Does This Retail Icon Have a Bullseye on Its Back?

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Saks’ (NYSE: SKS) share price jumped sharply in May 2013, based on speculation about possible merger and acquisition moves by strategic buyers.  The upscale retailer competes directly in the luxury category with privately-held Neiman Marcus Group, which was itself acquired in a leveraged buyout for roughly $5.1 billion in 2005.  While Neiman Marcus seems to have little interest in a tie-up, with a future initial public offering in the works, Saks could be a target of a value-priced retailer looking to add market share in the luxury space.  So, should investors take a ride down Fifth Avenue?

What’s the value?

It’s been a tough four-year stretch for Saks, with its 2012 sales barely eclipsing its sales from 2008.  The company has had minimal growth in its operating footprint lately, ending 2012 with 108 total stores versus 106 stores in the prior year.  However, the company has been a strong beneficiary of rising asset prices over the past two years, as its well-heeled customers are back to snapping up pricey products like Armani suits and Prada handbags.  In addition, improved product price mark-ups have allowed Saks to maintain a gross margin above 40%, leading to solid operating cash flow.

In its latest fiscal year, Saks reported mixed financial results, with a 4.3% increase in its top-line, but a 4.4% decline in its adjusted operating income versus the prior year.  While the company generated sales gains across each of its product segments, its overall profitability was hurt by technology costs needed to upgrade Saks’ online capabilities, including wireless networks in all of its stores.  Given the limited availability of upscale physical locations for its namesake stores, Saks is betting on its online channel to drive future sales growth and higher profits.

Following the leader

Saks seems to be trying to emulate leading department store operator Macy’s (NYSE: M), a fellow competitor in the luxury retail sector, through its Bloomingdale’s subsidiary.  Macy’s management wants to be the premier omni-channel retailer, spending the last few years creating attractive, customer-centric stores that are localized to each community and backed by online distribution capabilities.  The company’s success is also partially due to its focus on the high-margin women’s accessories segment, which accounted for 38% of total sales in 2012.

In its latest fiscal year, Macy’s reported solid financial results, with increases in revenues and adjusted operating income of 4.9% and 7.0%, respectively, compared to the prior year.  The company’s top-line growth was aided by a 41% jump in internet sales and strong store performance in the women’s accessories area, like watches and handbags.  More importantly, Macy’s operating margin reached a five-year high in 2012, due to management’s various productivity initiatives, allowing the company to repurchase shares and provide strong funding levels for its pension plans.

A possible buyer

While Saks will never have mass market appeal, due to its products’ price points, the company would lower its overall business risk by combining operations with a financially strong, value-priced retailer like Kohl’s (NYSE: KSS).  Despite a long track record of success and popular stores, Kohl’s has somewhat exhausted its growth opportunities with over 1,100 stores around the country in every state except Hawaii.  It could use its national base of operations to drive efficiencies in Saks’ overhead, a prime cause of its current low operating margin.

In its latest fiscal year, Kohl’s reported fairly weak financial results, with a 2.5% increase in total revenues, but a 12.4% decline in operating income.  While top-line growth was positively impacted by the opening of 19 new stores, Kohl’s inventory pricing mistakes led to weak 2012 holiday sales, ultimately leading to price cuts and a negative impact on its gross margin.  However, the company continues to generate solid operating cash flow, $1.9 billion for the period, which it is mostly using to repurchase stock and pay higher dividends.

The bottom line

Saks is premium priced at a current 33 P/E multiple, due to a recent 15% price spike attributable to media speculation about its future ownership.  However, a majority of Saks’ shares are held by a small number of institutional investors, making the prospect of a premium takeout of the iconic retailer a possibility at the right price.  Given the potential downside in the event of no change of ownership, investors might want to take a pass on Saks and focus on its more successful competitor, Macy’s.

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Robert Hanley owns shares of Saks. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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