Rising Margins Roundup
by Louis Corrigan (TMF Seymor)
Atlanta, GA (March 2, 1999) -- A lot of familiar names on our Rising Margins screen this week. Ever heard of the Gap (NYSE: GPS), Home Depot (NYSE: HD), Lowe's (NYSE: LOW), Dollar General (NYSE: DG), or The Children's Place (Nasdaq: PLCE)? With names like this appearing on our screen, it looks like the housing/remodeling market is still strong and that ubiquitous value-oriented chains are doing well. But hey, you already knew that.
First up, Dollar General, which operates 3,595 neighborhood general stores in 24 states. At $31 11/16, my 1999 Industry Focus pick in the discount chain category is now up 28% in three months. Not bad. The company reported preliminary Q4 sales in early February with final year-end numbers last week.
Fourth quarter sales increased 15.3% to $992.1 million on a measly 1.6% increase in same-store sales (SSS). But comps picked up in January to 3.2% despite stunning 19.8% SSS gain in the year-ago period. The company is facing tough year-over-year comparisons, but the SSS figures are expected to pick up steam later in the year as the 518 net new stores added throughout FY99 come into the mix.
Though Dollar General's Q4 EPS rose 20% to $0.36, the gain came thanks to a minor dip in the tax rate. Lower operating expenses as a percent of sales (16.8% vs. 17.58%) made up some for a 100 basis point decline in gross margins (to 28.73% from 29.77%), but operating margins still fell slightly to 11.93% from 12.19%. So, technically, the margins fell.
Though our margin screen keys off of the EPS number, we usually disqualify companies that don't hit the number clean. Technically, then, our margins theorem would say adios to the General. Personally, though, I'd be willing to ignore the theorem on this one and wait until the next report to see if this is a trend. This is a long-term growth story, and one questionable quarter doesn't bother me. After all, FY99 sales increased 22.6% and EPS by 26.9% to $0.85 thanks to 8.3% SSS growth. That was in line with the 8.4% increase recorded in FY98 and 8.2% gain in FY97. How's that for consistency?
Looking at the balance sheet, I see that inventories are up 28.5%. Though that's up more than sales, the company has added distribution centers and lots of new stores, so my guess is that inventories per square foot have risen less than sales. Annual return on equity came in at 27.8%, down slightly from 28.9% one quarter ago, but still pretty great. Meanwhile, cash is up and short-term borrowing down. Trading at 37 times trailing earnings and 31 times this year's projected $1.03 in earnings, the General ain't cheap. Barring a major recession, though, it's almost certainly a market-beater over the next few years.
Next up, the small cap Pure World (Nasdaq: PURW), a "nutraceuticals" company that produces kava, St. John's Wort, and other botanical extracts. Last August, with the stock at $10, I wrote a skeptical piece about this company's internal governance. Indeed, whenever a company changes its name a few times, I get worried.
The reason the stock is now at $5, though, seems to be a meltdown in the health supplements market and excessive inventories in the channel that will cause Q1 sales and earnings to be "significantly below" last year's levels. That news actually sank the shares to around $4 last week before investors piled back on. After all, the company will soon introduce a Maca extract (straight from Peru's Andes mountains) that's supposed to work wonders on male and female libido and male potency. Talk about aphrodisiacs often leaves investors excited.
Turning to the numbers, we see that product sales rose 199% in Q4 to $5.4 million while operating expenses increased just 70%. With that leverage, EPS more than doubled to $0.08 from $0.03 a year ago. That capped a terrific year, as product sales increased 114% to $23 million and EPS vaulted 138% to $0.62 versus $0.26. While that was below the estimates floating around last summer, it was still pretty great. Of course, a lot of shipped product is now just sitting on store shelves. Also, previous operating losses mean the company's tax rate was just 5.3%. Taxed at 35%, EPS would have been about $0.47.
With operating margins of around 25% and cash and securities of nearly $1 a share, is Pure World a bargain at just 11.2 times earnings? I don't think so. The Q1 weakness has to be discounted. So, too, does the fact that more than a quarter's worth of sales are sitting on its balance sheet in inventories. In other words, not only is the sales channel full of nutraceuticals, but so too is Pure World's factory. That's a major negative. While Pure World has shown flair in playing to this faddish market in the past, I'd file this in the very high-risk camp even as a speculation.
Finally, we'll look at Fossil (Nasdaq: FOSL), a company that designs and markets fashion watches and accessories sold in department stores. What a great fourth quarter! Sales rose 27.3% to $101.1 million while EPS shot up 81% to $0.58 per share from just $0.32 a year ago. That was well above the $0.46 per share consensus estimate floating around in December. The strong quarter drove FY98 EPS up 63% to $1.48 on a 24.5% boost in sales to $304.7 million.
Volume increases in Fossil brand watch sales drove the record results. But gross margins also increased about one percentage point to 49% for both Q4 and FY98. Also, operating expenses as a percentage of sales declined by about two percentage points. The company was prepared to spend more on holiday advertising but ultimately didn't see the need as its bracelet watches broadened its customer base and the malls were simply full.
Fossil ended the year with $57.3 million in cash ($2.62 per share); accounts receivable up 24.5%, in line with sales growth; and inventories up just 11.5%. Return on equity increased to 27.9%. The company expects sales to rise by 20% or more this year. With the stock at $33 1/2, it trades for about 23 times trailing earnings and 19 times the projected FY99 earnings of $1.75 per share.
While I'm inherently skeptical of makers of watches, sunglasses, and other high fashion stuff I don't wear, Fossil definitely deserves a closer look. It's benefited from the strong economy, but the sales growth suggests it's claiming market share, too. For more, see fellow Fool Warren Gump's recent Fool on the Hill.