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Friday, October 16, 1998

An Investment Opinion
by Warren Gump

Buckled Up for a Downturn

Is Chicken Little lurking on Wall Street? As pundits and speculators have been fretting about the impending recession, they have taken many retail stocks out to the barnyard for a true thrashing. This concern was the primary reason that some of the better know names such as Wal-Mart, Costco, Sears, and May Department Stores fell between 25% and 35% from their summer highs to their early October lows (most have rebounded somewhat over the past week or so).

If we want to find some really poor performing stocks, Fools need to look no further than small-cap retailers, which have been hit with the double whammy of being in the retail sector and falling into the currently abhorred small-cap universe. Here we find stocks such as Pier One, Gadzooks, Ross Stores, and The Buckle, which have been down between 53%-77% from their summer highs. Are there any interesting stories behind this carnage?

One that looks worthy of further investigation is The Buckle Inc. (NYSE: BKE). This retailer sells teen apparel through 209 "The Buckle" and "Brass Buckle" stores located in 28 states throughout the central, northwestern, and southern regions of the U.S. Almost 80% of sales come from tops (shirts, sweaters, blouses, etc), denims, and shoes. While the teen apparel market is extraordinarily fickle, The Buckle management has shown over the past few years an adept ability to meet the needs of its clientele. In addition, it has grown the company without using any debt and has maintained a cash and short-term investment balance that stood at about $64 million (a little less than $3 per share) at the end of its second quarter. This strong balance sheet should help the company to continue growing throughout any period of "economic turbulence".

Since January 1997, the company has reported double-digit same-store (10.2%-37.7%) sales gains every month except for two (in February 1997 and last month, when results were only up 7%-8%). These kinds of results are extremely impressive, particularly considering that most retailers are content with 5% growth. Why are same-store sales so important to a retailer? Many expenses that a retailer pays are relatively fixed (rent, utilities, and labor) and do not change significantly based on the actual sales experienced by the company.

For example, say "Politicos 'R' Us" (SCUM) opened in 1997, and sold $20,000 worth of merchandise, generating gross profit (sales minus cost of goods sold) of $8,000. The company paid rent and labor expense of $6,000, leading to a net profit for the year of $2,000. In 1998, the store reaped the benefit of hot selling Clinton-scandal paraphernalia (not to mention the new, glittery "Nuke Newt" bumper sticker) and saw sales and gross profit increase 50% to $30,000 and $12,000, respectively. Despite the dramatic sales increase, rent and labor costs only increased 10% to $6,600, leading to an annual profit of $5,400, up 170%.

That little example brings up another important point. While same-store sales are important, the company needs to be maintaining or increasing gross margins (gross profit divided by sales). In our above example, SCUM maintained its margins at 40% ($8,000/$20,000 and $16,000/$40,000). If margins had fallen, the results could have been quite different. For example, if margins had fallen to 30% in 1998, the company would have had gross profit of $9,000 (30% of $30,000 in sales), and an annual profit of $2,400 ($9,000 gross profit - $6,600 expenses). This 20% earnings growth is a far cry from the 170% we calculated in the original example. Looking at our real company, The Buckle, we are comforted to see that gross margins have increased from 31.6% in Q2 1997 to 34.4% in Q2 1998, continuing the positive trend of Q1.

There are, of course, risks to investing in companies like The Buckle. The foremost problem is fashion trends. At some point (hopefully sooner rather than later), the wide-legged jeans that have become so popular will likely go out of fashion. If management incorrectly projects that the trend will continue, they will be stuck with merchandise that no one will buy. The only way for them to get rid of the inventory will be to have dramatic clearance sales that reduce profitability. In addition, if a new trend emerges without the knowledge of a store's buyers, shoppers will go to another store that offers the "latest and greatest." This year, Gadzooks (Nasdaq: GADZ) and Wet Seal (Nasdaq: WTSLA), both youth-oriented retailers, have run into merchandising problems and seen their stock prices drop abruptly.

Paradoxically, another short-term obstacle for The Buckle is the company's tremendous success over the past year. Since the retailer did so well at the end of last year (same-store sales were up 22%-28% during the last three months of 1997), it will be harder for the company to show growth from those high sales levels. This issue is a likely reason that same-store sales were "only" 7% in September and will probably continue at more moderate levels going forward.

Compounding the worry over same-store sales trends is investor concern that consumers will slow their spending in a recession. Risk that consumers will pull back on spending if the economy starts to sputter is certainly present, but I would speculate that Mom and Dad are going to be much more willing to buy a new pair of pants or shoes for Junior than for themselves. In addition, to the extent that Junior earns spending money from his part-time job (where he just received a raise because of the tight labor markets for entry-level jobs), world-wide economic turmoil is of virtually no consequence. Analysts' estimates have The Buckle's earnings growing 17% from $1.43 per share in the year ending January 1999 to $1.67 per share in the following year, a solid showing (although it is below the 62%-109% gains over the past six quarters). Trading at a Price/Earnings ratio of slightly over 11x current year estimates and less than 10x next year's estimates, investors may want to consider hooking up with The Buckle.