It was the best of times, it was the worst of times - at least that's how the market sees it. Retailers experiencing rapid growth and upward sloping share price charts have become the apple of Wall Street's eye. Wall Street is an extrapolation machine and shares of such retailers have been driven to dizzying heights using generous (to say the least) assumptions. By contrast, some retailers, even though they have produced strong financial results, have been left for dead, selling at below market multiples. Being a contrarian, I'm going to recommend a portfolio long in laggards while shorting momentum favorites. For longs, my criteria is as follows: P/E ratio below 15x, a market leading position, and compound annual growth in operating profit or EPS of 5% over the past five years. For shorts, I'm looking for a P/E ratio greater than 20x, a dividend yield below 1%, and a year to date share price increase greater than 40%. Here's a look at what I came up with:
Sprouts Farmer's Market
CDW is something I normally would not recommend. I typically avoid companies which were recently brought public by private equity firms. However, I believe that CDW is simply too compelling (at least on a relative basis) to be ignored. The company occupies a dominant position in the computer hardware/software re-selling industry. This is a surprisingly good business. Capital employed is minimal (the goodwill on the company's balance sheet is actually fictitious - it was created when the private equity firms purchased the company off the exchange in 2007) - in fact returns on operating capital are nearly infinite because the company holds little inventory and typically gets paid before it pays suppliers. The company has minimal operating leverage - instead of stores, it has salespeople (on commission) in offices selling products over the phone (and also does a good deal of its sales directly on its website). As such, it can cut expenses quickly and still earn a healthy profit in a downturn (as we saw in 08-09). CDW is in a strong negotiating position with most of its suppliers - most of the hardware it sells is commoditized - thus if CDW doesn't like the terms being offered by HP it can buy from Dell or Lenovo. While I typically avoid companies with high debt loads, the business is extremely cash generative and there are no major debt maturities until 2016 and beyond.
Wal-Mart (WMT) is simply a terrific retailer at a modest multiple of earnings. Shares were knocked down after it reported disappointing earnings in the second quarter. I'm not overly concerned with quarterly earnings - Wal-Mart is a best in class retailers selling at a slightly below market multiple. It has a solid balance sheet (ND just greater than 1x EBITDA) and has been returning over $10 billion per year to shareholders via dividends and repurchases.
Kohl's (KSS) has been in the penalty box the past couple years. It used to trade at a premium valuation given as the company had grown rapidly in the decade leading up until 2007. As growth slowed, it lost its investor base. That said, the company continues to produce a strong return on equity (15% in the most recent fiscal year), has a good balance sheet (Net debt < 1.8x EBITDA), and is returning capital to shareholders via dividends and buybacks. While this won't be a homerun, at 13x earnings I think investors can expect an 8-10% annual total return holding Kohl's shares over the next 2-3 years.
Conn's (CONN) looks to be a good short for a number of reasons. First, we have seen the main owner group sell a tremendous amount of stock over the past year (at $25/share in December of 2012 and $60/share more recently). Second, and more importantly, is that Conn's is a predatory lender wrapped into a retailer. The company uses fast talking salespeople to coerce its customers (typically low income people) into not only paying high interest rates to finance their purchases but also into buying expensive product warranties of questionable quality as well as various overpriced insurance policies (if you get hurt and can't work or laid off). The company has been investigated regarding these sales policies in the past and I suspect we will see more investigations in the future given its extremely low customer satisfaction ratings. Pawn shops, payday lenders, and other sub-prime lending businesses usually trade at 7-10x earnings. This is not only because of the aforementioned regulatory risk but also because in recessions, these businesses can suffer large losses (Conn's business performed terribly from 2008-2011, losing money in some years). Under the guise of being a fast growing retailer, Conn's is selling at 23x P/E which I think is about twice what it's worth.
Restoration Hardware (RH) came public last fall and has nearly tripled from its IPO price. Like Conn's we have seen persistent and meaningful insider selling (over $1 billion worth this year at $50/share and again at ~$70). The company has recently announced that it will reduce the number of catalog mailings which could cause it to lose contact with its customer base (a large percentage of the business is direct selling). Also, like Conn's this is a very cyclical company. While it is profitable now, if housing or the economy turns south, we could see the business losing money again (as it did in the last downturn). At nearly 40x earnings, shares look to have considerable downside but minimal upside.
Sprout's Farmers Market (SFM) is positioned as a healthy grocery concept with a strong presence in the Southwest. It has soared +157% since its IPO in August and sells at 67x P/E. While the stores are popular with customers, in order to justify its high multiple, it must 1) maintain/expand its operating margins from an already high level of 6-7% and (2) successfully expand across the country. The healthy grocery market is getting much more competitive - with a flood of new entrants including Wild Oat's, Amazon Fresh, The Fresh Market and Wal-Mart's Neighborhood market (not to mention local players or Whole Foods growing its store base) which could cause some existing customers to go elsewhere and force Sprout's to lower prices. While the company has done well in the southwest, expanding retail outside of this core area could be more challenging - both from a logistical (Sprout's is heavily dependent on sourcing very cheap produce) and marketing perspective. At 67x P/E there is no margin for error and shares could quickly decline more than 50% (and it would still be up 33% from IPO price!) if investor expectations aren't met.
While it is psychologically difficult to sell (short) that which has increased rapidly in price while buying something which is languished, I believe that this strategy will produce above market returns over a three year time horizon.
Additional disclosure: I am long WMT.