Payless ShoeSource's (NYSE:PSS) stock was up 18% yesterday, and I'm not exactly sure what all the hubbub was about.
As I mentioned back in March after covering Payless's fourth-quarter earnings, the stock has had a great run over the past couple of years, having more than doubled from a low of $9 in late 2004. You have to credit the new management team for its laser focus on cost-cutting initiatives to revitalize margins and earnings. Back in March, I pondered whether Payless had entered a new paradigm of consistent growth in its 4,600-store base, or whether this was a one-hit wonder that had resulted more from cost-cutting. Despite the impressive earnings reported today, I'm leaning toward the latter conclusion for now.
Investors were clearly impressed that diluted earnings increased almost 18% for the quarter, driven by continued cost-cutting moves. But other than that, there wasn't much to be excited about. Last year's quarter included a restructuring charge, so results were depressed a bit. This quarter's same-store sales increased only 0.4%, and total store sales were down 0.1%, or basically flat from the same quarter in 2005.
Granted, this is consistent with the company's current strategy, which focuses on increasing per-unit sales -- in other words, selling higher-priced pairs of shoes. These sales can increase profit margins even if overall sales and same-store sales remain flat, as we just witnessed for the quarter. But was a stock run-up of 18% yesterday appropriate?
Besides Payless's sales weakness, I'm concerned that its inventories increased nearly 14% sequentially, which made cash flow from operations look pretty dismal for the quarter. Though clearly not a trend at this point, I'd keep an eye on inventory. As I mentioned in my previous write-up, bearish investors are concerned that the stock has run up too quickly and that Payless could lose its price-sensitive constituency as it pursues more fashionable -- and expensive -- shoe sales. Rising inventory could prove them right.
Bullish investors are being patient with management, cutting Payless slack regarding tepid sales trends as the company tries to woo customers willing to spend more on fashionable brands. In the bulls' favor, the company's margins are improving.
Payless is a company in transition. Earnings growth will likely continue because of cost-cutting measures, but eventually, sales will have to grow for this to represent a long-term growth story. For two reasons, I recommend waiting on the sidelines to see how things shake out.
First, the current valuation doesn't price in much downside. Witness Payless's trailing P/E of 19 and forward P/E of about 17. (We're talking about earnings, not the company's currently low free cash flow.)
Second, retailers can be compared using similar metrics, so you can afford to be overly selective. There's plenty of opportunity to find a name trading at a more compelling valuation with a more consistent track record, or a more stable business model with more visible growth prospects. If you don't think Payless is the right fit for you, try PetSmart (NASDAQ:PETM), Bed Bath & Beyond (NASDAQ:BBBY), or Pacific Sunwear (NASDAQ:PSUN) on for size.
Bed Bath and Beyond, PetSmart, and Pacific Sunwear are all Motley Fool Stock Advisor recommendations. Take the newsletter dedicated to the stocks at the very top of David and Tom Gardner's list for a 30-day free trial.
Fool contributor Ryan Fuhrmann is long shares of Bed Bath and PetSmart, but he has no financial interest in any other stock mentioned (that means he's neither long nor short the shares). Feel free to email him for feedback on this article or to discuss Payless further. The Fool has an ironclad disclosure policy.
