Best Buy Shines Even In Weak Economy

Back in November I wrote that Best Buy would be a prime beneficiary of Circuit City’s bankruptcy and given that they were already one of the best run retailers in the country, the stock was cheap at a single digit P/E (around $25 per share). Today Best Buy reported blowout fourth quarter earnings and predicted 2009 earnings of $2.50 to $2.90 per share, which is well above current estimates of below $2.50.

Best Buy shares are up $5 (15%) today to more than $38 per share, which brings the gain since November to over 50 percent. If you have been riding this trend, the shares look close to fair value from my perspective. Taking the middle of the earnings guidance range and applying a 15 P/E (a bit higher than I would choose normally, due to the recession) I get fair value of about $40 per share, so it appears the stock’s huge move is largely behind us.

Full Disclosure: Peridot Capital was long shares of BBY at the time of writing, but positions may change at any time

Reducing Unused Credit Card Lines Is Probably A Good Thing For Everybody

Meredith Whitney, long time bear on the banking sector, is pointing to the possibility that reductions in credit card lines could result in a sharp drop in consumer spending over the next year or two. In a recent television interview she predicted that outstanding credit card lines in the United States would drop from $5 trillion to $2.3 trillion by the end of 2010, a drop of more than 50 percent. Having less available credit, Whitney argues, will result in even less consumer spending and major problems for the economy.

While I don’t disagree that credit card issuers are going to reduce credit lines (we are already seeing this trend and there is no reason to think it will cease anytime soon), I am skeptical about how much this will really impact consumer spending. The main reason is because there is only about $800 billion in outstanding credit card debt in the U.S. right now, and that figure has not been growing as fast as may have thought in recent years. While this is clearly a large number ($2,600 per person), it is dwarfed by the credit lines currently outstanding and as a result, the credit line reductions should not really have a major impact on day-to-day spending.

Essentially, Whitney is predicting that the credit utilization rate will increase from 16% currently (800 billion divided by 5 trillion) to 35% within two years. For someone with $2,600 in credit card debt, that means their credit limit will be reduced from $16,000 to $7,500. While that may make the consumer a little less confident that they have a huge cushion of credit to fall back on in the case of an emergency, I don’t really agree that it will result in a significant pullback in regular spending habits.

Additionally, this action by the nation’s leading credit card companies may in fact help them as well as our consumers, who hopefully will realize that they should have a few thousand dollars in a savings account in case of an emergency rather than assuming they will get cards should something unexpected happen. This would be a welcome event for our banking system, which benefits greatly from an increasing deposit base. As for Whitney’s assertion that a credit card bubble is the next shoe to drop on our economy; call me a skeptic. The data simply isn’t all that scary to me and if we slowly lower our dependence on credit cards, our economy will be on stronger ground as a result.

Amazon Shares Look Expensive, Long Term Future Returns Appear Limited

In November of 2004 I wrote a piece entitled “Sleepless in Seattle” which postulated that shares of Starbucks (SBUX) were trading at such a high valuation (forward P/E of 48) that even if the company grew handsomely over the following few years, the stock’s performance was likely to be unimpressive. I projected an aggressive three-year average annual earnings growth rate of 20% and a P/E of 40 by 2007. I warned investors that even if those aggressive assumptions were attained, Starbucks stock would only gain 6% per year over that three year period.

The analysis proved quite accurate. Starbucks continued to grow its profits nicely, but the stock’s valuation came back down to earth. After three years had passed, Starbucks stock was actually trading 12% lower than it was when I wrote the original piece.

Today, shares of online retailer (AMZN) remind me of Starbucks back in 2004. Despite a cratering stock market and weak retail market, Amazon stock has been quite resilient. After a strong fourth quarter earnings report (released yesterday after the close of trading), the stock is up $7 today to $57 per share. Profits at Amazon for 2008 came in at $1.49 per share, which gives the stock a P/E of 38, which is very high, even for a strong franchise like Amazon.

I decided to do the same exercise with Amazon. I wanted to make assumptions that were both reasonable but also fairly aggressive. I decided that an average earnings growth rate of 15% over the next five years fits that mold. Projecting the P/E in January of 2014 is not easy, but given that Amazon’s growth rate should slow as the company gets larger, I think a 20 P/E ratio is reasonable given where other retailers trade (less than 15x). By 2014, Amazon’s growth rate should be more in-line with other retailers similar in size, so I chose 20 to be higher than average, but not in nosebleed territory like the current 38 P/E.

After some simple number crunching, we can determine that Amazon would earn $3 per share in 2013 in this scenario. Twenty times that figure gets us a share price of $60, versus today’s quote of $57. Even if the company hits these assumptions, shareholders will make a total return of 5% (only 1% per year!) over the next five years. I would be willing to bet the S&P 500 index far outpaces that rate over that time.

Obviously these assumptions could prove inaccurate, but I think this exercise is helpful in illustrating how hard it is for stocks that trade at lofty valuations to generate strong returns over the long term.

There is one interesting thing about Amazon’s business that I think is worth pointing out. You may recall that one of the bullish arguments for an online retailer like Amazon was that they could have a lower cost structure by eliminating the expenses associated with renting and operating large brick and mortar storefronts. Having a 100% online presence was supposed to result in higher profit margins, and therefore investors could justify paying more for Amazon’s stock.

It seems that argument has not been realized. Amazon’s operating margins in 2008 were 4.3%. If we look at brick and mortar retailers that are similar in business line and/or size, we find that Amazon’s margins are actually lower than their offline competitors. Here is a sample list: Kohls (KSS) 9.9%, JC Penney (JCP) 7.6%, Macy’s (M) 7.2%, Target (TGT) 7.8%, and Best Buy (BBY) 4.6%.

Maybe online retailers have to spend more on research and development and call center staff than offline stores do, thereby cutting into the margin advantage. Amazon also offers free shipping on orders of $25 or more, which many say they could eliminate to boost profits. Maybe so, but sales would be affected to some degree if they did that, not to mention customer loyalty.

Nonetheless, to me these statistics help make the case that a 38 P/E for Amazon is way too high. As a result, returns to Amazon shareholders over the next several years could very well be unimpressive, just as was the case with Starbucks five years ago.

Full Disclosure: Peridot Capital was long Best Buy and Target at the time of writing, but positions may change at any time

Retail Bottomfishers Have Better Options Than Saks

Last weekend’s issue of Barron’s highlighted a money manager’s bullish stance on shares of luxury retailer Saks (SKS). The stock is up more than 10% since then, and now fetches $4.50 per share. The manager in question believes Saks has normalized earnings potential of 50 to 60 cents per share, which he thinks will translate into a stock price of between $5 and $7 per share in more “normal” times.

I took a look myself and quite frankly I think retail bargain hunters have better options. Here are a few reasons why:

1) Normalized earnings of 50-60 cents per share seems high

Saks earned $0.42 in 2007, which most people would agree was the peak in the retail cycle. Therefore, assuming Saks will earn between 20% and 45% more than that during “normal” times is not a bet I would feel confident making.

2) In the red even during Q4

I am relying on analyst estimates here, but not only did Saks lose money in the second and third quarters of this year (before retail really started to get clobbered after the market collapse and subsequent increase in unemployment), but they are projected to lose money in the fourth quarter too. Good retailers tend to make money all four quarters even though the fourth quarter is by far the strongest. Historically, sub-par retailers have lost a bit or broken even during the first three quarters of the year and then clean up handily during the holiday season (bookstores and toy retailers fall into this category a lot). Even in a bad economy, if you are losing money in the fourth quarter, that is a sign of poor management or a severely tarnished market position (the former is more likely in this case).

3) Unimpressive gross margins

A premium store like Saks should have very impressive profit margins due to the luxury items they sell. In both 2006 and 2007 Saks posted gross margins of only 39%, and that was in a very strong retail cycle. For comparison, JC Penney (JCP) also had a 39% gross margin for both of those years. This signals some deficiencies in merchandising at Saks, as they should have more pricing power (less of a need to discount) than a lower tier department store.

4) There are competitors that are doing better and also have cheap stocks

I picked Nordstrom (JWN) here as an example. Their market sits between JC Penney and Saks, but they are viewed as a little higher end, approaching if not matching Saks. Nordstrom has made money every quarter this year and will continue that trend in the fourth quarter. Their stock price is similarly depressed, as are most retailers, so you are getting both value and what appears to be a better run company.

All in all I think there are better bargains than Saks on the retail racks right now.

Full Disclosure: No positions in any of the companies mentioned, but positions may change at any time

Abercrombie Chooses Fewer, More Profitable Sales Over Lower Margin Bargain Bins

Last month I mentioned I thought Abercrombie and Fitch (ANF) stock looked undervalued. A December 8th Wall Street Journal article entitled “Abercrombie Fights Discount Tide” discussed ANF’s strategy to maintain its premium brand image by choosing to accept higher rates of sales decline, relative to lower priced competitors, in order to hold up profit margins and not risk losing pricing power when the economy recovers.

The company has taken some heat on Wall Street for employing such a strategy, but it worked just fine for Abercrombie in the last recession. As an investor, I much prefer fewer sales at higher margin to higher volume (and less profitable sales) because it minimizes the risk of a retailer falling into the red.

The WSJ cites November same store sales drops of 28% for Abercrombie versus only 10% for Pacific Sunwear (PSUN) and 11% for American Eagle Outfitters (AEO) as evidence that markdowns boost sales in the short term, which is certainly true. But the key here is margins. While gross margin collapsed for the latter two retailers (Pac Sun from 34% to 29%, American Eagle from 47% to 41%), Abercrombie’s held steady at a stunning 66%.

Gross margins of 66% are usually reserved for software and medical device companies, not mall retailers. With retail markups of 50% above cost, Abercrombie clearly has a premium brand. It is expected that during tough economic times that many of its customers will trade down to cheaper clothes, but that does not mean the company should completely rebrand itself. ANF is debt-free with 66% gross margins, so sales can drop pretty significantly without jeopardizing profitability.

“We hear your concerns,” ANF Chief Executive Michael Jeffries said during an earnings call, but “promotions are a short-term solution with dreadful long-term effects.” Abercrombie’s general counsel, David Cupps, added that the company is “well positioned to deal with a tough market,” adding that cutting prices would be cutting the quality of merchandise. “We’re not going to follow the promotional pied piper,” he said.

Given the amount of bad news already priced into ANF shares, they look very cheap even if sales continue to drop throughout 2009. Even if you assume earnings fall 50% from their 2007 peak level, never recover at all, and the stock only fetches a 10 P/E, investors buying today will make a 30% return from current levels. That is a risk-reward scenario that looks very favorable.

Full Disclosure: Peridot Capital was long shares of ANF at the time of writing, but positions may change at any time

Financial, Retail Weakness Mask Underlying Core Profitability

Simply judging from the stock market’s performance over the last couple of months, you might think the entire U.S. economy is teetering on the brink of disaster. In reality though, the sheer ugliness of the financial services and retail sectors is masking the other eight sectors of the market that, while certainly weaker than they once were, are actually holding up okay given the economic backdrop. The easiest way to illustrate this is to show earnings by sector for the last three years; 2006, 2007, and 2008. Keep in mind the 2008 are estimates based on nine months of actual reported profits and estimates of fourth quarter numbers.

As you can see from this graph, earnings in areas like telecom, healthcare, staples, or utilities are doing just fine and can withstand further weakness in 2009 and still more than justify some of the share price declines we have seen in recent months.

The selling has been indiscriminate but the business fundamentals are quite differentiated, depending on sector, which is one of the reasons that the U.S. equity market has not been this cheap relative to earnings, interest rates, and inflation since the early 1980’s. It is a gift for long term investors.

Sears Holdings Has Squandered An Opportunity

The last four years or so for Sears Holdings (SHLD) and its shareholders would make for quite an interesting Harvard Business School case study. I have been writing about the company since 2005 and was an early investor in Kmart, even before Eddie Lampert used it as a vehicle to buy Sears.

The early success was very impressive. Lampert bought loads of Kmart debt as it filed bankruptcy and gained control of the company’s equity when it reemerged in 2004. In 2006 Sears Holdings earned a profit of $1.5 billion, or $9.58 per share, quite a turnaround for a retailer that had been bleeding red ink.

Lampert accomplished this not by turning Sears and Kmart into strong retailers like Wal-Mart (WMT) and Target (TGT) (sales and profit margins still lagged those competitors), but rather simply by running the companies very efficiently and milking them for cash flow. Even if you earn a 3% margin instead of 6%, that is big money when you bring in $50 billion of sales annually.

The Wall Street community was sold on the idea that Lampert would use the cash flow from Sears Holdings to diversify its business away from ailing retail brands. Maybe he would close down stores and sell the real estate, or lease it back to other retailers who wanted the space. Maybe Kenmore and Craftsman products, which are owned by Sears, would show up on other retailers’ shelves. Maybe Land’s End, also owned by Sears, would be expanded as an independent retail brand. Maybe Lampert would buy other companies outside of retail altogether. The possibilities seemed, were, and still are, endless.

And yet none of this has materialized. Sears continues to operate as a sub-par retailer and uses excess cash flow to repurchase stock. As the economy has faltered, so has cash flow. Adjusted EBITDA year-to-date has fallen to $700 million, from $1.5 billion last year. The only positive has been the reduction in share count. Sears earned $1.5 billion in 2006, or $9.58 per share. If they somehow are able to earn that much again when the retail environment improves, earnings per share would be nearly $12 per share because of the lower share count. With the stock at $31 today, you can see that the stock would trade back above $100 in that scenario.

But how will that happen anytime soon if Sears continues as is has? It won’t, which is why Peridot Capital has been steadily selling Sears stock over the last year. It used to be a very large holding, but is now one of our smallest. Eddie Lampert evidently was convinced he could do more with the retailer’s operations even after the low hanging fruit had been picked. That was a bad decision.

As long as the economy remains weak, Sears will likely use it as an excuse for its poor operating results. That is a shame, because they had a perfect opportunity to diversify out of retail and they chose not to, even when it was widely accepted as the right strategy for investors. The truth is, however, that Sears and Kmart are not strong retailers and likely never will be, at least not in their current form.

To me, Sears is in the same exact position as General Motors (GM) right now. They are operationally inferior to their competitors, but refuse to dramatically alter their business plans to adapt to the market. Today the Big 3 CEOs will testify in front of Congress and explain that the economy is the source of their problems. They need annual auto sales of 13 million units to earn a profit, far from the 10 to 11 million run rate we are now facing.

I don’t need to tell you that GM’s business model is the problem, not the economy. If the U.S. auto market shrinks due to higher job losses and tighter credit standards, managers need to make changes to ensure they can survive in such an environment. In that case, a stronger economy would mean higher profits, not just survival.

I heard a GM dealer on television complaining that he can finance customers with credit scores of 650 or higher today, whereas last year someone with a 550 could get a loan. He implied that the banks were at fault for cutting credit for people with bad credit (the average credit score in the U.S. is 680). Was it not the fact that 550 credit scores qualified for car loans in the first place that got us into this kind of financial crisis? We should give loans to low quality borrowers to save the Detroit auto industry? I think not.

The bottom line is, if your company adapts you will likely be a survivor. When times are bad the weak die out and the strong not only survive, but they come out of the downturn even stronger than they were before. In today’s market, when nearly every stock is down tremendously, there are fewer reasons to invest in Sears or GM when you can buy a stronger company like Target or Toyota on sale. When Target fetched a 20 P/E I preferred to buy the more undervalued Sears. Combine disappointing execution by Sears and a 50% drop in Target stock, and given the same choice I will take Target at a 10 P/E, which is what I plan to do.

Full Disclosure: At the time of writing Peridot Capital was long shares of Sears and Target and had no position in GM or Wal-Mart, but positions may change at any time

How Can Publish This Story?

In a piece written by Glenn Hall, published an article today entitled “Today’s Outrage: Sears Isn’t Worth $4 Billion.” I had to check my calendar to make sure it wasn’t April 1st because I can’t believe the editors at a prominent site would publish this nonsense.

Here is how the article begins:

“How can Sears be worth $31.84 a share? Target fetches only $29.54, and JC Penney is down to $16.55. At the other end of the retail spectrum, investors are only paying $6.41 for Macy’s, and at the low end, Family Dollar Stores are only trading at $26. Wal-Mart is one of the few higher-valued competitors, with its shares at $53. So I have to ask: Who thinks Sears is better than Target or even JC Penney for that matter?”

I would expect this from a market novice who does not understand that share prices themselves do not indicate which companies are “better” than others (the number of shares outstanding, and therefore the equity market values, are different). But from I think Jim Cramer needs to have a talk with his editors over there.

I was planning on writing about Sears today, and will still do so later, but I just had to point this out for those of you who are often a little too quick to act on something you read online. It has become very easy to reach the online masses with one’s views these days, given technological advances, but as a result the quality of the content is diluted, and perhaps even more so than I thought.

Full Disclosure: Peridot was long a small position in SHLD at the time of writing, but has been selling the stock steadily over the last couple of years, for reasons which will be explained in an upcoming blog post. Positions may change at any time.

Analyzing Stock Valuations During Recessions

Now that third quarter earnings reports have largely been released, I thought I would write a bit about valuing stocks during a recession. Having seen all of the numbers and listened to all of the conference calls, I am beginning the process of going through my client accounts and making adjustments, if necessary, based on what information has come out during earnings season.

Drastic business model shifts are rare, so this analysis largely involves looking at management’s execution of a company’s particular strategy (are they doing what an investor would expect) coupled with valuation analysis (what price is the market assigning to the business and what assumptions are embedded in those assumptions).

Valuation analysis is a bit trickier during a recession because earnings are at depressed levels. The key is to understand that a stock price is supposed to equate to the present value of expected future cash flows in perpetuity. As a result, corporate profits for any given single year are not always indicative of value, meaning that valuations using earnings during a recession will likely underestimate a company’s fair market value and vice versa during boom times.

A lot of people these days remain negative on stocks, despite the recent crash in prices, because they are assigning a low multiple to depressed earnings and are concluding that stocks aren’t very cheap, when in fact, they have not been this cheap since the early 1980’s. For instance, many expect earnings for the S&P 500 to dip to $60 in 2009. Market bears will assign a “bear market” P/E of 10 to those earnings and insist the S&P 500 should be at 600 (versus 865 today). More aggressive projections might use a P/E of 15 (the historical average) and conclude that the market is about fairly valued right now (15 x 60 = 900).

The problem with this analysis, of course, is that it assumes the economy is normally in a recession and a $60 earnings target for the S&P 500 is a reasonable and sustainable estimate for the future. In fact, it represents a trough level of earnings, which is not very helpful in determining the present value of all future cash flows a firm will generate, unless of course the economy never expands again.

Consider an entrepreneur who sells winter coats, gloves, and hats in an area that has normal seasonal weather patterns. If this person wanted to sell their business and a potential buyer offered a price based on the company’s profits during the month of June (rather than the entire year as a whole), the offer price would be absurdly low.

Because of that, you will often hear the term “normalized” earnings power. In other words, when valuing a stock investors should focus on what the company might earn in normal times, rather than at the extremes.

Take Goldman Sachs (GS) for example. Wall Street expects GS to earn $0.28 per share in the current quarter, whereas in the same quarter last year they earned $7.01 per share. Just as one should not use a $7 per quarter run rate to determine fair value for GS (the stars were aligned perfectly for them last year), one should also not use a $0.28 per share run rate either, because today represents close to the worst of times for the company’s business.

Investors need to value stocks using a reasonable estimate of normalized earnings power and apply a reasonable multiple to those earnings. With cyclical stocks, oftentimes you will see share prices trading at elevated P/E multiples during the down leg of the cycle because earnings are temporarily depressed. Investors are willing to pay a higher price for each dollar of earnings (as shown by high P/E’s) because they don’t expect earnings to remain at trough levels longer term.

One of the reasons stocks are so cheap today in historical terms is because many firms are trading at single digit P/E multiples based on recessionary profit levels. Buying trough earnings streams for trough valuations has always been a winning investment strategy throughout history, which is why so many long time bears are finally stepping up and starting to buy stocks again.

Take a very recent purchase of mine, Abercrombie & Fitch (ANF), as an example. The stock is trading at $16, down from $84. ANF typically trades for between 10 and 15 times earnings. They earned $5.20 per share last year but profits are expected to drop to $3.30 this year and to below $3 in 2009. The 2007 level of profitability is not what I would consider a “normalized” number, but earnings could drop 50% from the peak by 2009 (to $2.60) and that would not be normalized either.

The great thing about today’s market for long term value investors is that we can buy a company like ANF for only 6 times earnings, even after taking their 2007 profits and slicing that number by 50% to account for the recession! When the economy recovers, isn’t ANF going to earn more than $2.60 per share and trade at more than 6 times earnings? If one believes that, then ANF is a steal (as is any other stock that is trading at a similar price) as long as one is willing to be a long term investor and wait out the full economic cycle.

Full Disclosure: Peridot was long shares of ANF at the time of writing, but positions may change any time

Circuit City Bankruptcy Is Great News For Competitors

A week after announcing it would close 20% of its stores, electronics retailer Circuit City (CC) has announced it will file for Chapter 11 bankruptcy protection. While that really is no surprise (retailers can’t operate in the red forever), investors should consider who wins from this development.

The most obvious choice is Best Buy (BBY), the leader in the space. Although CC is a weak player, there are many places where Best Buy and Circuit City locations are very close to each other. Given the store closings, plus the stigma of Chapter 11 with the stores that will remain open, BBY should see some incremental benefit. BBY trades at 8-9 times earnings, quite a low price for the best managed consumer electronics retailer.

Full Disclosure: Peridot Capital was long BBY at the time of writing, but positions may change at any time