Upscale Brands Not Immune to Investor Wrath

Upscale consumer brands are getting downscale treatment on Wall Streets. Shares of Williams-Sonoma Inc. (WSM) fell 8.3 percent on the retailer's disappointing outlook. That was nothing compared to the beating Chico's FAS Inc. (CHS) took for its outlook with a 25-percent share price decline. Other brands that recently served time in Wall Street's doghouse include Starbucks Corp (SBUX), Panera Bread Co. (PNRA), P.F. Chang's China Bistro Inc. (PFCB) and Whole Foods Market (WFMI). This looks like a punishment for the group's high price/earnings [P/E] ratios - typical after a weaker-than-expected profits outlook. Yet in this case, valuation is probably not very relevant. The recent share price declines in the consumer sector reveal the degree to which the market's getting worried about people's shopping habits.

Table A, which also includes Coach Inc. (COH) and Nordstrom Inc. (JWN), two quality brands that have not been taken to the woodshed lately, shows how estimates, P/E ratios, and share prices have changed in the past year (more specifically, between Sept. 2 2005 and Thursday).

Notes:
EPS Estimate is for the current fiscal year, which at present, is the one ending on or about 12/30/06.
P/E is share price divided by estimate from the analysts on current year profits per share.

The numbers have come down for most of the companies. That's not surprising, considering the steady rise in interest rates and fuel prices over the period.

Table B helps us assess the trends by showing the degree to which estimates and P/E ratios have changed since Sept. 2, 2005. Sorting by the percentage change in share prices, we see that on average, stocks with lower P/Es at the start of the period outperformed those with higher P/Es. There are some exceptions, but the trend is clear.

Notes:
EPS Estimate is for the current fiscal year, which at present, is the one ending on or about 12/30/06.
P/E is share price divided by estimate from the analysts on current year profits per share.

The differences in share price changes are substantial. Still, from a practical standpoint, there isn't much distinction in how an investor would react to a 29.46 P/E versus a 34.59 ratio. Value investors would probably feel inclined to shun both; aggressive investors would likely accept either.

The column below, showing the same companies but now sorted from high to low, year-ago P/E ratios, finds a stark share-price performance gap. Steep share price declines appear more closely aligned with big downward revisions to earnings estimates.

Notes:
EPS Estimate is for the current fiscal year, which at present, is the one ending on or about 12/30/06.
P/E is share price divided by estimate from the analysts on current year profits per share.

The high-P/E group actually outperformed the low-P/E group by 12 percentage points. That's the opposite of what value theory assumes.

As to estimate revision, our first glance at Table C suggests this information may be no more useful than P/E as a predictor of future share price movement, contrary to the message we seemed to get from Table B.

On closer examination, though, we see the revision trend was skewed by one extreme observation: P.F. Chang. Subjectively, one might argue that aside from Chang, there does still seem to be some sort of relationship between estimate revision and share price movement.

Table D sorts the same stocks based on the estimate change and helps to clarify the relationship between share price movement and estimate revisions.

Notes:
EPS Estimate is for the current fiscal year, which at present, is the one ending on or about 12/30/06.
P/E is share price divided by estimate from the analysts on current year profits per share.

Table D confirms a visible, but lackluster, relationship between P/Es and price movement. It also demonstrates a much clearer connection between price trends and estimate revision.

Some investors bank on this. They seek to game the guidance, that is, invest in shares of companies they expect to beat their targets and shun shares of those they feel are likely to miss, or only meet, the numbers.

Yet it should be an eye-opener for those who've been avoiding some of these names simply because of the high valuations. If these trends persist, and if one believes companies like Starbucks or Whole Foods Market will now make their numbers, the high P/Es may not be an obstacle.

There may be something to be said for closing the 10-Ks and going to the mall to count cars in the parking lot. But we wouldn't go quite that far.

Table E presents a quantitative view of expectations, one that may give a sense of how high the hurdles really are.

Notes:
TTM = Trailing 12 months
The break-even EPS growth rate is the minimum growth per year over five years with we estimate the company would have to achieve in order to justify the current stock price.

As noted, we aren't necessarily nervous about P/Es we see for stocks like Starbucks and Whole Foods. But we are concerned with the relatively high EPS growth targets that remain mathematically implicit in those stock prices. Not having counted patrons waiting at the registers, we cannot presently dispute ability of these firms to beat expectations. But Table E establishes an analogy between those firms a baseball player trying to hit a home run in a stadium where the nearest fence is 500 feet away, instead of 350-400 feet. It can be done, but it requires a lot more effort.

Chico's is particularly interesting. Last week's beating was actually the third one it took this year — and the stock sloped steadily, albeit less dramatically, downward during the in-between periods — as the company exited the high-growth, do-no-wrong mode it seemed to be in for much of the past six years. Only time will tell whether Chico's can regain all or part of its earlier merchandising prowess. But pessimism now seems so deeply entrenched, it appears to company could impress by hitting a home run in a ballpark with a 250 foot distant fence. The company may still falter, but it wouldn't have to swing so hard to succeed.

At the time of publication, Marc H. Gerstein did not own shares of any of the aforementioned companies. He may be an owner, albeit indirectly, as an investor in a mutual fund or an Exchange Traded Fund.

Note: This is independent investment and analysis from the Reuters.com investment channel, and is not connected with Reuters News. The opinions and views expressed herein are those of the author and are not endorsed by Reuters.com.

Comments

[market timer]

Great piece Marc.

You seem to have a sound focus on the upscale retailers. Maybe you can help me understand the recent upward moves in both KSS and FD. I did some work on the retail sector yesterday and found them to be two upscale retailers surviving and actually thriving amid the recent shelling in the retail sector.

I was wondering are they just two really good houses in a bad neighborhood or is there something more to the recent rise in price, particularly concerning KSS. This stock has not been this high in almost five years.

Just wondering. Thanks.

Jason