3 Rough Stories in Retail -- Then Let's Hit the Links (and Buy Them)

On this Market Foolery podcast, host Chris Hill and Million Dollar Portfolio's Jason Moser discuss the market's deeply negative response to news that Abercrombie & Fitch (ANF -3.67%) doesn't plan to sell itself, why Costco's (COST -0.55%) strong June comps aren't enough to make investors smile. whether Apollo Global (APO) is getting a $1.1 billion bargain in its purchase of golf-course and country-club giant ClubCorp (MYCC), and the ongoing suffering of Dick's Sporting Goods (DKS -0.87%). 

A full transcript follows the video.

This video was recorded on July 10, 2017.

Chris Hill: It's Monday, July 10. Welcome to Market Foolery! I'm Chris Hill. Joining me in studio today, from Million Dollar Portfolio, Jason Moser. Happy Monday!

Jason Moser: Happy Monday!

Hill: Holy cow. Earnings season hasn't really kicked in yet, but we have a bunch of news.

Moser: I was going to say, this is a good Monday.

Hill: This is a good Monday.

Moser: Yesterday I was thinking, as I was doing yard work and work around the house, I looked quickly at the earnings calendar and I was like, "Damn, there's no real stories, we'd better hope for something." And hey, it looks like it turned out OK.

Hill: Yeah. We have some retail news; we have sports apparel; we have a Fool investing event that's coming later this month that we'll tell you about. But we're going to start with fashion apparel. Abercrombie & Fitch had been in discussions for a potential buyout deal, and this morning, Executive Chairman Arthur Martinez issued a statement that included the following sentence: "Board of directors has determined that the best path to enhance value for stockholders is the rigorous execution of our business plan." And investors were so impressed by that that shares of Abercrombie & Fitch are down more than 20% this morning. What are they doing?

Moser: [laughs] That quote is tantamount to "We see 2017-2018 as a year of investment." Whenever we see companies talk about the upcoming year as being a year of investment, particularly in retail, that's just code for "Batten down the hatches; we don't really know how this is going to work out, and it could be a long time if this ever actually turns around meaningfully." And with Abercrombie & Fitch, this is one we talked about a lot in the past earnings season, because they're really caught between a rock and a hard place.

To me, this is a great example of what we mean when we talk about not investing in something with acquisition as the main crux of a thesis. You could have gone into something like Abercrombie & Fitch and thought, "Well, now they're talking about acquisition, so it's going to be a matter of time; someone is going to go in there and sweep that thing up, and there's some value there." Well, you probably aren't feeling so good about that today if you took that direction. Every clue out there tells you that this is a business in crisis. Top line is shrinking; margins are getting crushed; you have a brand that really does appear to be losing relevance on a daily basis. 

Hill: And once upon a time, this was a really hot brand.

Moser: It was. Again, as we've talked about before, I looked toward my kids, their friends, the schools, to see what these kids are doing and wearing and what matters to them most. I just don't think Abercrombie & Fitch is something that carries any sway for generations of shoppers that are coming online now. I'm not saying it should or shouldn't. I don't really care, I'm sort of fashion agnostic, as you can tell by my Fool School T-shirt.

Hill: It's a nice T-shirt.

Moser: [laughs] Thank you very much. It's a nice thing we're doing. I enjoy it.

Hill: The stock is at its lowest point since June of -- would you care to guess the year? 2000! It's $0.30 away from being the lowest point this century. But, June of 2000, it was slightly lower than it is now.

Moser: I don't know why anyone would invest in this business. It's not a fundamentally good business. Every metric, every clue, tells you we shouldn't invest in this one. We'll take a pass. Now, does that mean that you couldn't jump in there today and make a couple of bucks if a deal is struck with some other party? Of course that could happen. But you have to weigh the chances of that versus the opportunities for other ways to make money out there. For us, as business-focused investors, this is one where there are enough red flags to warrant passing and not even thinking twice.

Hill: And to that point of someone is going to find value in it at some price, we've seen this movie before. Company X says, "We're putting ourselves up for sale." They don't like the offers on the table, so a few months later, as it is the case with Abercrombie & Fitch, they say, "We don't like these offers; we're going at it alone," and then six to 12 months down the line, it's, "Actually, we'll take that offer."

Moser: Right. Make no mistake -- this stuff can keep going down. We've seen situations like this before. What was it -- Aeropostale was a good example there on the retail side. Even something like LeapFrog, which I think a lot of people maybe thought there was some value still there, same thing. Those things just eventually go almost to zero. So there's no reason why that couldn't happen with Abercrombie & Fitch as well. I just don't think the brand really holds any value whatsoever.

Hill: Shares of Costco down a little bit today. Their same-store sales in June were up 6%. We were talking earlier this morning -- that's a good number for a retailer of that size. It hasn't really impressed investors, and I think you can look at the point where Amazon announced they were buying Whole Foods and draw a straight line from that point in time to where Costco shares are today. It's down about a little more than 15%, just in the past few weeks.

Moser: I think with Costco, the burden of proof with Costco is on the bull to explain why they think this is still a 30-multiple stock. This is not a bad business by any means. I think Costco is a good business, and it's one that we owned in Million Dollar Portfolio for a time. And we sold it back in May of last year, so it's been around maybe a year since we sold it, and it was in that $165 range, and the concern was just that. We thought, this is a situation where the retail space is changing very quickly. Obviously, e-commerce is becoming more meaningful. So looking forward the next decade, how attractive a proposition is that Costco membership, that Costco experience? And we felt like that just wasn't really the direction that shoppers were headed, for the most part.

And I think what we're seeing is, generally, a repricing on Costco shares. I don't think it's going to be a stock that commands that premium multiple that it once did. And I think it garnered that multiple because of a reliable membership model, very customer-centric management. And I think those qualities still exist today. 

But you get to a point where you're big enough to where it becomes more and more difficult to really stoke that growth. It's not like Costco is going to be able to keep on opening up stores left and right. We saw the same thing happen with Wal-Mart. We saw the same thing happened with Whole Foods. The Whole Foods-Amazon deal, that was probably the best-case scenario for Whole Foods investors right there.

It's not to say that Costco is a bad business at all. It's just that I think, going forward, the market is going to look at this stock from a little bit of a different perspective on the valuation side. If you look at the last three years, they've grown earnings at less than 10% annualized. The last five years is just at 10% annualized. I don't know why that stock deserves that 30 multiple. I don't think it's going to get it. So I think what we're seeing is the market repricing it a little bit. I think there are some areas where they need to improve, also.

I was just looking at some of these numbers here recently. Since 2012, they spent almost $2.5 billion on share repurchases. And yet during that same stretch of time, the share count is actually up. For a business like this, that is sacrilege. That cannot happen. You cannot be doing that. I think the special dividend that they just paid out in May, I think that was an implicit admission on management's part. They realized the headwinds on the capital-gains side for the stock, they know the challenges they face, and I think they wanted to reward shareholders in another fashion. And I think that was a fine offer there.

But when you look at it from an investment perspective, it's a different business today. It's a much bigger business than it was 10 years ago. And I think shopping behavior is going to be far different in these coming 10 years than it was before. And I think that's going to present some challenges to Costco.

Hill: And when you think about growth opportunities for any retailer, or restaurant for that matter, when you think about what is their physical presence, and what is their track record in terms of opening new locations? I've talked about this before with Chipotle, with how, for lack of a better term, how slow they are to open new locations. But you can flip that around and say they're not slow; they're methodical. Costco is the same way. Look at their history. They have grown steadily over time. But the pathway to growth for a business as mature as Costco is never going to be, "Gosh, if they could just open 60 new locations." No, that's not how this business has been run to this point, and you wouldn't want them to.

Moser: No. I think that would be a waste of capital. I think management is smart enough to know that, too. These guys are very smart. They know what's going on in the space, and they see the direction the consumer is headed. I think they're trying to figure out new ways to perhaps be a part of that. And I think there's a great opportunity for Costco to ink some new partnerships, new relationships with other players in the space. Maybe it's Amazon. I think they're doing neat things with Boxed.com that goes in there. Boxed.com uses Costco inventory to help fulfill their orders, and that's an online membership model, but you're not having to pay a membership fee. You go warehouse shopping without having to pay that fee.

So I think, generally speaking, there's enough value in the Costco membership where they probably keep that current base renewing at a healthy rate. I don't know how attractive that is, membership, for younger generations of shoppers coming online today.

I also thought, it was interesting to see this, knowing the U.S. makes up the gist of Costco sales, and it's a lot of it -- I didn't realize that California actually comprised 31% of their U.S. sales in 2016. This company is very dependent on California. It's kind of an interesting little factoid there. So any slowdown in California's economy obviously could play out on them as well.

Hill: You mentioned the management. Craig Jelinek, who's the CEO, I think deserves credit for the job he has done in the wake of Jim Sinegal, one of the truly great CEOs of the last 40 years, leaving enormous shoes to fill, and Jelinek and his team are doing a good job.

Moser: Yeah, that's a tough act to follow. And when you're following someone like Jim Sinegal, who set such a great standard, he has such a wonderful reputation and he left that business in great hands. And I think Craig Jelinek has done a very good job. I think it's a far more competitive situation today and looking forward, perhaps, than maybe he even anticipated.

But I think, again, it's not to say it's a bad business. I think you have to look at it from a sheer numbers perspective. Analyst estimates out there have, by 2021, they're seeing $8.92 per share in earnings. Now, stick a 20 multiple on that, and that gets you to about $180 a share. And that's up a little bit from today's $150 and change. Obviously, a 30 multiple takes that stock price into the $220 range. Again, is that fair to assume, that it's going to get a 30 multiple? I think if you look at this company's history, multiples are a bit high right now. I don't think they're going to stay at that lofty level for much longer.

Hill: Two news items from the world of sports. ClubCorp shares are up 30% today. ClubCorp is one of the largest operators of private golf clubs in the United States. Apollo Global is buying ClubCorp for $1.1 billion. I'm assuming that's a good price, only because shares of Apollo are up a couple of percentage points, and I guess if you're a ClubCorp shareholder, you're having a good day.

Moser: It's a decent price. I think if you're a ClubCorp shareholder, you're probably thinking that perhaps a better price is out there. But it's a very interesting space. I have worked at a ClubCorp club before, when I was in the golf business. We were members of one growing up. It's a nice sort of situation. I think it's the best way for golf clubs to exist, is to be part of that membership family of a bigger sort of umbrella company there. And we're seeing that is clearly the direction this is headed. More and more country clubs are becoming members of those ClubCorp-style families. It's just an easier way to spread costs around and really utilize scale as a big advantage, which is a meaningful advantage in this business.

But I think with Apollo, they see a large installed member base, and that, in turn, brings nice recurring revenue in the form of monthly membership dues. It's a pretty easy hurdle to clear for membership, too. These aren't your top-of-the-line member-owned equity clubs where you going to pay a $25,000 initiation fee to get in. There are reasonable initiation fees to getting into these clubs, and pretty easy monthly due bills to pay as well. 

I think with ClubCorp, they've done a good job of building up a family of good golf courses. The biggest problem with golf as seen in the U.S. here recently is an oversaturation. We've clearly had too many golf courses for not enough golfers. You saw a lot of golf courses that are really struggling. But the thing is, a lot of that saturation came on the public on the daily-fee side. A lot of those daily-fee courses that were meant to open the game up to more folks who either weren't looking to become a member of a club or didn't have the financial means to do so, it gave them an opportunity to play. But that saturation resulted in some clubs not being able to make up the cost of staying open. 

So the nice thing with these ClubCorp clubs is, their memberships maintain a pretty steady, consistent rate of renewal, and modest growth as well. I think Apollo sees that as a good opportunity to get this nice, sticky membership model. It's a company where, when you look at the income statement, their earnings, I think, are a little bit obscured by a lot of depreciation and amortization on the income statement, due to a lot of the property that they own. They own a lot of land, as you can imagine, with all of these golf courses. It's a very cash flow-rich company. I think today's offer shows that it's something like 7.5 times operating cash flow. I think that's probably a little bit cheap, given that historically, it's traded up toward 10 and 11 times operating cash flow. So it wouldn't surprise me, perhaps, if there was a competing bid.

But I think management in this case is going to be happy to get out of the public eye, because for a while they had some other activists in there trying to push them toward becoming a REIT and unlocking more value, as they always say. I think it's a good deal, but I wouldn't be surprised at all to see a competing bid coming.

Hill: Do you think, if Apollo offered a 30% buyout premium to Abercrombie & Fitch, they'd take it?

Moser: [laughs] I doubt it, because the logic would say you could stock your golf shop with a bunch of Abercrombie & Fitch crap, but nobody wants it, apparently.

Hill: One more sporting note. Dick's Sporting Goods shares are down 6% today off an analyst downgrade. This is a little surprising to me in this regard. One of the big stories in retail last year, certainly when you're looking at sports retail, was Sports Authority going bankrupt, going out of business. And by the end of August, Sports Authority had closed all of their locations. And since that time to today, shares of Dick's Sporting Goods, the No. 1 competitor to Sports Authority, and one you would absolutely be forgiven for thinking would benefit from Sports Authority going out of business -- shares of Dick's Sporting Goods are down almost 40% since the end of August last year, when Sports Authority disappeared from the plane.

Moser: Yeah. And I'll tell you, I don't know that it's reasonable to expect these guys to bounce back anytime soon. I was talking on Twitter with some folks a week or so ago, back and forth, with Nike's recent earnings, and the investments that Nike is making, for example, in their direct-to-consumer part of the business. That's up to 26% to 28% of the overall revenue that they're bringing in annually. You look at Under Armour doing the same thing. They're investing more and more in the direct-to-consumer, which means they're relying less and less on the middlemen like Dick's Sporting Goods. And I'll throw Foot Locker in there as well. These guys, Foot Locker and Dick's Sporting Goods, rely a lot on those two brands, on Under Armour and Nike. They sell a lot of that stuff. And I think, in the case of Dick's Sporting Goods, Under Armour and Nike combined make up more than a third of their inventory they keep. So if someone is saying, I can just buy it directly from the source via Nike or Under Armour, why do I need to go to Dick's Sporting Goods?

And clearly, people are buying from Nike and Under Armour directly. In the most recent earnings release, Nike noted they made more than $2 billion this last year in sales on their family of apps alone, primarily the Nike app. But, Under Armour is doing the same thing. Whenever I buy anything from Under Armour, I just go directly to that app. They have everything saved. They know what I'm looking for. So it's a very pleasant experience. It's easy. They're keying in on free shipping, free returns; they know what the consumers like. And it makes the hurdle that much tougher for these physical footprints that Dick's Sporting Goods and Foot Locker are holding. 

Dick's is typically going to be that big standalone store. Foot Locker, I think, is in a lot of malls, and they're not necessarily feeling all that great about that right now, either. So I think you look at Dick's Sporting Goods and Foot Locker, those are two companies I would be very wary of investing money in today. I'm not saying I'd short them, but I certainly feel like if you're going to invest in this market, it's easier to go ahead and invest in something like a Nike or an Under Armour, because the direction where that is headed, in the direct-to-consumer, they're making all those big investments. And they are paying off.

Hill: I'm assuming, though, that Foot Locker does better in terms of revenue per square foot, just because the locations are so much smaller.

Moser: Yeah, the locations are smaller. That's certainly the point.

Hill: You have to get more drop-in traffic than at Dick's. You go to a store that size, you are intentionally going there, whereas if you're just walking around a mall, it's easy to go, "Oh, let's just pop in here."

Moser: Yeah. I would imagine the traffic that goes to a Dick's Sporting Goods store is more intentional versus a Foot Locker where certainly it's going to be intentional, but I would also think the percentage of incidental traffic there is going to be much higher because of that mall setting. Again, you look at those mall numbers -- it seems like the traffic is dwindling. We've talked about companies that have strong mall presences, Starbucks being one where, thankfully it's so big and they have so many stores all over the world in all sorts of settings, I don't think they're going to feel the same kind of pinch that Foot Locker might, because that product that they're selling is so specific, and people know when they're going there and what they're trying to buy.

Hill: Thanks for being here!

Moser: You got it!

Hill: As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. That's going to do it for this edition of Market Foolery. The show is mixed by Dan Boyd. I'm Chris Hill. Thanks for listening. We'll see you tomorrow!