Portfolio Update: Retail Roundup

I take a comprehensive look at the retail sector in the United States. In the end, two new names enter the portfolio and four existing holdings get the boot.

Out With The Old, In With The New

A highly unusual summer has drawn to a close and it is time to get back to the business of the markets. After surveying the second quarter results in the retail sector, I decided to do a bit of house cleaning. Hibbett Sports, Tilly’s, Francesca’s and Gildan Activewear were out and newcomers Kohl’s (KSS.NYSE) and Genesco (GCO.NYSE) joined Foot Locker to become the new standard bearers for my retail strategy.

For this latest portfolio update, I’m going to try something a little different: Instead of spending all my time talking about the new companies I bought, I’m going to spend more time talking about the process I used to get to that final decision.

I’ve been spending more time than usual in the retail sandbox over the last year or two, mainly in the US where the twin specters of over-capacity and crushing online competition have wrought the most destruction.

Profit margins have been sliding over the past 5 years at many retailers as shoppers move online and companies are forced to spread their high fixed costs over a smaller revenue footprint. While companies have tried to compete with Amazon by offering their own online shopping experience, they have been playing catch up against a monolithic competitor who is way out in front and has sizable advantages of scale.

Before covid hit, though, it was beginning to look like maybe the tide was starting to turn. Retailers have been shrinking their physical store count and getting rid of the least profitable real estate to focus on their most successful stores. They have been busily adding e-commerce capabilities, using their large networks of physical stores to act as fulfillment and distribution hubs. They have been embracing social media as an effective way of marketing their brands and they have been using popular services like curbside pickup and “buy online, pick up in store” to further broaden their appeal.

Profit margins were picking up at a number of the retailers I follow. While this latest viral pandemic has hit the retail sector particularly hard, pushing once-iconic brands into bankruptcy, it has also dramatically accelerated the sector’s move to a fully hybridized, “omnichannel” mix of online and offline shopping. As we recover from this pandemic, a lot of new online customers are going to be sticking around. Companies have been saying they’ve formed new customer relationships and introduced new people to their brands. As well, the bankruptcy of a number of key players is going to help reduce the prevalent over-capacity the industry was facing. There is going to be plenty of opportunity to divide up some of that market share. And mall landlords may be inclined to offer lucrative breaks on rent to fill up recently vacated storefronts.

I think it’s possible we’re nearing an inflection point here, beyond which the retail sector starts to regain some of its good health or at least stops the bleeding. There are exceptions, but for the most part companies in this sector are in good financial shape with low debt levels. Quite a few even carry around a healthy slug of excess cash. While covid put a bit of a dent in the typical balance sheet, the full effects were remarkably short lived. Q2 results were almost universally better than Q1 and in fact, due to a combination of pent-up demand and consumers whose pockets were bulging with stimulus money, a number of retailers (including Hibbett) managed to report their highest second quarter profit ever.

I’m a big believer in reversion to the mean. Bad things tend to get better and good things don’t last forever. To a certain extent, the latest set of quarterly results are somewhat irrelevant and in more than a few cases, quite misleading. In my opinion, the market seems to be unduly focused at present on the short term. Companies which have been prospering during covid (and there are a surprising number of those) have seen their stock prices soar while those that have born the full brunt of the epidemic have been shunned and ignored. But a company’s value is not dictated by a single quarter or even a string of quarters, especially when that quarter is as bizarre as the last two have been. Instead, it is dictated by how the company is expected to perform over the next 5, 10 or 15 years. Investors’ focus on the short term may be creating pockets of real value as they chase the shiny new things and ignore the underdogs.

That said, a dollar today is worth more than the promise of a dollar 5 years from now. This is particularly relevant as we may be in for a prolonged period of weakness as the aftershocks of covid work their way through the system. A company that is thriving and doing well right now and more importantly, one which is expected to hold up better under the strain of a long, drawn-out recession is going to be worth more than one that is currently struggling. But on the whole, I think that investors have overstated this effect, valuing strength (growth) too highly and pricing weakness (value) too low.

Retail Roundup

With all these things in mind, I embarked on a review of the US retail landscape. I started out with a list of around 100 US based retailers. As a Canadian investor, using my RRSP as my principal investing tool, I am barred from owning over the counter stocks, so these were all companies listed on one of the main US exchanges. Using some basic historical data downloaded from the internet, I studied each company’s past history to see how they’ve performed over the past 20 years, paying particular attention to their performance during the recession of 2008/2009 and their more recent performance during the slow burn “retail apocalypse” of the last few years. In any cases that looked interesting, I’d dive into the latest annual and quarterly reports and calculate my own earnings numbers, which in some cases can be quite far removed from the officially reported figures, if there are a lot of unusual items to back out. I made adjustments for minority interest, variable tax rates, restructuring expenses and whatnot. I formed an estimate of future growth prospects using historical performance as a guide but also paying attention to what plans management had for the future. I calculated tangible book values and debt levels to see what sort of backstop there was under the share price, if earnings didn’t materialize as expected.

In the end, I sorted each company into one of several broad categories. The bottom tier, what I’m calling “headwinds” in the table below, is where I am seeing most of the value these days. This tier is made up of companies whose short-term prospects are in question. They’re either losing money right now (very common under covid), have a history of poor performance during the last recession or have failed to demonstrate any growth over a full business cycle. This covers a lot of ground. Basically, if there is anything not to like about the company it gets thrown into this basket. I’m a pretty harsh critic. It doesn’t take much for a company to be consigned to this lower tier. About half of the retailers I looked at ended up falling into this category. Surveying the current market landscape, I’ve come up with an approximate target p:e of 10 for these sorts of companies. That’s what I would consider “fair value”. This assumes that their debt levels aren’t out of hand and it is not using the current depressed earnings but rather my best estimate of what earnings might recover to. In most cases, I simply use last year’s 2019 earnings for this figure. And again, I use my own earnings calculations, not necessarily what is reported by the company.

The next tier up, the “average growth” category, belongs to companies that are still doing okay under covid. They’ve been reasonably solid performers over the years, doubling in size over the last 10 years or so. Debt levels are good and they saw their profits drop by less than half during the last recession. I’m ascribing a “fair value” p:e of 14 to these sorts of companies.

Above that, we have companies that managed to grow consistently through the last recession. They have grown more rapidly than the typical company, tripling in size or more since the peak of the last business cycle in 2007 and are handling the current covid crisis well. They don’t quite make it into the high growth basket but their solid, steady performance and strong track record of above average growth merits them a fair value p:e ratio of 20.

Then we have the high growth tier. The market is in love with these stocks right now and the prices for some of the better growth names are through the roof. Until the market cools off, I don’t expect to find many values hiding out in this category, although I’m willing to look. I’ll give a company that is making money now and is doubling in size every 3 or 4 years a p:e of 25. If I can snap it up for significantly less than that, I’m certainly open to the opportunity.

Finally, I’ve got two other categories for the stocks that don’t make it into any of the above 4. The first is the “turnaround“. These are companies that were losing money even before covid struck. There could be some opportunities there but they’re going to be risky and don’t necessarily lend themselves to a simple p:e analysis.

A interesting subset of this turnaround category I’ve labelled the “internet phenom“. These are internet based retailers that, like many internet companies, were losing money before covid hit, but with the rush of online shoppers  during this crisis, they have seen sales soar and have actually managed to turn a profit in their latest quarter. They still all look wildly overpriced to me, but if you’re of the opinion that this pandemic is going to lead to dramatic and lasting changes to society, you might be more interested in these than in the rest of the more stodgy retailers on the list.

With this rough framework in mind, I went through my list of retailers, deciding which category they best belonged to and then comparing their current p:e ratio using my earnings estimates to the p:e ratio I would have expected given the growth category I had assigned them to. You can see the full list in the table below. Keep in mind that this is not a precise accounting. To fully investigate a company usually takes me 4 to 5 hours. I spent less than 4 to 5 minutes to make a snap judgement on many of these. However, it’s a starting point. I use this list to give me an important overview of the market and help me generate a shorter list of potentially attractive opportunities that I can then dive into in far more detail.

In the table below, the “debt level” column refers to how much debt a company is carrying relative to my annual earnings estimate. If the balance sheet looks reasonably robust, with net debt of less than 3 times earnings, the company gets a green rating. If debt is between 3 and 5 times earnings that starts to make me uncomfortable and I’ve given it an amber designation. Any companies sporting debt levels that are over 5 times their annual earnings get a red flag.

Scorecard

Here then is how I saw the market as of the close on Friday, Sep 4, 2020 (sorted by valuation category)…

Narrowing the Search

By slicing and dicing this table, I can use it to narrow in on a shorter list of promising investment candidates worthy of a more detailed investigation. I start off by considering only those companies whose debt levels are comfortably in the “green zone”.  Then I calculate the potential upside in the share price that I might enjoy if the p:e ratio were to move from its current level to the target p:e, a number determined by whatever valuation category I had slotted the company into. From this, I get the more manageable “short list” of potentially undervalued companies below…

The Cream of the Crop

As you can see, Kohl’s and Genesco found their way to the top of this short list and an-depth review did nothing to knock them off that perch. Foot Locker also scores high on this ranking and merits itself a continued place in my portfolio. After their runups off the March lows, Hibbett Sports, Tilly’s and Gildan Activewear were close enough to my fair value estimates that they got the boot.

Keen-eyed readers may note that Big Lots also finds itself near the top of this list of potentially undervalued stocks. Selling Big Lots back in the very depths of the covid meltdown was one of my bigger regrets of late. At the time, it seemed like a prudent decision and looking back, I suspect I’d make the exact same decision again, so evidently I haven’t learned anything from my mistake. But very shortly after I bailed out, Big Lots brokered a sale/leaseback arrangement of their large distribution center which significantly improved their balance sheet. At the same time, they managed to argue that they were an “essential service” and they kept their stores open during the entire lockdown period. Being one of the few stores remaining open at the time, they were absolutely flooded with customers. Their last two quarters have been phenomenal, giving them the best trailing 12 month earnings in their history and powering the stock price up nearly 300% from where I sold it. Ouch. Even now, despite this incredible performance, the stock looks like it could be undervalued depending on how much of their recent earnings success you think is durable and how much is a transitory surge. I don’t have a good handle on that yet, so I am avoiding getting back in at this stage. That, plus, it would just be too damaging to my psychological health to do so!

Other stocks a the top of this list that probably bear watching are Cato Corp, Buckle and Rocky Mountain Chocolate Factory. Cato Corp seems to be sticking aggressively to its offline model. Heading into this crisis, they only transacted 3% of their revenue online. They do, however, have a very impressive pile of cash that they’ve managed to accumulate over the years. Buckle is a shopping mall staple and is looking cheap. Unless, of course, shopping malls are headed for oblivion. And Rocky Mountain Chocolates could be a fun one to own if they can get over the bankruptcy of their largest customer, FTD Florists, late last year. I’ll be keeping an eye on all three of these. G-III is still lurking out there as well and looks even cheaper than the two new stocks I just acquired, but their debt levels are up in the “amber” zone and I am nervous about how they will deal with the bankruptcy of Nordstrom and JC Penney and the difficulties facing the whole department store sector. Their second quarter results haven’t come out yet but when they do, I’ll be looking closely at those too.

Rebirth and Renewal

I am continually striving to cycle my portfolio. On average, I end up holding the stocks I own for a little over a year. Mostly, I am trying to profit from pricing discrepancies (mispricings) in the marketplace, not from the long-term growth of the company. Having said that, the long-term growth is what gives a stock its value and I’m always mentally prepared to sit tight and hold on for as long as is needed for the market to reflect the value that I’m seeing.

Ideally, I’d like to buy a stock at a low p:e and then turn around and sell it a few months later at a higher valuation, pocketing the difference. This is what I just did with Tilly’s and Gildan. Hibbett took a little longer to play out but it paid off in the end. I’m always trying to buy low and sell high. Or, more accurately, buy low and sell medium. Buy cheap and sell fair? That has a bit more of a ring to it.

At the prices I sold them at, Hibett had a p:e of roughly 14, Gildan was at 12 and Tilly’s was at 10. All those prices make sense to me and are in the rough ballpark of what I would consider fair value. Hibbett has been the star performer of late. Their latest quarter was an absolute knock out as they benefitted from covid-induced buying of sporting paraphernalia. Gildan has a very solid track record behind it and would normally be worth more than 12 times earnings but they are facing some substantial headwinds right now as many of their core markets (sporting events, corporate gatherings, tourism) are shut down, so I knocked down my fair value target a peg or two. Tilly’s has the lowest p:e ratio of the three and is arguably still somewhat undervalued, but it has not been smooth sailing for this brand either. They painted a fairly downbeat picture of the upcoming back to school season in their latest conference call and they have had performance issues in the past. Somewhat uncharitably, I decided to put this into my bottom valuation tier and so their p:e of close to 10 meant it was time to move on.

New Kids on the Block

In contrast, the two new retailers I have added to the fold score top marks on the valuation front. Kohl’s is a well-known department store chain. They offer a lower-priced selection of goods and have a reputation for solid value with their customers. While Macy’s is technically cheaper, they carry a lot more debt and target a more upscale clientele. If we’re headed for a prolonged recession, Kohl’s should do better than most at weathering the storm and indeed that is exactly what we saw in the last recession. Their covid losses have been well contained and they have been making great strides with their various e-commerce initiatives. A recent move to start offering dedicated Amazon return counters in their stores seems like a masterful move. With a p:e using last year’s earnings of 4.3 (at my purchase price of $21.70), a p:b ratio of 0.7 and a modest debt load, this stock looks very attractive to me. Everyone says that the department store concept is dead. Could this be one of the few exceptions? Two years ago the stock was trading at a p:e of 12 and I see no reason why it can’t get back to that same level again.

Like Foot Locker, Genesco sells shoes through its over 1400 primarily mall-based stores. They mostly target the younger consumer with trendy, casual styles under their Journeys and Schuh brands although they do also have a smaller banner called Johnston & Murphy that carries men’s dress shoes. By the numbers, Genesco looks like a virtual carbon copy of Kohl’s. At the $21.50 I paid for it, this stock has a trailing p:e of 4.7 to last year’s earnings, a p:b of 0.7 and a healthy balance sheet. Both companies have grown at a roughly average rate over the last business cycle. Although Genesco stumbled a bit more during the last recession, they made up for it coming out the other side.

During the most recent second quarter, their core Journeys brand, which accounts for over 60% of sales, did very well, with strong gains in e-commerce and a healthy operating profit. Unfortunately, these results were swamped by a large loss at its much smaller Johnston & Murphy banner. Without any weddings to attend or corporate board rooms to shake up, men weren’t interested in splashing out on a fancy new pair of dress shoes. Sales and earnings at this division were abysmal in the second quarter. Normally, this division is a relatively minor contributor to overall net sales and profits but without any traffic coming into the stores, its fixed costs are dragging down the profits for the whole group. This needs to reverse before Genesco can really shine again. They are consciously moving the inventory at their J&M stores towards more casual styles and my hope is that they can slow or reverse the flood of red ink over the next few quarters.

With a very similar valuation to Kohl’s and a line of business (selling shoes) that is essentially the same as Foot Locker, you might reasonably ask why I didn’t just pass on this name and put all my money into Kohl’s and Foot Locker. Indeed, I thought about doing exactly that. However, I never like to put all my eggs into one basket. Genesco looks like a good buy in it’s own right and let’s me spread around my risk a little bit more.

Lastly, a final word concerning Francesca’s. After owning this stock for about a year, I just exited with my tail between my legs. This was always a bit of a long-shot but the potential upside made it worth the risk. I felt they occupied a fairly unique corner of the retail market and with the right management, might be able to regain at least some of their former glory. Even when covid hit and stores were shut down, their strong balance sheet going into the lockdown gave me hope that they could emerge intact on the other side. However, as the pandemic drags on, it makes it harder and harder for this company to stage an effective turnaround. They have already given notice that their second quarter results are going to be ugly. They have started using the dreaded phrase in their financial reports “substantial doubts about the company’s ability to continue as a going concern.” If I was confidant that this whole covid mess would be over and done with by the end of this quarter, I would be tempted to hang on. But I am increasingly worried that the fall-out from all of this could drag on for a long time to come. At the current price, I can exit this investment with a loss of about 50%. Considering everything that has transpired since I thought I saw the early signs of a recovery last fall, I can hardly complain.

Portfolio Weightings

Once the dust had settled on this latest flurry of transactions, here’s how my portfolio weightings shake out…

Full disclosure: I own shares in Foot Locker, Kohl’s and Genesco. I do not own shares in Hibbett Sports, Tilly’s, Gildan Activewear, Francesca’s or any of the other stocks mentioned in this article.