Three Stocks to Buy on Evolving Business Models
Zain is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Last week's earnings results were fun to watch, as three of the names blew away expectations, and each redefined their upside potential. What was most intriguing was that two of the three names, O’Reilly Automotive (NASDAQ: ORLY) and Lumber Liquidators (NYSE: LL), trade at relatively high multiples, implying that the market accepts that they are no slouches. The third name, GNC (NYSE: GNC), which actually provided the biggest change in perception, saw the largest move, as expectations were subdued to negative going into results.
The question we touch on here is whether this is a precursor as we move into our heavier earnings season, or was this just the luck of the draw? Also, should we expect others to duplicate this?
What brought the surprise?
To address the above and to try to pick other names that may provide similar upside, let’s begin by looking at what caused the upside for the three names above. In each case, there was a change in the way the retailer came to market and a change in the value-add to consumers. Importantly, the market surprise was a reflection of the previous lack of understanding the potential from these changes.
For example, GNC's change in its Gold Card membership program brought in significantly more customers, and the 60-day free offering did not impact gross margins as much as expected. That points to much higher earnings beginning later this year into next year.
The GNC story, which has a powerful catalyst in Member Pricing over the next several quarters, is shaping up nicely. Some 3 million incremental consumers joined the program in Q2 (on top of 5.9 million existing members) and the business is on track to generate high single-digit comps in Q3 and Q4. This sets the stage for an acceleration in top- and bottom-line growth and positive earnings revisions.
Lumber remains an evolving story. Through store redesigns, expanding product offerings, and an advertising program to attract segments that traditionally did not consider buying their own flooring, Lumber has changed its model. That continues to lead to higher expectations of ROIC, but where that ends is still undefined.
Lumber Liquidators reported very strong results, with comps of 14.9%, and EPS rising 68% to $0.73. As important, while beating expectations by $0.12, the company raised guidance on the high end by $0.25, showing confidence in upcoming results. In addition to strong comps, gross margins rose an impressive 400 basis points as the company continues to improve execution and benefit from changes in mix and sourcing.
Under Rob Lynch, this company has redefined the way it comes to market, redesigning the stores, revamping its advertising program to attract new customers, buying its key sourcing partners and investing in systems and distribution. Moreover, the margin power in the mid-to-high teens is becoming more visible.
O'Reilly, which benefited from easy weather comparisons, also has revamped its retail offering and that is leading to much stronger results than others in its segment. It continues to be one of the favorite names in the do-it-yourself auto segment and Q2 results reminded us why. Nearly all metrics were better with stronger comps (+6.5%), gross margin and expense leverage. The result was a $0.09 earnings beat on the back of a record quarterly EBIT margin of 17.3%.
Gross margin seems to be an under-appreciated lever to the story as it rose a much better-than-expected 94 bps in Q2. That level of improvement is impressive following the multiple quarters of previous expansion. The growth in Q2 stemmed from product mix, lower acquisitions costs and price optimization, with the latter two likely persisting given a heightened focus in those areas.
Which names are changing their model?
As we look at this segment, two names stand out that are changing their model and offer the same potential upside should the changes resonate with consumers. Best Buy, one of the favorite names in this industry, is changing nearly every aspect of its business. That does not mean that it will be successful, but the Street likes the management, the overall plan, and the valuations.
The Street does not expect Best Buy to show the breakout quarter now, as it is knee deep in investments, the stores have not dramatically changed, and most importantly, consumers do not read research reports and it will take longer for them to recognize the changes than Wall Street.
The second name is Staples, which is destined to benefit from fewer competitors after recent consolidation in the industry. Those who are clueless of what I am talking about should be reminded of the recent merger of Office Max and Office Depot. It has led to a substantial reduction in competition for Staples, as the merger has led to the closure of numerable stores of both Office Max and Office Depot. Moreover, Staples’ internal changes and attractive valuations may also lead to more upside than projected.
Attractive marketing schemes and the redesigning of business models have worked well for GNC, Lumber Liquidators and O’Reilly, which makes me bullish on them. However, when viewed across the industry, Best Buy and Staples also seem to be poised to benefit from similar restructurings. However, one should not expect either of these two to show the upside this quarter; but as investors contemplate where one may see out-sized returns, in my opinion, these two will lead the pack.
The Motley Fool's chief investment officer has selected his No. 1 stock for this year. Find out which stock it is in the special free report: "The Motley Fool's Top Stock for 2013." Just click here to access the report and find out the name of this under-the-radar company.
Zain Abbas has no position in any stocks mentioned. The Motley Fool recommends Lumber Liquidators. The Motley Fool owns shares of Lumber Liquidators and O'Reilly Automotive. 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!