Cato: Avoid

| About: The Cato (CATO)

Summary

Cato recently downgraded its earnings guidance for its fiscal third quarter following weak comparable sales in August and September.

While Cato doesn’t disclose the underlying driver for its poor sales, we can surmise from other apparel stocks that, they’re also not as enthused with Cato’s product offerings.

If so, this will necessitate what could be a lengthy adjustment for Cato and we don’t foresee much near-term traction for its Cato’s stock price.

Cato Cuts Profit Outlook after string of poor comparable sales reports

Cato Corporation (NYSE:CATO) recently downgraded its earnings per share guidance for its fiscal third quarter after its comparable store sales declined by 8% and 9% in August and September, respectively.

Cato, which sells trendy casual and work apparel primarily in the Southeastern United States under its eponymous Cato brand - as well as other labels such as 'Versona,' 'It's Fashion' and 'It's Fashion Metro' - has said that it now expects its third quarter (which ends at the start of November) earnings per share to fall between 63% and 77% from $0.30 a year ago to between $0.07 to $0.11 per share this year.

Cato's shares have tumbled by 8.2% since the announcement, bringing its year-to-date loss to 17.8%. Consequently, Cato's annualized dividend yield, which stood at 3.26% at the end of 2015 is now at 4.36% - and is nearly triple that of the Russell 2000 small cap index. Cato also has among the higher yields of its peer group in the apparel store sector.

This, investors who buy $10,000 worth of Cato shares can expect to receive cumulative dividends worth $436 in a year's time just by holding Cato's stock - but given its obvious pitfalls, should they? Let's take a look.

An Ugly Outlook

Prior to its recent outlook revision, Cato had been expecting Fiscal 2016 earnings of between $2.32 to $2.41 per share - at the top end of this range, its 2016 earnings per share would have been a slight improvement over the $2.39 it earned in fiscal 2015.

Investors should take note that Cato did not adjust its full-year guidance - it only reduced its third quarter guidance, suggesting that the company is holding out for a strong holiday season to boost its fourth quarter numbers and thus offsetting its third quarter decline.

Having said that, if we simply take the downward revision in Cato's third quarter and assume that its 4th quarter comes in as currently expected, its full-year earnings could come in between $2.26 to $2.34 per share. At the top end of this adjusted forecast, Cato would realize a 2% decline in its fiscal 2016 earnings per share compared to fiscal 2015.

Negative year-on-year earnings aren't, strictly speaking, a disaster - the S&P500 itself is now in the midst of what could be a six straight quarters of negative earnings performance. Moreover, it's not like Cato is alone - bigger retailers such as Gap (NYSE:GPS) and Buckle (NYSE:BKE) have likewise reported weaker comparable sales in their fiscal third quarters (which cover around the same periods as Cato's).

These results are reflective of basically flat consumer spending on clothes compared to a year earlier. However, Cato doesn't provide much commentary on its results except to say that comparable store sales were the cause of its lower Net Sales and that its results were "well below" management's expectations.

Considering the hefty decline in its comparable sales, we can assume that - similar to Buckle - consumers aren't necessarily enamored with Cato's product designs and that it has engaged in discounting to move merchandise. If so, there's a simple-sounding solution to Cato's problem - introducing new designs and 'fresher' merchandise - but even if these new designs hit consumers' sweet spot, it will take time to implement and so Cato is likely to see further sales attrition as it tries to move old inventory. In that sense, we estimate that Cato will see continued comparable sales attrition over the next 12 months.

Another thing that investors should be wary of is outside Cato's control - given Cato's geographic concentration in the Southeastern United States, it's likely that its October sales took a hit from Hurricane Matthew, further impacting its performance for the period.

A Balance Sheet to Weather the Storm

Fortunately for investors, Cato has a strong balance sheet that will enable it to weather lengthy adjustments and occasional business disruptions. To wit, its cash and equivalents alone are enough to cover its short-term liabilities by 1.95 times, which is close to five times the average for its peers. Meanwhile, its overall working capital position superior to the industry average: $3.11 of working capital for every S1.00 of short term liabilities.

Cato also has no short- or long-term financial debt so, unlike its peers that usually leverage most of their equity, Cato's free cash flow can be paid out to investors in the form of dividends (or even share buybacks). In short, Cato's capital base is more than enough to ensure a steady stream of dividend payments; its current level short-term investments alone are sufficient to cover 7 years' worth of dividend payments - and certainly enough to warrant further increases of 5% to 10%.

Hard to justify over $30 per share

Cato is currently trading at 11.7-times its trailing earnings and even if we assume that it only achieves $2.34 in earnings this year, it would only be trading at 12.9 times earnings. Both these readings are well below the 20-plus times multiple of the broad market indices. We anticipate that owing to what will likely be a down year this year, Cato's management will focus on reducing its leverage to drive better results for fiscal 2017. Such efforts will only serve to offset declining sales and we anticipate flat earnings for 2015.

In such a scenario, Cato would still be priced at less than 13-times earnings but given its likely 'zero earnings growth' scenario, we believe that this multiple is justified. Consequently, we view Cato as fairly valued at $30 per share.

Conclusion

Although we like Cato's strong balance sheet that, in turn, enables it to pay a regular and relatively generous dividend, we're a bit concerned regarding its immediate future. The intensity of its declining comparable sales, while no doubt driven to some extent by the weak retail environment suggests deeper issues than macro trends - mostly likely, Cato will have to significantly change its product offerings, which can be a daunting proposition, as we've witnessed with Abercrombie and Fitch (NYSE:ANF).

Given this, there aren't isn't much to look forward to for Cato - at best, we're looking at a 2% decline in its full-year earnings per share and a 6% decline in its comparable sales. Why allocate funds to a stock with such prospects? Investors would be wise to avoid the stock for now - solid balance sheet and dividend notwithstanding.

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.

Additional disclosure: Black Coral Research, Inc. is a team of writers who provide unique perspective to help inform dividend investors. This article was written by Jonathan Lara, one of our Senior Analysts. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article. Company financial data is taken from the company’s latest SEC filings unless attributed elsewhere. Black Coral Research, Inc. is not a registered investment advisor or broker/dealer. Readers are advised that the material contained herein should be used solely for informational purposes. Investing involves risk, including the loss of principal. Readers are solely responsible for their own investment decisions.