2012-02-20 09:05:22
May 14 2007 | Filed Under Options , 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 metrics and tips that all investors should
use in the research process:
1. Visit the Stores
An investor can learn a lot simply by perusing the aisles of a particular
retail location. Information such as the store's layout, the availability and
appearance of the merchandise, and the prices being charged can be found
readily.
As a general rule, investors should look favorably upon stores that are well
lit, sell timely and fashionable merchandise, have neat displays, and offer
very few "sale" or 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 literally or figuratively begging shoppers 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 as a result 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. (To learn more, see The Bottom Line On Margins.)
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 mark-downs 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. Generally speaking, the higher the
sales-per-square-foot the better.
For example, Wal-Mart's sales-per-square-foot is more than $400. This is quite
good given that some of its competitors, including Kmart, for example, have
historically reported sales-per-square-foot of around $300. In other words,
using this metric, an investor could assume that Wal-Mart's management is
making better use of its floor space than its counterparts at Kmart. It may
also suggest that Wal-Mart has a better merchandise mix, and may have more
flexibility with respect to its margins, although 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. (To keep reading on this subject,
see Measuring Company Efficiency.)
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 exists 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. (To learn more about the P/E ratio, see Understanding The
P/E Ratio and Analyze Investments Quickly With Ratios.)
For 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 be 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.
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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, a leading U.S. pharmacy in the Northeast. 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, a company with a broad revenue base, such Walgreen, that maintains
thousands of stores in a number of states nationwide, (and that also maintained
stores in the New York area at the time) was much more insulated against these
regional difficulties, and did not suffer the same degree of sales decline.
Put yet another way, try not invest in companies with too much at stake in one
geographic region.
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.
For more insight, check out Choosing The Winners In The Click-And-Mortar Game.
by Glenn Curtis