FOOL ON THE HILL
Rebounding Retailers?

With so much economic and geopolitical uncertainty, American consumers finally appear to be reining in their spending, which is bad news for retailers. As a result, the sector is out of favor on Wall Street, which creates some compelling opportunities. Whitney Tilson shares four cheap stocks on his radar screen.

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By Whitney Tilson
February 19, 2003

The economy continues to sputter. War with Iraq appears imminent; consumer confidence is hitting new lows; and many retailers are reporting disappointing earnings and giving cautious guidance. Definitely time to avoid the retail sector until visibility improves, right? Wrong!

If you wait to buy until visibility appears good, you'll almost certainly end up paying too much. As Warren Buffett once said, "The future is never clear; you pay a very high price in the stock market for a cheery consensus. Uncertainty actually is the friend of the buyer of long-term values."

To be successful, an investor needs the courage to bet against the herd and the ability to look ahead a few years, not just a few months, which, based on my unscientific observations, is the time horizon driving stock prices. With a medium- to long-term perspective, I believe the retail sector offers plenty of attractive opportunities.

Without further ado, here are four stocks I'm currently analyzing -- none of which I own yet, but all of which are extremely interesting. (They are listed in descending order of interest.)

Limited Brands
Limited Brands
(NYSE: LTD) operates 4,594 specialty stores under the names Victoria's Secret, Bath & Body Works, Express, Express Men's (Structure), New York & Company (Lerner New York), Limited Stores, White Barn Candle Co., and Henri Bendel. Victoria's Secret, the gem of the portfolio that accounts for a significant majority of Limited's profits, is going gangbusters, with same-stores comps up 11% in January on top of an 11% gain the previous January. The rest of the company is mostly sucking wind, with flat to negative comps recently.

Limited generates high returns on equity (above 20%, adjusted for excess cash) and robust free cash flows. While sales and earnings growth over the past five years (0.5% and 9.1%, compounded annually) may appear anemic, that's misleading since Limited has successfully developed and then sold or taken public a number of divisions, including Abercrombie & Fitch (NYSE: ANF), Too (NYSE: TOO), and Lane Bryant (sold to Charming Shoppes (Nasdaq: CHRS)).

The company has also returned capital to shareholders by aggressively repurchasing shares and paying a healthy dividend, which is currently 3.4%. According to the company, "Since 1996, we have returned almost $6 billion in value to our shareholders through the repurchase of shares, payment of quarterly dividends and spinoffs." For comparison, Limited's total market capitalization today is $6.2 billion.

The stock, after bottoming below $10 after 9/11, and then rising above $20, has now nearly made a roundtrip. At $11.89, it sits less than $1 above its 52-week low, which it hit last week. After Limited reports Q4 earnings next week, it should have roughly $2 billion in net cash, or about $3.75 per share, meaning you're really only paying slightly more than $8 per share for a company expected to earn $0.96 per share in 2002 (fiscal year ending January 2003) and $1.10 in 2003 -- multiples of 8.5x and 7.4x, respectively. That's cheap!

Home Depot
I've long admired of Home Depot (NYSE: HD) and its unique, entrepreneurial culture, which is captured by the book Built From Scratch, written by the company's two founders. The problem until recently was that everyone else admired the company, too, such that the stock was a Wall Street darling for the better part of two decades and consistently traded at 30 to 45 times earnings. How the mighty have fallen! Home Depot's stock has steadily plunged from its peak of $70 in 2000 to today's level of $21.90, just above its five-year low and equal to only 13.2 times 2003 estimates. Ironically, this has occurred while the housing market continues to boom.

Home Depot continues to generate returns on equity in the high teens, and is pounding out massive amount of cash: Operating cash flow over the 12 months ending in Q3 was $6.4 billion (vs. $2.8 billion of cap ex), which has allowed the company to repurchase $1 billion of stock and build its cash hoard to $4 billion (vs. only $1.3 billion of debt).

So why is the stock so cheap? Home Depot had a dismal fourth quarter, with same-stores comps and EPS down an estimated 10% (we'll know for sure when the company reports earnings on Tuesday). In addition, last month, Home Depot reduced guidance for 2003 to 9% to 12% sales growth (on flat comps) and 9% to 14% EPS growth, far below the 15% to 20% growth goals the company set in 2001. This has triggered a massive shift in the shareholder base, as growth investors have fled, replaced by value investors like Oakmark's Bill Nygren and Legg Mason's Bill Miller. I don't blindly follow anyone when making investment decisions, but if I had to do so, these two outstanding investors would be near the top of my list. Home Depot is worth a careful look.

Liz Claiborne
Liz Claiborne
(NYSE: LIZ) designs or licenses and then markets an extensive range of women's and men's fashion apparel, accessories, and fragrances under a wide range of brand names, including its own (which accounts for 39% of sales), Lucky Brand, Mexx, DKNY, Kenneth Cole, and more than a dozen others. Under its outstanding management team, this well-diversified retailer has steadily produced solid growth (9% top-line and 11% EPS growth over the past five years; similar growth is expected in 2003), generated returns on equity of nearly 20%, and produced a ton of cash. It has used that cash to reduce debt (in the 12 months ending Q3 02, net debt fell by 66% to only $198 million), acquire other companies (Liz has regularly bought small- to medium-sized companies to add brands, distribution channels, etc.), and buy back stock (the share count has fallen by a remarkable 25% over the past six years, and by 37% over the past 11 years).

Unlike many retailers, the stock is not distressed -- at $27.77, it's 18% above its 52-week low of $23.55 -- but at 13.2 times trailing earnings and 11.1 times 2003 estimates, it's very reasonably priced. Liz reports earnings tomorrow before the market opens, which I'll examine closely.

Borders Group
Borders
(NYSE: BGP) is the No. 2 player in the book retailing business, and operates over 400 domestic superstores, 30 international stores, 37 Books etc. locations, and approximately 775 Waldenbooks stores. It's not a great business, but it's a decent one: The company has 12% returns on equity while using only modest leverage, has grown its sales and earnings at a high single-digit rate over the past five years, and generates a lot of cash, which it's using to repay debt and, especially this year, repurchase shares. Last week, management reaffirmed it would meet Q4 earnings expectations and guided to 5% to 12% EPS growth in 2003.

Intrinsic value for a company with these characteristics is probably about 15 times earnings, which is roughly the average P/E multiple over the past few years. Thus, I believe the stock today is moderately (though not screaming) cheap at yesterday's closing price of $14.73 -- less than a dollar above its 52-week low -- which is equal to 10.3 times trailing earnings and 9.5 times management's estimate for 2003. The stock probably won't be a home run from this price, but it should be a solid performer.

Conclusion
I am developing a high degree of confidence in these four companies; however, I don't have much confidence in the U.S. economy and consumer spending, as I've written in previous columns. So, should I wait to buy until I have more certainty in these areas? I think not, for the reasons Warren Buffett outlined in his 1994 annual letter:

We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen. Thirty years ago, no one could have foreseen the huge expansion of the Vietnam War, wage and price controls, two oil shocks, the resignation of a president, the dissolution of the Soviet Union, a one-day drop in the Dow of 508 points, or Treasury bill yields fluctuating between 2.8% and 17.4%.

But, surprise -- none of these blockbuster events made the slightest dent in Ben Graham's investment principles. Nor did they render unsound the negotiated purchases of fine businesses at sensible prices. Imagine the cost to us, then, if we had let a fear of unknowns cause us to defer or alter the deployment of capital. Indeed, we have usually made our best purchases when apprehensions about some macro event were at a peak. Fear is the foe of the faddist, but the friend of the fundamentalist.

A different set of major shocks is sure to occur in the next 30 years. We will neither try to predict them nor profit from them. If we can identify businesses similar to those we have purchased in the past, external surprises will have little effect on our long-term results.

Whitney Tilson is a long-time guest columnist for The Motley Fool. He did not own shares of the companies mentioned in this article at press time, though positions may change at any time. Under no circumstances does this information represent a recommendation to buy, sell, or hold any security. Mr. Tilson appreciates your feedback on the Fool on the Hill discussion board or at Tilson@Tilsonfunds.com. The Motley Fool is investors writing for investors.