The Fool recently presented several candidates for The Best Retail Stock for 2007, and our readers picked a winner. Sadly, my choice was not the favorite, but I didn't stay down for long. Instead, I got back on the prowl and found three more solid retailers that we investors should keep our eye on in 2007.
Retailing is all about good operations. That's because, like it or not, retailers are essentially middlemen. They connect people who make goods with people who want to buy them. So when I'm researching retailers, I look for good operating performance, good future prospects, and, most importantly, good returns on invested capital (ROIC). I may sound like a broken record, but high ROIC is critical, because I believe that, over time, capital gets allocated to businesses that generate the highest returns.
So what did I find? One retailer that's had a stumble, one that's largely unnoticed, and one that continues to have a tremendous future ahead of it.
Down but not out
If you've followed retail this year, you know that the home-decor business has been rough. And no one has been immune. Matthew Crews and I recently debated one of the biggies, Bed Bath & Beyond (NASDAQ:BBBY), and while looking at its competition, I noted that I needed to take a longer look at Williams-Sonoma (NYSE:WSM). So I did.
Williams-Sonoma is a multibranded, multichannel retailer. It has under its roof Williams-Sonoma, Pottery Barn (which one Fool thinks is broken), and other brands, and it uses catalogs, retail stores, and e-commerce to peddle its goods.
The second half of the year has not been good for the housewares peddler. Sales growth has slowed considerably. Can we blame it on the housing slowdown? I don't know. All I know is that Williams-Sonoma, historically, has been a good operator and is working actively to get growth back on track. Here's how it's fared in the past.
|
FY2001 |
FY2002 |
FY2003 |
FY2004 |
FY2005 |
LTM | |
|---|---|---|---|---|---|---|
|
Gross |
38.1% |
40.3% |
40.3% |
40.5% |
40.7% |
40.1% |
|
Operating |
6.3% |
8.9% |
9.3% |
9.9% |
10.2% |
9.8% |
|
Net |
3.6% |
5.3% |
5.7% |
6.1% |
6.1% |
5.7% |
But remember, it's not just margins that tell this story. Williams-Sonoma's management has been able to allocate capital well and turn those operating improvements into increasing returns:
|
FY2001 |
FY2002 |
FY2003 |
FY2004 |
FY2005 | |
|---|---|---|---|---|---|
|
ROIC |
10.5% |
13.3% |
13.7% |
13.8% |
14.4% |
Management has some work to do to get things back on track. The expectations built into today's stock price (currently around $34) are fairly moderate by my calculations, so the stock is not a great bargain. But if it drops $5-$10 during the year, I would become very interested.
Who?
If you have a car and you've done any repairs on it, you've probably visited an Advance Auto Parts (NYSE:AAP) or an AutoZone (NYSE:AZO). I would say it's less likely, however, that you've visited an O'Reilly Automotive (NASDAQ:ORLY) store. With only about 1,600 stores in 25 states, it's considerably smaller than its better-known competitors.
In a duel over AutoZone with Ryan Fuhrmann, I noticed that although the company's ROIC was less than AutoZone's, it's been growing. One of the reasons its ROIC continues to increase is that O'Reilly serves both the do-it-yourself wrench-turner like me and the local professional mechanic whose know-how prevents him from cracking his knuckles as much. From the looks of the margins, it apparently serves its shareholders as well as its customers.
|
FY2001 |
FY2002 |
FY2003 |
FY2004 |
FY2005 |
LTM | |
|---|---|---|---|---|---|---|
|
Gross |
42.8% |
42.2% |
42.2% |
43.2% |
43.6% |
44.2% |
|
Operating |
10.4% |
10.5% |
10.9% |
11.1% |
12.4% |
12.6% |
|
Net |
6.1% |
6.3% |
6.6% |
8.1% |
8.0% |
7.9% |
Being in a limited number of states and in a fragmented industry, O'Reilly has plenty of growth opportunities, both organically and through acquisitions. Checking the expectations built into its stock price, I found that they're a bit lower than I was expecting. This leads me to believe that the stock could be undervalued a bit, especially given the increasing returns that management continues to generate.
The 800-pound blue gorilla
Blue and orange. No, I'm not talking about the Florida Gators' national champion college football team. I'm talking about the classic showdown between big-box home-improvement retailers Lowe's (NYSE:LOW) and Home Depot (NYSE:HD), respectively.
I've said my piece about Home Depot already. And despite Lowe's return back up toward its 52-week high, I think it remains an interesting opportunity.
First of all, it's a great operator, as these numbers show:
|
FY2001 |
FY2002 |
FY2003 |
FY2004 |
FY2005 |
LTM | |
|---|---|---|---|---|---|---|
|
Gross |
29.0% |
30.4% |
30.9% |
33.6% |
34.2% |
34.4% |
|
Operating |
8.2% |
9.9% |
10.1% |
10.2% |
10.8% |
11.3% |
|
Net |
4.7% |
5.7% |
5.9% |
5.9% |
6.4% |
6.7% |
Second, as with the other companies we've discussed here, management has turned those great operations into increasing returns on invested capital.
|
FY2001 |
FY2002 |
FY2003 |
FY2004 |
FY2005 | |
|---|---|---|---|---|---|
|
ROIC |
11.5% |
13.6% |
14.0% |
14.5% |
15.5% |
Unlike Home Depot, Lowe's is sticking to its knitting by opening and operating more big blue home-improvement stores. And since it has a long way to go before equaling Home Depot in the number of stores open, it also has the opportunity to continue to increase its ROIC via improved buying power, more efficient distribution, and improved operations.
I admit that Lowe's was a much better bargain six months ago. However, Lowe's is still selling at an historically low EV/EBITDA multiple, and its implied expectations are significantly lower than I would expect. As such, if the price falls again during 2007, Lowe's would definitely become a company to consider as an investment.
For more on these retailers, check out:
AutoZone and Home Depot are both Motley Fool Inside Value recommendations. You can discover which other companies Philip Durell has tapped as good investments by taking a free trial today.
Bed Bath & Beyond is a Motley Fool Stock Advisor recommendation.
Retail editor David Meier is ranked 619 out of more than 21,000 participants in Motley Fool CAPS and does not own shares in any of the companies mentioned. You can view his TMF profile here. The Fool takes its disclosure policy very seriously.
