Hottest Trend in Retailing: Department Stores?

Group 1: Best Buy, Walmart, Target, Home Depot, Lowes.

Group 2: Federated, May, Kmart, Sears, JC Penney.

Rewind the investment landscape a year and see which retailers Wall Street was talking about. It was the first group of companies listed above. However, nowadays it’s the second group that is getting all of the attention.

First it was Kmart buying Sears. That was supposed to be a unique situation. Kmart had come out of bankruptcy. Eddie Lambert already owned a chunk of Sears, so it made sense to buy the rest with the fortune he was making on his contrarian purchase of Kmart. Kmart owns most of its locations and has cheap lease agreements dating back decades for the rest of its attractive off-mall locations. However, once the real estate strategy was uncovered by Kmart, Wall Street analysts turned their attention to every other major retailer to try and quantify how much hidden value was there.

Federated recently announced they were buying fellow mall-based department store giant May. The stock have been on fire ever since. JC Penney has jumped 25% since rumors of that deal heated up. All of the sudden, department stores in malls across the country are the hottest investment idea in retail. But does this make any sense? Will every retail merger result in a Kmart-like jump in shareholder value?

Not likely. Merging two poorly-run retailers does not create a larger better-run, more profitable company. Shoppers have abandoned mall department stores over the years for good reason. And they’re not coming back. The attractiveness of the Kmart/Sears deal is less about improved operations as it is about creating shareholder value via other means. This will be done by selling real estate and other non-core assets. Sears can sell its stake in Sears Canada and its Lands End subsidiary. Kmart can sell more store locations since there is usually a Sears within a few miles of Kmart. The cash flow is not going to come from an influx of new customers beating down the doors of the recently renovated Kmart store that now is called Sears and carries Craftsman tools.

Why then, are the share prices of Federated, May, and Penney through the roof? It’s a valid question. A lot of people think every retailer can harness the Sears/Kmart model. If that was the case, wouldn’t they all have done it long ago? To show how speculative some investors have gotten, you only need to look at rumors that helped Circuit City stock rally. They were rumored to be looking at selling some of their real estate, given their dismal track record competing with Best Buy. Only one problem, though. Circuit City doesn’t own any real estate, they lease their stores.

I would be leary of the rallies in Federated/May and JC Penney. I hope they can get their acts together and increase profitability. It just seems unlikely that the people that have driven customers away and created an abundance of poorly-run and unappealing department stores would all of the sudden be able to turn their companies into gold, simply by merging and trying to duplicate someone else’s strategy.

Kmart Gets Another Nod from UBS

With hundreds of investment firms employing thousands of equity research analysts, you would think Wall Street would be paying a little more attention to Kmart (KMRT). How many analysts do you think cover the company? I bet very few people would say only one, but they’d be right. What sets UBS retail analyst Gary Balter apart, even moreso than his lack of fellow Kmart followers, is his track record.

Balter initiated coverage of Kmart with a “buy” rating on April 4, 2004. Back then, investors thought he was crazy. After emerging from bankruptcy, KMRT shares rose from $15 to $41 before Balter recommended them to investors. Baffled by such a move, given Kmart’s horrible track record as a money-losing retailer, people ignored Balter’s advice and many shorted the stock. That was a decision many would live to regret.

Balter was one of the few who realized that not only did Kmart rid itself of its massive debt load after its reorganization, but that its real estate was a hidden crown jewel. As the company began to sell off some valuable stores to the likes of Home Depot and Sears, investors began to realize that Kmart had potential for a monumental turnaround. Short sellers were forced to cover their positions, and investors who listened to Gary Balter and bought the stock in the low 40’s saw it soar to $109 per share by November of last year.

At that point, Balter pulled his buy rating on Kmart, reducing shares to “neutral” after the stock had jumped more than 150% since his initial recommendation and announced plans to acquire Sears. Concerns over merger integration and short selling by arbitrageurs proved the UBS downgrade to be very timely. The stock, after hitting nearly $120 when the merger was announced, fell to as low as $86 within several weeks.

In early January, I wrote a piece alerting readers that KMRT (then at $92 per share) was a smart buy amid the merger-related concerns. Once the deal closed in late March, shorts would be forced to cover and more value in the Kmart/Sears combination could be realized. Since then, the stock has risen to $112, with the deal expected to close within weeks. Tonight, sensing the deal will prove to be a success, Gary Balter is once again slapping a “buy” rating on Kmart stock, raising his price target to $160 per share. The stock is trading up $7 in after-hours trading as a result.

Investors can choose to continue to voice skepticism about the Kmart/Sears combination, but betting against Balter at this point seems risky. Eddie Lampert, the chairman and majority shareholder of the combined company, has a great track record in retail and should be able to improve operations and sell off more real estate to unlock value for all KMRT shareholders, himself included.

Below is a 1-year chart of KMRT stock. Balter’s initial recommendation, subsequent downgrade, and latest upgrade are labeled A, B, and C.

Has Oil Peaked?

Everybody is talking about oil and a potential double-top after the commodity failed to break through $55 a barrel in yesterday’s trading. Nobody can really predict these short-term movements, and enough people look at charts that we might not see $60 near-term. Even if we get a pullback in oil prices on technical trading, I doubt that is the end of high oil prices. Any meaningful pullback should be bought as far as the energy stocks are concerned, just as a run above $55 presents a good opportunity to take some profit off the table.

High oil prices are here to stay, contrary to many people who blame the current escalated priced to hedge fund trader speculation. We might not see a run to $60 this week or next, but I would not be surprised if we saw oil hit $60 before it drops to $40 per barrel. When picking stocks in the group, focus on those companies that not only do well with prices high, but will have strong production growth as well, so when prices do give back some ground, their earnings won’t collapse.

BSX Hits New Low

Shares of medical device maker Boston Scientific (BSX) are hitting new lows today at $29 per share. The stock now trades at less than 14 times this year’s expected earnings, despite being the leading maker of a new class of heart devices known as drug-eluting stents. These new stents are coated with drugs that help patients heal from cardiovascular surgery and are widely becoming the de-facto standard within the industry.

As has always been the case with medical devices makers such as BSX, Guidant (GDT), St. Jude Medical (STJ), and Medtronic (MDT), competitive concerns continually drive share price fluctuations. While Boston Scientific is in the lead today, Johnson & Johnson (JNJ) has solidified the number two position and will surely be helped by its pending acquisition of Guidant. Both Medtronic and Guidant have yet to begin selling their drug-eluting stents, but they are in testing. Within a year or two, most players will have competing products on the market, cutting into Boston’s lead. Hence, BSX shares are making multi-year lows today.

The good news though, is that the number of competitors is decreasing due to consolidation in the industry. The medical device market is still growing at a double digit clip annually. Although BSX’s stent market share will likely decline in coming years, the company will remain a strong competitor and currently trades at a steep discount to the other companies in the industry. The stock’s near-term momentum is definitely down, but investors should keep a close eye on Boston Scientific, as an opportune time to buy the beaten-down shares will most likely present itself at some point in the future.

Morgan Stanley Analyst Understands COF

You won’t find me praising Wall Street analysts very often, but sometimes investors can find a diamond in the rough here and there. Morgan Stanley’s upgrade of Capital One (COF) this morning, following the lender’s announced buyout of Hibernia (HIB), warrants such praise. The analyst raised the rating on COF to buy from neutral.

An upgrade in and of itself never gets me too excited. The next thing I look at is the particular analyst’s track record with respect to that individual stock. After all, if they’ve been dead wrong on a company for years, why should one all of the sudden listen to them now? A little research finds that Morgan Stanley last put a buy recommendation on Capital One shares on May 12, 2004. This bodes well for investors, as you can see from the chart below.

After getting hit hard in early May of last year, Morgan came out and pounded the table when others were fleeing the name. The buy recommendation at $63 was the right call, and I’d be willing to bet few other analysts were making the same conclusion at that time. It looks like we can add the Morgan Stanley’s Ken Posner to the list of relevant Capital One analysts.

Capital One to Buy Hibernia

Investors who closely follow Capital One Financial (COF) shouldn’t be very surprised to hear that the company has agreed this weekend to buy New Orleans-based Hibernia Corporation (HIB), a bank with over $22 billion in assets, for $5.3 billion in cash and stock. The writing for a deal like this has been on the wall for a while. Capital One, which focuses on marketing directly to customers, is seeking to boost its reach by acquiring a regional bank, opening up new avenues for growth.

From an investing standpoint, it makes little sense to bet against Capital One based on this acquisition. The company is run brilliantly, having increased earnings per share at least 20 percent every year since its IPO in 1994. Wall Street will likely sell off COF shares tomorrow, given the company is paying a 24% premium and many will likely question the decision for a direct marketing lender to spend over $5 billion for a bank with branches in Louisiana and Texas.

In such a case, investors who have missed out on Capital One’s magnificent track record thus far should consider stepping up to the plate and buying the stock on any merger-related weakness. The stock trades at only 11 times 2005 earnings, and that valuation will only get more compelling should the stock get hit tomorrow. And who knows, an analyst downgrade or two might spark enough of a sell-off that existing shareholders, such as myself, should consider adding to their positions.

Housing and Rising Interest Rates

After months of baffling investment strategists and economists, long-term interest rates have finally begun to rise. The 10-year bond rate has risen from under 4.00% to nearly 4.40% in a heartbeat. Prospective home buyers are finding their rates rising, putting pressure on them to lock in a low rate as soon as possible.

There is little doubt that higher rates will hurt the housing market. The homebuilding stocks haven’t been hit much yet, but it’s certainly dangerous to own them for the rest of the year, if this rate trend continues. If you believe rates will continue to move higher, the housing stocks could make for an attractive short (especially with the S&P 500 setting up for a potential triple top).

If you want further evidence to question the sustainability of the homebuilding sector’s tremendous run on Wall Street, below is a piece written this week by a very competent hedge fund manager:

“According to the National Association of Realtors, who should know, second homes accounted for 36% of U.S. home purchases last year, up from more than 16% in 2003. That 36% breaks down thusly: 25% of homes were bought for investment; 13% bought as vacation homes.

Think about that for a second. More than a third of all homes bought last year were bought for either speculative purposes or as vacation homes.

This doesn’t square at all with the mantra of the home building companies and their fans, which is that the U.S. has a perennial housing shortage caused by job creation, immigration and the deep-seated hunger for home ownership.It has nothing to do, they assure investors, with the recent 4% 10 year treasury yield.

It has nothing to do with adjustable rate mortgages or “IO” loans–interest only loans–in which the only thing the homeowner pays is the interest, leaving the principle for later (which to the buyer means “when I flip the thing for a big profit”).

And it has absolutely nothing to do with speculative buying, according to home builders including–and I’ve heard them all say it–Toll Brothers, Pulte, Lennar, KB and Hovnanian.

But now we know the facts: home purchases were inflated a full 20% (the jump from 16% in 2003 to 36% in 2004) by boomers snapping up spec housing and vacation homes around the country. That’s a bubble.

And not for nothing, it seems the average single-family home financed by Fannie Mae or Freddie Mac shot up almost 12% last year, the highest rate since 1979. For those who remember that far back, 1979 ushered in a couple of pretty ugly years in the housing market.”

Tibco Software Falls Victim to Wall Street’s Short-Term Thinking

In less than two weeks, shares of Tibco Software (TIBX) have been decimated, falling from $11.88 on February 18th to $7.00 this morning. Rumors have been swirling that weakness in Europe would lead to a profit shortfall in Q1 2005. Sure enough, TIBX issued a press release last night saying that first quarter sales and earnings per share would likely come in at $100 -$102 million and 4-5 cents, versus prior guidance of $116-$120 million and 8 cents.

Tibco shares had been one of the few bright spots in the software sector in 2004. The shares soared from under $6.00 last August to hit a high of $13.50 in December. Not surprisingly, with such enthusiasm for the company heading into 2005, this quarter’s miss has caught investors by surprise. Most have chosen to sell.

Wall Street too often focuses on the short-term, and can punish companies (especially those of the small cap technology variety) in extreme ways after an earnings warning. While the Q1 hiccup is undesirable, have the company’s fundamentals gotten so bad that it warrants a $13.50 stock getting cut nearly in half over the course of a couple months? Not in my opinion. There is a ton of stock for sale today. Take advantage of it.

Brilliant Brokerage Call of the Day

A few years back, Prudential Securities got out of the investment banking business. It was widely expected that without the typical conflicts of interest that other diversified investment companies faced, Pru’s research department would be less biased, and therefore produce more valuable recommendations for their clients.

So much for valuable research. Prudential lifted its view on the energy sector to overweight today, and slapped a buy rating on shares of ExxonMobil (it was rated neutral before). Evidently their energy analysts see something fundamentally favorable to the big oil stocks, as of this morning. I’m sure Pru’s clients are thrilled with such a timely call.

Oil Volatility Continues to Drive Stock Prices

The Dow staged a late day rally today, closing up 75 points to 10,750, despite the fact that oil prices have once again cracked through $50 per barrel. Many would expect that with oil at $51.39, stock prices would have suffered. After a 170-point Dow drop on Tuesday (oil soared more than $2 that day, to over $50), we have recouped most of those gains already without a pullback in the oil market.

From this, we see that the relationship between oil and stock prices can get pretty interesting. Many economists hate to see increasing energy prices, fearing it will cripple any moderate economic growth we do have in this country. They see higher gas prices at the pump as an indirect tax on consumers, curbing their disposable income. Since the consumer represents two-thirds of the U.S. economy, stock prices generally falter when gas prices head higher.

While I won’t argue there is some connection, I have long thought that the impact higher energy prices have is somewhat exaggerated. After all, if the average consumer fills up his or her 15 gallon tank once a week, a 25 cent increase in the per-gallon price of gas costs that person about $195 per year extra. Hardly insignificant, but not enough to cripple an economy by any means, in my opinion.

Another interesting thing is how energy prices are affecting corporate earnings. While many will make the case that high gas prices will hurt the profit of consumer-related companies, earnings estimates have actually risen since the beginning of the year, even though oil prices have gone up as well. Growth in earnings for the S&P 500 was initially expected to be in the 7 to 8 percent range in 2005. Estimates have creeped up to between 9 and 10 percent already in the first two months of the new year. This has mostly been driven by the energy sector, whose profits are through the roof, and show no signs of slowing down.

As a result of higher profit estimates and a stock market that is down 1% thus far in 2005, the forward P/E on the S&P 500 has fallen to 16.2 or so. With the 10-year bond only yielding 4.29%, investors probably feel pretty comfortable buying stocks at these prices. The risk of course, is that energy prices fall meaningfully from here. The stock market might react postively to that initially, but don’t forget that such a move will lower corporate profit estimates, leaving stocks relatively more expensive than they are now.