Does Your Favorite Retail Investment Make the Cut?

Here's a checklist covering six key areas that can help you find better retail stocks.

Mar 28, 2014 at 11:49AM

If you're shopping for retail stocks, you'll want to know the right way to measure their merits. At the Motley Fool, we're big fans of using investment checklists to help us make smarter decisions about stocks. Here's a checklist covering six key areas that can help you find better retail investments for your stock closet -- er, portfolio.

Unit economics
Do new stores earn back costs and start returning income quickly? This one's a pretty simple concept, but sometimes you need to dig to find the information you need to evaluate this. It's usually a good sign when a company provides per-store numbers up front, as Nebraska-based teen apparel retailer The Buckle (NYSE:BKE)

With those numbers, it's an easy calculation to figure out how long it will take each store to earn back its cost. Once you've done that, compare those numbers to competing retailers in the company's category to see if it has a faster return on capital.

Business quality
Next up, it's time to evaluate how well the company generates returns on capital. To figure out whether or not it's a good operator, look at its working capital to sales, cash conversion cycle -- this is the number of days it takes to sell inventory, collect revenue, and pay off receivables -- and change in revenue compared with change in inventory. For a strong business, these numbers will be lower than competitors' and possibly decreasing. Another great metric is sales per square foot. It's fine to look at the ubiquitous same-store sales, but make sure you know whether the company is including online sales in this number. Because some do and some don't, it can skew the comparison.

And speaking of online retail, is the company's direct-to-consumer strategy viable? Is it increasing its online sales, which usually have higher margins than bricks-and-mortar (BAM) sales? Home goods purveyor Williams-Sonoma (NYSE:WSM) is doing an excellent job of boosting its online sales in tandem with its BAM strategy, which bodes well for its ability to withstand competition from the likes of Amazon.com.

Room to grow profitably
If you like how your retail stock fits so far, it's time to look into its future prospects. Does the company have a large opportunity to increase the store base? Can it add new merchandise categories, such as The Buckle's recent move into accessories, or new concepts, such as Williams-Sonoma's successful West Elm and Pottery Barn Kids lines? Check whether its store growth rate makes sense -- slower may be better if management is waiting to find and develop excellent managers before opening new stores, or if it is creating scarcity with fewer locations, a strategy that's working well for Urban Outfitters (NASDAQ:URBN)

Competition
The next big question is how well your retailer can withstand competition, especially from Amazon and Wal-Mart. If you haven't already, compare the company's key metrics to those of its main competitors. Does it stack up favorably? Does it have a unique strategy or approach that distinguishes it from the pack? This can be hard to quantify but is nonetheless essential, such as The Buckle's committed, knowledgeable salespeople and free jeans hemming service, which create extremely loyal shoppers who return again and again.

Management
A terrible leader can ruin a great business. When it comes to retailers, ask yourself whether the CEO's incentive and compensation structure focus on the right metrics (Warren Buffett likes pre-tax earnings per share) and how much of it is in options and stock awards, which will align management's goals with shareholders. It's also good to check whether the CEO has a large personal stake in the company, another sign that she'll do her best to create shareholder value. At the same time, beware of key-person risk -- if the company is too dependent on a single person, such as the CEO or chief merchandising officer, it could spell trouble should that person leave. Finally, a good culture is a sign of great management and a strong company. How do your retailer's Glassdoor ratings and company policies stack up to those of the competition?

Financials and valuation
If you've made it this far and still like what you see, it's time to dig into the numbers. Does the stock price make sense relative to reasonable estimates of cash flow and earnings? Are profit margins increasing? Does the company generate enough cash to support its growth strategies? Don't forget to see how much debt and cash it holds on the balance sheet, and take a look at off-balance-sheet obligations, such as store leases, too.

The Foolish bottom line
At this point, you should have a clear idea of whether this retailer is a keeper for your portfolio. If it is, you now also have a great baseline to help you judge the company's progress in future years. Depending how the company performs in these six areas, you may decide it's time to put it back on the rack, or to go back for more.

Two stocks changing the retail world
To learn about two retailers with especially good prospects, take a look at The Motley Fool's special free report: "The Death of Wal-Mart: The Real Cash Kings Changing the Face of Retail." In it, you'll see how these two cash kings are able to consistently outperform and how they're planning to ride the waves of retail's changing tide. You can access it by clicking here.

Sara Hov owns shares of Amazon.com. The Motley Fool recommends Amazon.com, The Buckle, Urban Outfitters, and Williams-Sonoma. The Motley Fool owns shares of Amazon.com and The Buckle. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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