These Retail Stocks Are On Sale Now!

By Brian Shaw - October 9, 2012 | Tickers: ANF, BIG, DLTR, GPS, PERY | 0 Comments

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 Everyone loves a good sale.  Whether it is a new pair of shoes or a new car, there's more satisfaction when you think you are getting a deal.  The same is true with the stock market; stocks trading at dirt cheap valuations can be quite enticing.  However, the trick is to make sure you do enough diligence to make sure you are finding a diamond in the rough rather than a company that is struggling to survive.  

The Screen

A good way to identify stocks that are "on sale" is through stock screens.  For this article, I ran a screen of stocks with a  forward P/E of less than 15, an EV/FCF ratio of less than 8 (said differently, a TTM free cash flow yield of 12.5%) and a PEG ratio (based on analysts' 5 year growth estimates) of less than 1.  This screen is certainly no magic formula for identifying the perfect stock, but it does identify companies that generated significant cash in the past year, are expected to be profitable next year, and are projected to grow at a healthy amount in relation to their current valuation. Three retail stocks appeared on this screen: Abercrombie & Fitch (NYSE: ANF), Big Lots (NYSE: BIG) and Perry Ellis International (NASDAQ: PERY).  Here are the results of the screen for each company as of October 5th:

Does This Mean Abercrombie & Fitch is a Buy?

Not necessarily.  Apparel is a tricky business for investors.  The hot store one year can be struggling the next as fashions change; management must adapt, or struggles will follow.  This is exactly the case that Abercrombie & Fitch finds themselves in today; teen fashions can move quickly, and recent declines in same store sales are a strong indicator that Abercrombie has not adapted.  Margins at Abercrombie are also weaker than the competition as illustrated in the chart below:

Declining same store sales and margins are not a recipe for success.  However, analysts are clearly expecting something big out of this Christmas season in order for the company's P/E ratio to drop from the current TTM ratio of 32 to the forward P/E ratio of 11.  That is really what the investment thesis comes down to; can an established retailer with brand name recognition like Abercrombie reverse its course and win big this holiday season?  If you believe the answer is yes, than the October 5th closing share price of $32.54 looks like a compelling entry point in comparison to analysts' EPS estimates of $2.52 for this year and $3.08 next year.  Momentum is clearly not pointing in that direction, which certainly provides a sufficient amount of downside risk to temper any excitement.  Competition from better-managed retailers like The Gap (NYSE: GPS) has only intensified and the market has clearly identified which retailers are believed to be the best long term investments; shares of The Gap are up 100% in 2012 while shares of Abercrombie are down over 33%.

Big Opportunity at Big Lots?

Given the current economic environment in the U.S., it would seem as though Big Lots and its 1,500 closeout locations would be thriving.  Like Abercrombie, Big Lots has no shortage of competition, albeit in an entirely different segment of consumer spending.  Competitors such as Dollar Tree, Inc. (NASDAQ: DLTR) and Family Dollar have been able to grow significantly faster than Big Lots in recent years, as illustrated by the table below

While Big Lots may not be growing fast, it does have significant positives such as its strong cash flow and very reasonable valuation.  While there certainly isn't the upside that Abercrombie has, Big Lots doesn't have a lot of risk to its current share price either.  The TTM P/E is less than 11, the company has been generating strong and consistent cash flows for years, and the nature of the company's business doesn't create any risk in terms of shifting fashion trends.  However, competition from larger competitors like Dollar Tree (which has almost 4,500 locations) and Family Dollar (which has 7,400 locations) and the budget-mindedness of the target consumer make growth through price increases and expanded assortment difficult.

Is Consistency the Key for Perry Ellis?

Perry Ellis’ mix of distribution between a limited number of company-branded retail locations and a much larger business with big-box retailers (i.e., departments stores, national chains, sporting good stores, etc.) is comparable to the brands offered by rival apparel companies such as Ralph Lauren, PVH, and V.F. Corporation.  What jumps out as you compare these much larger competitors to the small-cap Perry Ellis is volatility.  A good example is the FCF yield trend of these companies over the past 5 years:

Perry Ellis has darted above and below the peer group, including a number of periods with negative free cash flow.  Additionally, recent earnings releases have featured reductions to revenue, margin and guidance.  Volatile results and negative trends are never a good thing, and the market has punished Perry Ellis' stock (which is down 11% over the past 5 years) as its competitors have been rewarded with substantial stock price increases over the same period.  

Lessons Learned

Each of the three stocks above appear cheap by the numbers.  However, each has at least one good reason why the stock appears to be cheap, resulting in a significant amount of risk that an investment in one of these companies will underperform the market going forward.  On the plus side, all three are healthy, profitable, and have generated some high expectations from the analyst community.  If you think the forward looking estimates are reasonable for any of these companies, the current prices provide an attractive entry point.

There is one common theme to the stocks listed above: they are being outclassed by superior competitors in their respective industries. Whether it be the examples noted above (e.g., Gap, Family Dollar or V.F. Corp) or other competitors, there are companies out there that are executing better today than each of the three stocks that are "on sale."  There is of course a premium for buying shares of a business with superior execution (in terms of higher earnings multiples, etc.) but the guidance from The Motley Fool to "1. Buy businesses, not tickers, 2. Own great businesses and 3. Think long-term" has proven that picking best-in-class companies leads to better performance than focusing strictly on ratios and metrics that indicate that a stock is "on sale."

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