as extinct as a T-Rex.
Yet, despite just a 1% gain in FY99 sales (and a 1% dip in Q4 revenues), operating profits improved 5.3% as margins hit 4.85% versus just 3.62% for Best Buy. Thanks to aggressive share buybacks, a sustainable tax break, and one-time asset sales, FY99 earnings per share (EPS) soared to $1.43 from $0.91 in FY98.
More recently, REX has started offering merchandise from top manufacturers Maytag (NYSE: MYG) and Sony (NYSE: SNE). It's also ditched its old advertising agency and started a new television campaign on Fox Sports and local channels that should better reach younger consumers. Also, the demand for hot new digital products that's driven sales at its larger rivals has begun to reach the smaller cities where REX operates.
First quarter results announced June 3 showed sales up 12.6% to $99.1 million, thanks to a 11.9% gain in same-store sales. That lowered selling, general and administrative (SG&A) expenses to 23% of sales from 24.1% a year ago, more than making up for a 60 basis point drop in gross margins to 26.7%. As a result, operating income leaped 32.2%. Add in a one-time gain and a significantly lower tax rate (25.0% versus 39.5% a year ago), and EPS doubled to $0.27 from $0.13 last year.
With improving sales generating considerable operating leverage and REX facing three years worth of weak comparisons, investors embraced a value stock in the midst of a turnaround that appears to be driven by a sustainable upgrade cycle as we all rush to become more digital. As a result, the stock price has nearly tripled over the last three months.
BUSINESS DESCRIPTION
A specialty retailer of consumer electronics headquartered in Dayton, Ohio, REX Stores operates 227 stores in 35 states, mainly in smaller cities (population of 300,000 or less) in the Midwest and Southeast. The average store size is just 10,900 square feet, and most stores are located in freestanding buildings.
The company opened six net new stores during FY99 after adding no net new stores in FY98. The company could add 15 net new stores this year.
The bulk of sales comes from brand name consumer electronics products, such as televisions and other video equipment (53% of sales) and audio equipment (18% of sales). REX also sells major household appliances such as refrigerators and washer/dryers (21% of revenues) and home office products like fax machines and telephones (8% of sales).
It offers everyday low prices and a low-price guarantee. Over half its merchandise comes from "opportunistic" purchases from vendors looking to move excess products.
Unlike many retailers, REX owns the real estate underlying a significant number of its stores (110). Its long-term debt is also mortgage-related.
Also, REX recognizes revenue from its high margin extended service plans (3.7% of FY99 sales) over the three-to-five-year life of the contracts, leaving the company with $16.3 million in deferred income. By contrast, Best Buy and Circuit City recognize such income immediately.
Insiders own 39.4% of the stock, with most held by Chair/CEO Stuart Rose. In March, Rose and president Lawrence Tomchin exercised decade-old stock options to buy 512,000 shares at $3.38 per share. They apparently have not sold those shares, however.
Another 38.9% is held by six institutional investors (including Fidelity Magellan) with a better than 5% stake each.
FINANCIAL FACTS
Income Statement*
12-month sales: $427.8 million
12-month income: $12.26 million
12-month EPS: $1.57
Profit Margin: 2.87%
Market Cap: $285.2 million
(*Including one-time items and a reduced tax rate)
Balance Sheet
Cash: $9.3 million
Current Assets: $168.3 million
Current Liabilities: $89.8 million
Mortgage Debt: $55.9 million
Other LTD: None
Ratios
Price-to-earnings: 23.8
Price-to-sales: 0.67
HOW COULD YOU HAVE FOUND THIS DOUBLE?
When the Amazon news was announced, REX was still trading below its book value, now around $112 million, or $14.67 per share. Thinking beyond the recently flat same-store sales, an investor should have seen solid and potentially improving fundamentals, especially given the success enjoyed by other consumer electronics retailers.
Although REX's sales declined slightly over the past three years, the company's earnings have continued rising from their FY97 trough partly because it has been steadily buying back its stock at ever higher average prices: 854,000 shares in FY97 at $8.77 apiece; 567,000 shares in FY98 at $8.85 each; and 632,000 shares last year at $11.82 per share.
It acquired another 71,000 shares in the first weeks of Q1 FY2000. The board is authorized to repurchase another 394,000 shares.
Such repurchases suggested that Chair/CEO Stuart Rose thought the stock was cheap and had confidence in the firm's prospects. The buybacks have reduced the company's fully diluted shares by about 19% from the FY96 average weighted sharecount to the 7.59 million shares with which REX ended FY99.
WHERE TO FROM HERE?
REX's prospects look appealing. The challenges that buffeted its business have now driven some competitors out of the market. Meanwhile, only about 35% to 40% of its stores compete with a Best Buy or Circuit City, mostly with the latter's small store format.
Tandy's (NYSE: TAN) Radio Shack is broadening its product offerings and could pump up competition. But for now, REX appears to operate in an attractive niche much as Dollar General (NYSE: DG) and other small-store value chains have prospered by operating mainly in markets too small to support a Wal-Mart (NYSE: WMT).
Analysts are looking for sustainable same-store sales growth of around 5%, assuming the economy remains solid. Some project long-term earnings growth of 20%. Both targets seem quite reachable given the weak comparisons REX is up against and the attractive new merchandise mix.
Wall Street is expecting EPS of $1.61 per share for FY2000 and $1.87 for next year, according to the three-analyst estimate from I/B/E/S. Zacks' survey of five analysts came up with a $1.46 a share FY2000 consensus (range $1.35 to $1.65) and $1.75 for FY 2001 (range: $1.60 to $1.90).
That large range (and discrepancy) is probably caused by combining estimates that both do and do not include REX's investment in a limited partnership (LP) that produces synthetic fuels and generates tax credits -- and the analysts have interpreted the LP quite differently.
Some analysts figure the LP creates a sustainable (10-year) tax rate of 25%, so their EPS projections assume that's the normalized tax rate. They then apply an earnings multiple to that figure to get a target price. Others argue -- correctly, in my view -- that you want to apply a multiple to the fully taxed EPS figure and then add a net present value of about $2 per share for the LP's value in order to get a target price.
The method you choose can dramatically impact the valuation process. Morgan Keegan analysts David Childe and Timothy Lipton put FY99 operating earnings at $1.10 per share (versus the $1.43 reported) and Q1 FY2000 earnings at $0.20 versus the $0.27 reported. Conservatively, they see FY 2000 earnings coming in at $1.35 per share without the LP, or $1.75 to $1.80 after taking it into account.
On the other hand, other analysts calculate earnings, both past and future, quite differently. In a June 7 report, George K. Baum analysts Dean Ramos and John Schmieder put FY99 earnings at $1.17 per share and FY2000 earnings at $1.59 per share including the LP and $1.22 without it.
By my calculations, FY99 fully taxed (35%) operating earnings after interest expenses were $9.17 million, or $1.17 per share. Assume REX does $465 million in sales this year and delivers a 5.2% operating margin -- optimistic though not outrageous assumptions. Then, fully taxed operating earnings would be $11.75 million, or $1.54 per share.
Slap a multiple of 20 on that, and you get $30 per share. Add $2 for the LP, and fair value would be about $32. In other words, REX looks fairly priced at the moment. Yet, given the premiums placed on REX's more formidable but less profitable competitors, REX might still be worth a closer look.
-- Louis Corrigan (TMFSeymor@aol.com)
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