A couple of weeks ago I wrote a piece on retailer Shoe Carnival (NASDAQ:SCVL) wherein I said that the company's margins had me worried. SCVL has a couple of challenges but chief among them remains its ability to turn revenue dollars into profit dollars and indeed, I believe the company's lack of efficiency will hold the stock down over the longer term. But in an effort to truly explain my side, I'll take some space here to look at SCVL's margins and dive into the problem and what it means for the stock.
I'll be using some data from Morningstar and the charts are my own.
The main thrust of my argument against SCVL at this point is simply that the company's earnings estimates - as laid out in the linked article - are too high. Analysts are very excited about SCVL's ability to grow and that implicitly includes margin growth simply because SCVL's revenue growth is nowhere near enough to hit the double digit goals set forth by the analyst community. That's the flaw in the valuation right now.
In Q1, SCVL saw its merchandise margins plummet by 90bps and although that was offset by a gain in occupancy costs, the fact that the loss was on merchandise margin is alarming to me. I posited that perhaps management is trading revenue for margins in what it sees as a weak environment and if it does that, SCVL's earnings are at serious risk. But what about the company's history? This chart shows us what SCVL's gross margins have looked like for the past decade.
You can see they are all over the place for one but the second thing I noticed immediately is how low the company's margins are. Gross margins routinely have a two handle for SCVL, a fairly extraordinary level for a retailer (and not in a good way). The company's razor-thin margins have at least been somewhat stable in recent years as the chain has grown but as we saw in Q1, this number could be at risk if sales weaken and management chases the top line at the expense of product margin again.
The other major piece of operating margins is SG&A costs and as shown below, the story is pretty similar.
We can see wild fluctuations in SG&A costs but over the last few years, back office costs have risen on average. In Q1 we saw some positive leverage, which helped offset the product margin weakness we talked about, but the story for the longer term here again is that SG&A costs aren't likely to be a significant driver of EPS growth. Gross margins and SG&A alike are both flattish in recent years but analysts are building in growth in operating margins.
Speaking of operating margins, I like to take the spread of gross margins over SG&A costs to proxy for operating margins for a retailer because this is the purest read we can get on a company's profitability. It is just how much profit you made minus what it cost you to make it and I've charted the spread below for SCVL.
Unsurprisingly, SCVL's operating margins are very low. Efficient retailers can operate in the low or even mid-double digit range but SCVL is under 5% most of the time. The company's merchandise margins are terrible and that is certainly the reason why its operating margins are so poor. SCVL does have an eye for expense control which is key because without it, much of this chart may have been close to zero. Where I worry is that in recent years - which have been strong for good retailers - SCVL has struggled to even maintain its operating margins, let alone grow them. And with analysts expecting the latter for the foreseeable future, I think those estimates are at risk.
In addition to the fact that SCVL's already-low gross margins are going lower, if you look at results for the period of 2007 to 2009, you see what happened during a period of economic stress. What happens if we do indeed see a softer US economy and consumers spending slows a bit? We could easily see SCVL's operating margins cut in half and with the stock already priced for margin expansion, that could be absolutely devastating. If SCVL had deleveraged its occupancy costs in Q1 I wouldn't have thought much of it. But with product margins that are already low falling 90bps, it's too much to ignore whether you're long or not.
But I don't think SCVL is expensive only if consumer spending slows; I think it is expensive right now with the potential additional downside catalyst of lower consumer spending. Margins tell most of the story for SCVL and it is not a bullish one right now. Falling product margins in Q1 are a huge red flag to me and I think if you own SCVL, the time to get out is now.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.