Nothing new under the (Pac)Sun
There's not much surprising in Thursday night's earnings release from Stock Advisor recommendation Pacific Sunwear
To me, the only minor shocker is that somehow the business-media bubbleheads out there are referring to the $0.14 per share as a "miss" even though the dismal guidance given just days ago had that number at the low end of the range.
Still, with the number of companies out there that habitually sandbag guidance in crummy quarters so they can come back and "beat" the reduced expectations by a penny, I suppose we can't blame analysts and investors for hoping PacSun would use the same trick and pull a rabbit out of the hat. Let me be the first to salute management for not resorting to that kind of chicanery.
Wreckage on the beach
Unfortunately, PacSun's magic toque is chock-full o' problems. Overall, sales rose a paltry 1.5%, which isn't surprising given that same-store sales were down 5%. Earnings dropped by 50% compared with the prior-year quarter, something that's not too hard to understand when you take a look at what happened to margins.
| Margin |
Q2 2006 |
Q2 2005 |
Change* |
|---|---|---|---|
|
Gross |
31.06% |
35.71% |
(4.65) |
|
Operating |
4.64% |
10.60% |
(5.96) |
|
Net |
3.10% |
6.83% |
(3.73) |
To put that in perspective, my data show PacSun's average gross, operating, and net margins over the past five years to be 34.8%, 11.2%, and 7%, respectively.
That suggests that if or when PacSun turns this around, and margins move back toward the mean, there would be major earnings growth to be had, along with share-price appreciation.
This skeptic's valuation
But I continue to disbelieve that happy ending, for a couple of reasons. First, PacSun hasn't showed that it can correct its fashion missteps, and until it does, investors need to entertain the uncomfortable prospect that this might just be a mostly dead brand, like HotTopic
Of course, everything is worth something, and PacSun is no different. But what to pay? That's always the trouble, isn't it? Some are going to take a look at the recent drop, ogle the enterprise value-to-revenues multiple of 0.7 and say, "This is cheap enough." Of course, they were likely saying that back at $18, and probably $21.
The numbers also show that, year-to-date, there's a swing toward decidedly negative free cash flow this quarter. Most of that looks to be due to poor management of inventory (up 18% versus the 1.5% sales increase) and other working capital. That would square with PacSun's longer-term trend of declining free cash flow, something I've commented on before.
There are many ways to value a stock, but I tend to prefer those that don't depend on the old baseball-card system, meaning I don't just buy on the face value of stats and hope some sucker will come along and take it off my hands for more. Rather, I try to figure out what a stream of future cash flows looks like and is worth in today's dollars, and then I try to pay no more than 80% of that price.
As PacSun's glories fade and it looks less and less like a future cash-flow stream, my model has ratcheted down accordingly. These days, with a discount rate of 12% and a still-generous assumption about base-line cash flow and growth, I see the shares at a fair value of $12 each. I'd consider a buy at $10, which would put it at an EV/R multiple of about 0.5, the kind of number that just might be a universal signal for "wicked-cheap retailer."
Foolish bottom line
I know there are a few Fools out there who think I'm too hard on the old PacSun, especially since one of the guys signs my paychecks. Fool co-founder Tom Gardner recommended the stock for Motley Fool Stock Advisor 42% ago.
I don't have much to say to that, except that it gave me hives when he picked it because I'd recently bailed on my own position, but I felt it was entirely possible that my pessimism was unwarranted. So far, observing PacSun through the hairy eyeball has been the right thing to do. I've learned some hard lessons by buying retail screamers myself. I'm much more careful these days, but if you folks buying today can make some dough in the coming months or years, good on you.
There's just too much uncertainty here -- aside from the consistent backslide in cash profitability -- to warrant my investment except at stupid-cheap prices. There are plenty of great, steady, large-cap companies already selling at good discounts to my estimate of their present value -- Nike
For related Foolishness:
- PacSun's Troubled Waters: Fool by Numbers
- The Problem at PacSun Is Price
- Low Tide at Pacific Sun Again
Pacific Sunwear and American Eagle Outfitters are Motley Fool Stock Advisor recommendations. Johnson & Johnson is an Income Investor recommendation. You can try any of our market-beating newsletter services for free .
Seth Jayson has been burned by retail, which is why he's very, very picky. At the time of publication, he had shares of American Eagle and Johnson & Johnson but no positions in any other company mentioned. View his stock holdings and Fool profile here. Fool rules are here.
