Profit From Panic: Retailing

Sometimes uncertainty is a value investor's best friend.

We've got historically catastrophic hurricanes, a housing bubble, astronomical gas prices, and tapped-out consumers whose confidence appears to be waning. Retail stocks should be the last thing on my mind, right? Well, not if I'm supposed to be greedy when the market is fearful and fearful when the market is greedy.

First things first
I must thank fellow Fool Richard Gibbons for letting me steal his headline and put it into practice. He is a very Foolish value investor, and I encourage you to read his articles every chance you get.

Retail is a tough business
Retail's not a sexy business by any stretch of the imagination. It's a roll-up-your-sleeves, "get'r done" type of business that lives and dies by the consumer.

High gas prices can certainly put a damper on consumers rushing here or there to buy things. But did you know that consumer confidence, suffering its biggest drop in 15 years, might be playing a significant role here, too? And did you realize that household debt as a percentage of GDP and on an absolute basis (thanks, Prudent Bear) are at all-time highs?

It seems that consumers are running out of places to fund their consumption addiction. And what does it mean when high gas prices contribute to consumers missing their monthly credit card payments? Isn't that the fifth sign of Armageddon?

I'm not sure about the latter, but those graphs scare me -- and I'm sure they scare retailing executives.

And they should be scared, mostly because of their massive investment in inventory. Inventory is classified as "current" on the balance sheet (i.e., the company is able to turn it into cash in less than a year), but it is not always so. If retailers make poor choices about what they want to sell, for instance, or if they have consumers who don't want to buy, that inventory can be a major drain on a company's ability to generate cash. And if a retailer can't create cash, it will have a tough time staying in business.

Ripe or rotten?
I knew it wouldn't be too difficult to find good retailers near their 52-week lows, but I had to run the screen anyway to see which retailers near their lows were ripe and which were rotten.

Margins are very important, especially to retailers. I wanted my screen to weed out those retailers producing lower gross margin percentages and profits so that I could find the strongest of the bunch. Below are the results:

Company Market Cap (millions) % Change from 52- Week Low Gross Margin % Gross Profit (millions)
Gap (NYSE: GPS  ) $15,014 2.4 39.2 $6,381.0
Limited Brands (NYSE: LTD  )

$8,099

6.5 35.9 $3,378.0
Dollar General

$6,019

3.6 29.5 $2,263.2
Family Dollar Stores $3,262 1.8 33.8 $1,785.6
Big Lots (NYSE: BLI  ) $1,259 9.9 40.6 $1,777.4
Dollar Tree Stores $2,357 1.6 35.6 $1,112.5
PetSmart $3,053 0.0 30.8 $1,035.2
Petco Animal Supplies $1,237 2.3 34.9 $632.5
Cabela's (NYSE: CAB  ) $1,331 1.3 40.5 $630.3
Dick's Sporting Goods (NYSE: DKS  ) $1,492 3.7 27.8 $586.5
*Data provided by Capital IQ as of Sept. 27, 2005.

Some of those companies have certainly had a tough year. But is all lost? Here's what I see from that list.

Leave it on the tree
I have written before that I think Big Lots has a very weak competitive position. You can't expect a close-out retailer like Big Lots to compete when stuck between the massive scale of Wal-Mart (NYSE: WMT  ) and the more efficient business models of eBay (Nasdaq: EBAY  ) and Overstock.com. And the data prove just how uncompetitive Big Lots really is.

Sales and gross margins have been expanding for years, but operating income and net income have been steadily declining. While these trends are alarming, the declining operating cash flows are even more troubling. This tells me that it costs Big Lots too much to attract and service customers while selling its close-out merchandise. You have to wonder why management would continue to grow when each incremental store takes away from the bottom line.

Looks nice on the outside
Of all of the companies on the list, Limited Brands gives me the most trouble. It looks nice on the outside, particularly on the outside cover of its Victoria's Secret catalog ...

Dream sequence ...

Where was I? Oh, right. As I was saying, it looks nice on the outside, but I can't tell whether the fruit is ripe on the inside. Limited has a very nice collection of brands (Express, Victoria's Secret, and Bath & Body Works) and a very experienced management team. It remains free cash flow positive and sports a yield of 3%. What's not to like?

While it's good to hear management admitting to poor performance (and that it's working hard to correct the problem), it would be better if performance wasn't a problem in the first place. But nothing in life is perfect. So the question becomes: Where is Limited Brands in its turnaround and how confident am I in the company's plan? I don't know those answers right now, but they are definitely worth asking.

Smells good, too
The company that looks good on the outside and smells nice, too, is Cabela's. The retailer of outdoor sports equipment is an excellent investment opportunity right now in my eyes for a number of reasons: productive stores, economies of scale, a wonderful customer base, and an attractive stock price.

To fund its transformation from a catalog-based retailer to a multichannel retailer, Cabela's raised capital via a public offering in July 2004. Over the next three years, it plans to open three to four stores per year. Per my calculations, which accounts for the economic development bonds used to buy land and buildings (see the company's 10-K for a good explanation of these bonds), each Cabela's store earns a 16% return on invested capital without considering any growth in same-store sales. That's impressive when you consider that a 180,000-square-foot store requires about $60 million of capital to build and stock with merchandise.

According to conversations with the company and its public information, its distribution system is too large for the 13 stores currently open. So as each new Cabela's store opens, there is a productivity benefit associated with getting closer to scale. For evidence, look no further than the operating income in the retail unit, which is growing at 30% per year, while corporate operating expenses (the distribution assets are housed under the heading "corporate") are only growing at 16%. Over time, this means that more profits will drop to the bottom line. It's a good thing that Cabela's management made the decision to own its assets rather than lease them, because shareholders, not leaseholders, will capture the productivity benefits.

What's more, Cabela's targets a special set of customers with their co-brand credit card program. And interestingly enough, those 620,000 (up 18.3%) customers have a median FICO score of 774 and increased their average monthly balance 6.3% to $1,436 in 2004. In addition, Cabela's has very low delinquency and charge-off rates as a percentage of credit card receivables. While no customer is immune to changing spending habits, it's good to have creditworthy customers who like to shop and can also pay their bills.

Using this information, I calculate that Cabela's shares are worth about $26 each (they currently trade around $19). But while Cabela's looks undervalued relative to its growth prospects, we have to remember that nothing is without risk.

Bass Pro Shops is a very powerful competitor. In fact, Bass Pro Shops has been a major factor in Cabela's recent decline in same-store sales growth. In addition, while outdoor sporting goods is a $65 billion industry, the number of outdoor sportsmen is in decline. And finally, just because Cabela's has a strong consumer base doesn't mean those customers will continue to spend.

The Foolish bottom line
The 52-week-low list and a smattering of statistics only create a starting point. You've got to dig in and understand how these companies create value and whether they'll be able to do so in the future. But I recommend you always remember one thing I mentioned earlier: Look for bargains where the crowd fears to tread.

Philip Durell doesn't mind a little uncertainty or controversy. That's because he makes sure he knows what he's buying and then buys it at a good price. To see how hisMotley Fool Inside Valuenewsletter is beating the market, take arisk-free trial for 30 days.

David Meierowns shares of Cabela's but no other companies mentioned. Dollar Tree is an Inside Value recommendation. Gap, PetSmart, and eBay are Motley Fool Stock Advisor recommendations.Overstock.com is a Motley Fool Rule Breakers recommendation. The Fool has adisclosure policy.


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