Retail: Sorry Free Cash Flow Lovers, Capex Is Also Important

by: Wall Street Strategies

By Brian Sozzi

The story of the retail sector in the past two years has been one of curtailing operating expenses to adjust for the up and down nature of consumer spending. Only recently, say the last six months, has the consumer returned to the equation to bolster the work done by retailers on the operating expense line. Underperforming stores have been shuttered, headquarter staff reduced and inventory maintained below 2007 peaks (fewer goods being shipped, less costs). Costco (NASDAQ:COST) has even gone as far as to lower the height on its fresh grape containers and introduce square packaging to improve truck yield. Retail has gotten creative, no doubt about it. However, underneath all the feel goodness by the market that comes when a company trounces an EPS estimate as a result of laying off 100 teenagers, there is an untold story of underinvestment by retailers.

The sharp pullback in capital expenditures across the retail sector from the 2007 peak (capex is down for companies outside of retail of course, explaining our underwhelming employment recovery) has increased the free cash flow yield of many retailers, which is why dividend increases, share buybacks, and special dividends were commonplace in 2010. If management was not going to invest for future growth, then shareholders demanded to be compensated through different means.

To obtain a handle on the situation I compiled data on 70 retailers. The data was a calculation of annual capex spending divided by annual revenue for the years 2006 to 2010. With FY10 numbers not yet out for retailers, I used year to date figures.

2006-2009 Measurement Period
* 40 companies had peak capex commitments in 2007.
* In 2007, companies allocated 5.03% of their revenue to capex.
* In 2009, companies allocated 2.40% of their revenue to capex (52% decline from peak to trough).
* The cuts primarily revolved around fewer new U.S. store openings, less capital allocation to unpromising store concepts, and more discriminatory budgets for various projects.

Big Capex Cutters Peak to Trough
* Bebe (NASDAQ:BEBE), Pacific Sunwear (NASDAQ:PSUN), Ann Taylor (NYSE:ANN), Hot Topic (NASDAQ:HOTT), Wet Seal (WTSLA), Talbots (NYSE:TLB), Chico's (NYSE:CHS), New York & Company (NYSE:NWY), Cache (NASDAQ:CACH), Children's Place (NASDAQ:PLCE), Steve Madden (NASDAQ:SHOO), Finish Line (NASDAQ:FINL), Collective Brands (NYSE:PSS), DSW (NYSE:DSW), Sears (NASDAQ:SHLD) (no surprise here; company spent much, much less on capex than competitors from 2006 to 2010), La-Z-Boy (NYSE:LZB), Kohl's (NYSE:KSS), JC Penney (NYSE:JCP), Lowe's (NYSE:LOW), Home Depot (NYSE:HD).


Although capex as a percentage of year to date revenue is tracking well short of the 2007 cycle peak, management has opened up the spending spigots once again. In 2010, budgets were focused on developing the online experience, laying infrastructure in China, opening stores in Europe, opening outlet stores in the U.S., opening up smaller prototype stores in the U.S., improving the in store experience (such as at Target, which invested in fresh food presentations), and technology that enhances warehouse functionality or store level productivity.

The returning spenders:
* Urban Outfitters (NASDAQ:URBN), Aeropostale (NYSE:ARO), Limited Brands (LTD), Guess (NYSE:GES), Gap (NYSE:GPS), Buckle (NYSE:BKE), Wet Seal, Chico's, Children's Place, Finish Line, Skechers (NYSE:SKX), Ulta Cosmetics (NASDAQ:ULTA), Target (NYSE:TGT), Furniture Brands (FBN), Tiffany & Co (NYSE:TIF)., Kohl's, TJ Maxx (NYSE:TJX).


I know the masses are waiting for retailers to announce dividend hikes and share buybacks on 4Q earnings release day. Flush with cash and rich stock prices, all signs point to retailers going one, if not both, of those shareholder friendly routes. However, I am placing added importance on capex budgets for 2011 to compile a list of the probable winners during the next business cycle. For if a company does not invest in its business for the long-term, the existing asset base will become obsolete.

Assume company A and company B have similar business models. If company A invests 5% of its revenue on capex in 2011 and company B 3%, I would say company A has greater confidence in its business model and is putting down the roots to take share from company B. Increasing capex doesn't have to be aggressively opening up new stores, it could mean investing in a new inventory management tool that allows for faster speed to market of merchandise that in turn, creates share gain from a competitor myopically attuned to the near-term. As we move beyond the Great Recession, it will be those companies that invest for the future that are likely to be the winners financially.

Disclosure: None