They May Be Cheap, But Don’t Buy Retail Stocks Now - Here’s Why

October 30, 2017

They May Be Cheap, But Don’t Buy Retail Stocks Now – Here’s Why

  • Don’t look at past figures and expect them to suddenly reappear. Retail is a tough business with tight margins.
  • Retailers have experienced a margin decline recently. But there’s still plenty of room for them to fall further and the situation may get really ugly.
  • Some will win, but who can identify the winners now?



Introduction

Retail stocks keep getting cheaper and cheaper, and many investors look at current valuations and think they are too cheap to be true. In today’s article, we’ll dig into the sector, see if there is value, or if the “too cheap to be true” retailers are all just Potemkin’s villages.

Before digging into specifics, I want to share a retail example from my neighborhood.

About a year ago, a retailer selling fancy soaps opened a store in a village near where I live. It rented out a 700-square foot premise on the main shopping road and opened for business. The issue is that the village where it opened has less than 10,000 inhabitants and the rent was around 48,000 EUR per year, or 4,000 per month.

Figure 1: The fancy soap store in a small village. Source: Funda.

This means that, just to cover the rent, the store would need to sell 2,000 bars of soap per month, or about 100 per day assuming a gross margin of 50%. Add the costs of two employees, transport, insurance, and who knows what else, and you quickly go to 200 or even 300 soaps per day just to break even. All of this in a village with a population of 10,000. Needless to say, the shop closed pretty quickly and the image above is from the re-listing of the shop for rent.

The point of my story is that you can never apply past growth to the future with retailers because the profitable markets are quickly saturated and expanding into new areas does lead to higher growth, but also to lower overall margins.

A good example is Bed Bath and Beyond (NYSE: BBBY). In their last earnings report, BBBY reported a comparable sales decline of 2.6% (comparable sales take into account stores that have been operating for more than a year), while revenues declined only 1.6%. The 1% difference comes from new stores which increased growth. Needless to say, gross margins also fell 1%.

As the environment is highly competitive and you as a consumer aren’t going to buy two lamps, 20 soaps, or eat more than you used to just because there is more supply, it’s highly probable that these margins will keep declining on aggregate. Additionally, online demand will continue to take more and more off brick and mortar revenues.

Don’t get your hopes up on online retail as the margins there are even worse. Just think about how you or your kids shop online and how much time it takes to find the cheapest seller of the item you seek.

Another interesting note is that BBBY has spent more than $6 billion on share repurchases in the last 5 years. The fact that the current market capitalization is $3 billion tells you a lot about how shareholder value is being destroyed by doing reckless buybacks at whatever stock price.

Figure 2: BBBY’s stock price over 5 years. Source: CNN Money.



Now, getting to the question of if there is value in the retail sector. If we take a look at BBBY’s financials, we can see that growth has been slow in the last few years and that the huge earnings growth was just from financial engineering through buybacks. The company bought back almost half of the outstanding shares but the book value didn’t grow at all as the purchases were all above book value, and thus the buybacks destroyed long term shareholder value. As soon as margins started contracting, there was nothing to save the stock from plunging.

Figure 3: BBBY’s financials. Source: Morningstar.

Nevertheless, the company is still profitable and the free cash flow is around $4 per share which isn’t bad considering that the stock price is at $21. However, if we apply the same rate of decline we have seen in the past two years into the future, the available cash flows per share wouldn’t justify the current price as, sooner or later, the cash flows would turn negative.

What’s also very important with retail is that margins are tight. BBBY’s net profit margin is currently 4.6% which means that another two drops in comparable sales like the previous quarter would completely erase earnings and free cash flows.

The $1.5 billion in long term debt certainly doesn’t help BBBY’s situation. I just hope the management hasn’t been given big bonuses in the last few years as they were also using debt to indulge in the $6 billion spending spree that definitely left many pension funds and long-term investors as suckers.

Now, I know that the valuations are tempting, but it could take a long time before we know who the winners among the many cheap retail stocks will be. In the table below, I’ve shown what happens to earnings as margins are squeezed. The best example is Finish Line which quickly went from a P/E ratio of around 15 in 2015 to nothing and with a 60% decline in its stock price.

Figure 4: Example of 4 cheap retail stocks and their margin evolutions. Source: Morningstar.



Just a note on Sally Beauty (NYSE: SBH). It may look attractive and it perhaps is, but the book value is negative and at the first sign of declining margins, similarly to the situation with the soap store I described above, the stock will plunge.

Conclusion

There will definitely be great winners coming from the retail sector in the next 5 years, but if it’s one out of 5, the return of investing in a bunch of them won’t be positive.

Don’t forget that in a few years, you will hear only the stories of those who boast about how they picked the right retailers due to survivorship bias. You won’t hear anyone bloat about how they lost money in the retail sector. Thus, even though I’m a value investor, I’ll avoid investing in retail for now. I’ll wait for a bit as there is a chance that retail stocks could get much cheaper as the competition is strong, all of them want to grow, but demand is stable.

There will definitely be a dead cat bounce soon, so if you are a trader, you can take advantage of that.

By Sven Carlin Investiv Daily Retail Value Traps Share: