Fool.com: The Retail Blues[Fool on the Hill] June 22, 2000

FOOL ON THE HILL
An Investment Opinion

The Retail Blues

By Warren Gump (TMF Gump)
June 22, 2000

Summary: Most retail company stocks are singing the blues, thanks to slowing performance and fear that the trend will spread. Some stocks deserve the beating, but some interesting opportunities might be presenting themselves at others.

Stocks in the retail industry have been knocked down by investors who believe that the Federal Reserve will be successful in slowing down the torrid growth experienced over the past few years. The stock price tumbles have been broad-based, hitting discount stores like Wal-Mart (NYSE: WMT) and Target (NYSE: TGT); department stores such as May (NYSE: MAY) [Lord & Taylor, Famous-Barr, Filene's, and Hecht's] and Federated (NYSE: FD) [Bloomingdale's, Macy's, Rich's, and Stern's]; apparel stores like Gap (NYSE: GPS) and American Eagle Outfitters (Nasdaq: AEOS); and home supply stores like Home Depot (NYSE: HD) and Lowe's (NYSE: LOW).

Certainly, some of these stock price declines seem justified. The Gap's overall same-store sales have decline 2% for the year to date period, a noticeable turnaround from the 10% rise in the prior period. Many retailers post lower comparable-store numbers the year after strong results since the sales base from the prior year was so much higher. Nonetheless, a decline in this number not only means that growth is slowing down, but also the company isn't able to hold onto prior year sales gains.

While not so dramatic a turnaround as the Gap's experience, a wide variety of chains are reporting an ebbing in year-to-date same-store sales growth:

            YTD Same-Store Sales
                 1999   2000    
Wal-Mart         8.6%   6.8%
Target           6.8%   2.6% 
Kohl's           9.0%   7.6%
Federated        4.0%   3.2%
American Eagle  25.1%   2.7%
Limited         12.0%   8.0%
Home Depot(Q1)   9.0%   7.0%  
A few companies have avoided this sales slowdown, but they are mostly stores that are executing turnarounds. For example, year-to-date comp-stores sales at Talbots (NYSE: TLB) are up 19.9% compared to a 3.9% gain last year. Over at Pier One (NYSE: PIR), same-store sales were flat in 1999, but have moved up 9.7% this year. Both of these chains are recovering from strategic missteps a couple of years ago.

What's the problem with these stocks? Investors had become accustomed to the terrific same-store sales growth from most of these companies and assumed they would continue for at least the intermediate term. With that assumption in place, extrapolating significant earnings growth over the next five years was easy.

Now that the economy's starting to slow down, that assumption is being challenged. Maybe sales growth won't be so strong. Lowering comparable-store sales growth by a couple of percentage points can take a significant notch out of earnings growth. Even worse, if companies didn't plan for reduced sales growth, they could be stuck with too much merchandise and need to resort to markdowns. That'll result in lower margins, which can have a seriously detrimental impact on the income statement (at least in the short run).

With sector optimism waning, investors are starting to value many of these stocks as if they are heading into permanent stabilization or decline. After being overly optimistic when things were going well, they seem to have turned around and become overly pessimistic in many cases. Companies like Ross Stores (Nasdaq: ROST), Abercrombie & Fitch (NYSE: ANF), TJX (NYSE: TJX), Saks (NYSE: SKS), and May Department Stores are all trading at or below 10 times trailing earnings. The list goes on with companies that are trading at significant discounts to their previous trading ranges.

Some of these stocks are cheap for a reason: they haven't done a good job adapting to customer needs over the past few years. Even though most of the traditional department store company look cheap using a price/earnings analysis, they have some serious fundamental issues to address before achieving serious long-term success. The hefty debt levels carried by many of these companies makes their situation even more perilous.

Looking at other retailers is a trickier proposition. Figuring out where investor sentiment, long-term success (or failure), and stock prices mix can be hard to figure out -- particularly in the short-term. I was flabbergasted when Abercrombie fell below $20 earlier this year, thinking it was a great opportunity to invest in a terrific company.

The company carries no balance sheet debt, shows terrific profitability metrics, controls a great brand, and serves a target market with substantial demographic growth. Although same-store sales were likely to decline and margins poised to suffer in the intermediate term, the company seemed positioned to participate in significant long-term growth. That analysis may still be correct (then again, maybe it's not), but the stock can now be picked up for about $11 a stub.

How can people wade into the retail field when investor psychology is so negative and fundamental trends are weakening? The most risk-averse strategy is staying away from the stocks until their sales growth stabilize or improve (I would use a three- month moving average rather than monthly results, which can be quite volatile). This strategy will tend to keep you out of the worst declines, but it also means that you'll probably pay more for stocks when you decide to get back into them because other investors have already moved the stock price up by the time you decide to buy.

Another strategy, which I prefer, is finding companies with a smart management team that can quickly adapt to changing consumer needs and demands and maintain superior profitability. I also like to see only modest (or no) debt and overall company valuations that are low relative to long-term growth opportunities.

These companies' stocks can certainly fall further before they improve, but chances are that a savvy management team will address the challenges being faced if they have enough time. Since the companies I'm talking about have low debt levels, they should face little risk of liquidity problems. The light balance sheets should also give them the flexibility to remodel and renovate if that is necessary to regain a competitive edge. Once these companies regain their mojo, you can bet that their stocks will move significantly higher.

Related Links:
  • Ross Stores: The Rodney Dangerfield of Stocks
  • Gap Inc. -- Should You Stay or Go?
  • Limited Too Cool
  • May Retail Details