FOOL ON THE HILL
Gems in the Retail Rough

Whitney Tilson recommends looking for stocks that are either unknown or unloved. Wall Street hates such situations, but the stocks of good companies can get punished unreasonably in such cases. Just make sure that when you're examining such situations -- this week, he looks at four in the retail sector -- you're buying a well-managed company with a strong competitive position and a healthy balance sheet.

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By Whitney Tilson
October 23, 2001

Investors are naturally drawn to stocks that are popular. After all, who doesn't want to be part of the "in" crowd and have a hot, sexy stock to talk about at a cocktail party? An investment strategy built around such stocks, however, will likely be ruinous, as so many investors have discovered over the past year and a half. Instead, I suggest that investors look for two types of stocks: those that are either unknown or unloved. Such stocks are most likely to be severely undervalued.

With this approach in mind, I'd like to follow up on a column from three weeks ago in which I wrote that "The entire retail sector has gotten whacked on fears of damaged consumer confidence, presenting many interesting opportunities." At that time, I mentioned two retailers, Intimate Brands (NYSE: IBI) and Limited (NYSE: LTD), which have since risen by 20% and 17%, respectively. Let's take a look at some others stocks in the retail sector, broadly defined, that might present good investment opportunities.

Jones Apparel Group
Jones Apparel
(NYSE: JNY) designs and markets a broad range of clothing, footwear, and accessories, mostly for women, under various brand names, including Jones New York, Nine West, and Easy Spirit. It also sells using brands licensed from Polo Ralph Lauren (NYSE: RL). The company has a well-respected management team that owns 10% of the stock, has grown its top and bottom lines by more than 20% annually for the past 10 years (and 30%+ over the past five years), consistently generates strong free cash flows, and earns high returns on equity of 20%.

So why has the stock been cut in half over the past five months, such that it trades at less than 10x this year's and next year's expected earnings? Jones missed earnings estimates in the second quarter, mainly because it bet incorrectly that sandals would be hot sellers again this year, and then was hit by the decline in consumer spending in the aftermath of the Sept. 11 attacks. The company recently warned that Q3 earnings would be down more than 10% year-over-year, Q4 earnings would be down by more than half, and 2002 earnings would be flat with 2001's.

No doubt results will be poor in coming quarters, but earnings will likely recover. That should expand the stock's valuation multiple, making it a good bet for the next few years. 

Liz Claiborne
Like Jones, Liz Claiborne (NYSE: LIZ) designs and markets a wide range of apparel, accessories, and fragrances under various brand names, including its own, DKNY's (NYSE: DK), and Kenneth Cole's (NYSE: KCP). Also like Jones, it has a strong management team, has grown steadily, consistently generates strong free cash flows, and earns similarly high returns on equity.

The key differences between the two companies are:

  • Jones has grown roughly twice as fast over the past five and 10 years; but
  • To do so it has assumed more debt, such that its debt-to-equity ratio was 0.82 vs. 0.55 for Liz as of Q2.

For more than a decade, Liz has regularly used its cash flows to buy back a large amount of stock, such that shares outstanding have fallen by more than 25% over the past five years. Jones, meanwhile, has plowed its cash flow into growth and used stock for acquisitions, such that its sharecount has risen 17% over the same period.

Liz appears to be weathering the current storm better. It just reported Q3 earnings that rose 9.5% year-over-year on a 14.7% increase in sales. The company also projected flat earnings in Q4 and a 6% increase in 2002. Liz is trading at a slight valuation premium to Jones, at about 12x trailing EPS and 10x next year's estimates.

I don't think either stock is a good short-term bet, as the near-term outlook is poor, but I don't worry about such things. I believe both stocks could be good choices over the next few years, with Jones offering slightly more risk -- but perhaps more upside as well.

Zale
Zale
(NYSE: ZLC) is North America's largest specialty retailer of fine jewelry, operating more than 2,300 retail locations throughout the United States, Canada, and Puerto Rico. (The largest seller of jewelry in the U.S. overall is Wal-Mart (NYSE: WMT). I didn't even know Wal-Mart sold jewelry!) Zale's business units include Zales Jewelers, Gordon's Jewelers, Bailey Banks & Biddle, and Piercing Pagoda.

Under the leadership of Robert DiNicola, the company emerged from bankruptcy in 1994 and grew its revenues, margins, earnings, and returns on capital strongly through 1999, when DiNicola turned the reins over to a successor. Unfortunately, she made a complete mess of the situation -- though the company remained healthily profitable -- and DiNicola returned in February to lead a turnaround.

The jewelry business is a good one, as evidenced by Warren Buffett's numerous acquisitions in this sector, but turnaround efforts can take time, due to low inventory turns. With the stock trading at 12x trailing earnings, it's not cheap enough for me, but should it fall back into the low $20s, I might be willing to bet on DiNicola's turnaround.

Liquidation World
One of the more unusual stocks I've ever looked at is Liquidation World (Nasdaq: LIQWF). On the surface, all sorts of warning flags immediately appear. First, its business sounds suspicious: Through 87 retail stores, the company, according to its press release, is "a liquidator of merchandise for bankruptcies, receiverships, closeouts, inventory overruns, buybacks, insurance claims and other inventory challenges." In other words, it buys all sorts of stuff at pennies on the dollar and auctions it off or sells it in its stores, where bargains constantly abound.

A second concern is that the company is headquartered internationally (in Calgary, Alberta) and has most of its operations in Canada (though Liquidation World has a presence in Washington state, Montana, Idaho, and Alaska). Finally, this is a small company (revenues of $185 million Canadian) with an even smaller market cap ($54 million U.S.). Not surprisingly, the stock is extremely illiquid, and is thus only appropriate for small investors. (For more on investing in small companies, visit the Fool's Small Cap Foolish 8 area.)

If you can overcome these issues, I think you'll find a solid company and a reasonably priced stock. Since inception 15 years ago, Liquidation World has grown its sales each year and, far more impressively, has never had an unprofitable quarter. How many retailers can say that? Over the past three years, the top and bottom lines have increased at an average rate of 11% annually and, with more and more distressed merchandise becoming available, growth is picking up this year. It's nice to find a counter-cyclical stock in times like these.

Margins are slim, but the company turns its inventory rapidly, yielding a healthy 15% return on equity, with minimal leverage. The only real weakness in the financial statements is that cash flow is weak because, like many growth companies, Liquidation World needs to invest in working capital to grow.

Trading at slightly less than 12x earnings, the stock isn't cheap enough for me -- and too illiquid for me to buy anyway -- but for small investors, it's worth watching closely. Companies like this tend to grow erratically, so when the inevitable weak quarter occurs, the stock can get pummeled. This is what happened last year, causing the stock to fall to a low of $2.62.

Conclusion
Before buying any stock, I ask myself: "What mistake is the market making in pricing this stock at such a low level?" In the case of Liquidation World, the answer is easy: The company is unknown. The other three companies I discussed above are unloved. All are facing weak year-over-year comparisons and there is no obvious catalyst for any of them.

Wall Street hates situations like these, which is precisely why I like them, as the stocks of good companies can get punished unreasonably. Just make sure that when you're examining such situations, you're buying a well-managed company with a strong competitive position and a healthy balance sheet.

-- Whitney Tilson

Guest columnist Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. He did not own shares of any stocks mentioned in this article at press time. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous columns for The Motley Fool and other writings, visit http://www.tilsonfunds.com/