Buy This Stock Before It Rockets Upward

Ted is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Teen fashion retailing is a tough business with cutthroat competition and uncertainty at every corner. Ubiquitous brands are necessary in order to compete, but provide no competitive advantage -- one season of poor merchandising can set a company back over a year as it sheds inventory.

Retailers in general tend to have volatile stock prices; investors overreact to one quarter's same-store-sales figure and push the stock higher or lower than it really should be based on extrapolating short-term data to create the long-term outlook.

The extreme myopia in retailing creates opportunity for the level-headed investor, even in a highly volatile industry. For instance, Guess (NYSE: GES) is trading at an unreasonably low multiple of earnings considering its high growth prospects.

Low multiples

Guess is not the only retailer whose stock price is trading at below-average multiples; Abercrombie & Fitch (NYSE: ANF) and American Eagle Outfitters (NYSE: AEO) also suffer from the market's momentary disdain for the industry.

<img alt="" src="http://g.fool.com/editorial/images/35202/ges-price-multiples_large.png" />

When analyzing an investment, it is important to always look at long-term figures; focusing on one-year or even three-year averages will make you as myopic as sell-side analysts.

Furthermore, it is important to figure out what the company's current operating assets can generate on average before growth. This can be extrapolated from past results by applying average operating margins and average free cash flow margins to the current level of revenue.

All three companies look even cheaper based on normal operating earnings and free cash flow, but Guess is still the cheapest.

<img alt="" src="http://g.fool.com/editorial/images/35202/ges-normal-price-multiples_large.png" />

Outlook

Not only is Guess the cheapest based on back-of-the-envelope measures, it also has the best growth prospects. While Abercrombie and American Eagle suffer from plummeting margins in the wake of the recession, Guess has reached scale in markets where it was previously underperforming. This has allowed the company to earn a stable operating margin despite the slowdown in the global economy.

Also contributing to Guess' improved operating margin is the acceleration of its licensing segment. Licensing brands is akin to selling restaurant franchises; it requires little or no additional investment on the part of Guess and provides stable annuity-like cash flow.

The stock is cheap due to Guess' heavy concentration in Europe, which is undergoing a prolonged economic slowdown. While a rebound in Europe would send the stock soaring, Guess has more promising growth opportunities in Asia that should propel growth going forward despite troubles in Europe.

Meanwhile, Abercrombie continues to struggle due to its higher price point, from which consumers have fled amid a stagnant U.S. economy. This is strong evidence that Abercrombie's brand provides no real competitive advantage. In addition, the company is currently executing a plan to close 180 locations, which is not a good sign for revenue growth going forward.

Like Abercrombie, American Eagle is also heavily exposed to the U.S. market. The U.S. has become saturated with teen fashion brands, and further competition from H&M, Forever 21, and others is causing American Eagle's margins to deteriorate. The extreme saturation of the U.S. market, in addition to the increasing competition, makes American Eagle's growth prospects less promising than that of Guess.

Bottom line

The industry isn't pretty, but it is hard to argue against a stock trading for 10x normal free cash flow before growth. As a result, Guess looks a like a bargain in an unloved industry.


Ted Cooper has no position in any stocks mentioned. The Motley Fool recommends Guess?. The Motley Fool owns shares of Guess?. 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!

blog comments powered by Disqus