The Retail Scavenger Hunt

Retail stocks are crumbling. I know because I have a front-row seat as the retail editor at The Motley Fool. Trust me. It hasn't been pretty.

Maybe I shouldn't be surprised. After all, we've got economic worries, a housing slowdown, subprime lenders falling by the wayside, and high gas prices. Consumers can't have much stamina left, despite their unrelenting urge to buy.

But don't take my word for it. I ran a screen to see just how bad it's been recently. Of the 405 retailers with a market capitalization of more than $250 million, 126 of them have had their stock price drop more than 25% from their 52-week high. Here are the ones that caught my eye.

Bad movie, part 2
I'm not surprised to see many of those names on the list. After all, I've written about them over the past year.

Circuit City is working hard to turn itself around. In July, Executive Vice President Dave Matthews presented a plan to analysts, but if the stock-price decline is any indication, I'm not sure the analysts are buying it. It's tough to turn around when you're a distant second in your niche and having trouble generating adequate returns on the capital that shareholders provide.

As for Finish Line, I have not been impressed. Its decision to acquire Genesco had me scratching my head and wondering what was going on. If the company can't run its own operations consistently, what makes management think it can run its business plus another one?

On the other hand, I have been a fan of Build-A-Bear from the beginning. I even followed its 2004 IPO. I really liked the combination of the concept and the store layout and how influential that combination has been. But then came Webkinz, whose popularity has taken off right at a time when Build-A-Bear's seems to be waning. Coincidence? Webkinz's hook -- one that has successfully captured the imagination of our family and friends -- is the interactive website and social network attached to the fuzzy little critters. Maybe that's why Build-A-Bear is stuffing its own interactive website as fast as it can to catch up.

One of the common threads for the companies I've mentioned is that returns on invested capital have been decreasing. Borders Group and Panera are not exceptions. In fact, I identified this trend in both companies earlier this year. I noted it in a bearish view of Borders in a June edition of "Dueling Fools" and in a look at Panera, following my wife's request for us to consider it as an investment idea.

And last, but certainly not least, I have also been critical of Whole Foods, long before the recent firestorm over John Mackey's secret online identity. As with Panera, our family loves Whole Foods' stores and products. Along with the salmon spread, we've learned the crab dip is to die for as well. But just because it's a great store, that doesn't necessarily make it a great investment.

A diamond in the rough?
Surely, you've noticed the one I haven't mentioned yet. That's right -- bebe Stores. So what separates bebe from the rest of the group?

If you haven't guessed, I'm big on return on invested capital. And since fiscal 2003, bebe's returns have been rising even as it opens new stores. The recent slowdown will likely make it hard for the company to repeat such a bravura performance in fiscal 2007, but returns are currently still well above a conservative estimate of the company's cost of capital.

Sitting there at the top of the balance sheet, as beautiful as Eva Longoria dressed in, well, just about anything from the BEBE SPORT collection, is about $4 per share in cash. A quick look at the cash flow statement shows that bebe is amassing its treasure the fashionable way: by earning it.

Don't get me wrong, I know the company is not performing very well right now and that there's a lot of uncertainty. Same-store sales have been declining as of late, and that's not a good sign. In addition, because of Manny and Neda Mashouf's divorce, the company lost Neda, who was head of merchandising. Losing its fingertip on the pulse of fashion is not good for a company that relies on fashion.

Still, I think the market has gone too far with its pessimism. A thumbnail valuation shows that the market thinks the company will grow only about 6% per year for the next 10 years. There seems to be a disconnect, since the company is growing its retail square footage between 10% and 15%. Remember, management is generating good returns on invested capital.

The Foolish bottom line
I think this is a case where the market is throwing the bebe out with the bathwater. Sure, there are lots of concerns in the economy and with the consumer today. But that doesn't mean every retailer is in trouble.

Whole Foods and bebe are Motley Fool Stock Advisor selections. Borders Group is a Motley Fool Inside Value recommendation. Try out either Foolish service free for 30 days.

Retail editor David Meier does not own shares of any of the companies mentioned. The Motley Fool has a disclosure policy.