Analyzing Retail Stocks

In spite of the fact that their products are relatively easy to understand and relate to, retail companies can be difficult for the average investor to analyze. But the good news is that if an investor knows what metrics to look for, the stock selection process will be much easier.

To that end, below is a list of nine tips that all investors should use when determining whether a retail stock is worth the investment:

1. Visit the Stores
An investor can learn a lot simply by perusing the aisles of a particular retail location. Information that can be found readily include the store's layout, the availability and appearance of the merchandise, and the prices being charged.

As a rule, investors should look favorably upon stores that are well-lit, sell timely and fashionable merchandise, have neat displays and offer very few discount items.

The savvy investor will also take note of the foot traffic in store. Is it crowded? Are there lines at the registers? Are shoppers buying big-ticket items in bulk, or merely lurking around the discount racks hunting for bargains? In fact, these are all questions that the investor should ponder that will help him or her determine the overall health of the company.

2. Analyze Promotional Activities
Is the company promoting its merchandise to drive foot traffic or earnings? Does it try to get every last dollar it can out of the consumer out of desperation or weakness (because it can't sell it wares)? This is an important point to clarify because companies that are willing to sell their merchandise at deep discounts just to unload it before the end of a selling season often do so at the expense of margins and earnings.

Visiting the store, and examining the weekly circulars, can give the investor an idea of whether the company is begging shoppers, literally or figuratively, to come into the store, which can be a sign that the company is headed toward an earnings shortfall.

3. Examine Gross Margin Trends
Investors should look for both sequential and year-over-year growth in gross margins. However, investors should also keep seasonality effects in mind. Most retailers see a surge in revenues in the fourth quarter compared to the third quarter, because of the holiday season. In any case, gross margin trends will give the investor a better idea of how good current and/or future period earnings will be.

Investors should be extremely wary of companies that are experiencing a decline in gross margins (either sequentially or year-over-year). This is because those companies are probably experiencing a decline in revenue or foot traffic, an increase in product costs and/or heavy markdowns of their merchandise, all of which can be detrimental to earnings growth.

4. Hone in on Sales-Per-Square-Foot Data
This metric (that some companies reveal in conference calls, and others reveal in their 10-K or 10-Q) is a reliable indicator of how good management is at using store space and allocating resources, the higher the sales-per-square-foot the better.

For example, Coach's sales-per-square-foot was more than $1,800 in 2012. This is quite good, given that some of its competitors, like Michael Kors, for example, reported sales-per-square-foot of around $1,400. In other words, using this metric, an investor could assume that Coach's management is making better use of its floor space than its counterparts at Kmart. It may also suggest that Walmart has a better merchandise mix, and may have more flexibility with respect to its margins, though other factors would have to be examined to determine whether this is the case.

5. Examine Inventory/Receivable Trends
Investors should examine sequential and year-over-year trends in both inventories and accounts receivable. If all is well, these two accounts should be growing at about the same pace as revenues. However, if inventories are growing at a faster rate than revenues, it may indicate that the company is unable to sell certain merchandise. Unfortunately, when this happens, companies are usually left with just two options - they can either sell the merchandise at a really low price point and sacrifice margins, or they can write off the merchandise altogether. (Which also could have a significant adverse impact on earnings.)

If receivables are growing at a faster rate than revenues, it may indicate that the company is not getting paid on a timely basis. This may lead to a deceleration in sales in some future period. In short, changes in the inventory and receivable accounts should garner a great deal of attention, because they can often signal future fluctuations in revenue and earnings.

6. Examine Same-Store-Sales Data Closely
This is the most important metric in retail sales analysis. Same-store-sales data reveals how a store, or a number of stores, fares on a period-to-period basis. Ideally, an investor would like to see both sequential and year-over-year same-store-sales growth. Such an increase would indicate that the company's concept is working and its merchandise is fresh.

Conversely, if same-store-sales numbers are decelerating, it may signify that a host of problems exist, such as increased competition, a poor merchandise mix or a number of other factors that could be limiting foot traffic.

7. Calculate and Compare P/E Ratios Vs. Expected Earnings Growth Rates
When analysts review retail companies to determine whether they are "cheap," they typically calculate the current price-to-earnings ratio (P/E) of a particular company, and then compare it to the expected rate of earnings growth for that same company. Companies that trade at an earnings multiple that is less than the expected growth rate are considered to be "cheap," and may be worth a further look.

Let's look at an old example: in December 2006, Target traded at 18.31 times its fiscal 2007 earnings estimates. This was at a premium to its expected 13% earnings growth rate in the coming year (from $3.18 to $3.59 per share). Using this method of evaluation, analysts would probably not think that Target's stock is very cheap. However, at the same time, Sears Holdings traded at about 20.4 times its fiscal 2007 earnings estimates. That is at a slight discount to its anticipated 23% earnings growth over the next year (from $8.45 to $10.37 per share). Using this data point alone, Sears would have been considered the "cheaper" stock.

With that in mind, investors should be cautioned that this is just one metric. It should go without saying that same-store-sales numbers, inventory trends and margins (in addition to a number of other factors) should also be considered when selecting a retail stock for investment.

8. Tabulate Tangible Book Value
A company's tangible book value per share will reveal what its assets are really worth, and what the investor is really getting for his or her money.

To determine this number, investors should take the total "stockholder equity" number from the company's balance sheet and then subtract any intangibles such as goodwill, licenses, brand recognition, or other assets that can't be readily defined or valued. The resulting number should then be divided by the total number of outstanding shares. Companies that are trading at or near tangible book value per share are considered to be a good value.

For example:

Let's say that a company has $20 million in shareholder's equity, and goodwill and brand recognition worth $2 million each. With two million shares outstanding, the tangible book value per share would be as follows:

With all of that in mind, sometimes companies that trade at a very low multiple of tangible book value are trading that low for a reason. There might be something wrong! In any case, its worth investigating, because it will give investors a sense of what the business is truly worth (on an asset basis).

9. Examine the Geographic Footprint
If an investor is comparing two companies that are otherwise identical, the investor should select the one (for investment) with the most diversified revenue base and store locations. Why?

Consider the case of Duane Reade, which in 2010 became a subsidiary of the Walgreen Company. In 2001, Duane Reade had a huge presence in New York City. Its business, along with the local economy, was booming. Then the September 11 terrorist attacks occurred. As a result of its narrow geographic footprint, its company-wide sales took a big hit, as a number of its locations were either closed or made inaccessible by construction.

However, back then, its former rival Walgreens maintained thousands of stores in a number of states nationwide (and that also maintained stores in the New York area at the time), and was much more insulated against these regional difficulties and did not suffer the same degree of sales decline.

Put yet another way, try not to invest in companies with too much at stake in one geographic region.

The Bottom Line
To analyze retail stocks, investors need to be aware of the most common metrics used, as well as the company-specific and macroeconomic factors that can have an impact on the underlying stock prices.

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