Brick and mortar vs. online retail - If you wanted to describe the past 10 years of stock trading you could point to the dogfight going on between "new" economy stocks and "old" economy stocks. While the old economy stocks have underperformed the technology names over the past few years, over the past 10 years the Nasdaq 100 is still almost 50% below its all time high. That said, the technology market has run pretty far pretty fast. We think the so called "terminal business model" names may actually outperform their online competition because they trade for a much lower multiple to earnings, cash flow and book value.
The short selling argument against BBY, BKS and GME is pretty simple - these businesses are in terminal decline and will be gone in three years. That's really what the shorts think. The companies are so uncompetitive against online media that they will go extinct by 2015. The shorts have plenty of evidence behind their arguments with DVD sales down some 35% since the peak, physical book sales being outpaced by E Books, and with the strong rise of online video gaming. The shorts are in the new media camp and they think that any company not adapting is going to fall by the wayside.
Best Buy (BBY) - The shorts in Best Buy wouldn't dare dream of shorting Apple (AAPL) or (ZAGG), but the fact of the matter is that sales of Apple and other technology companies' products are a major driver of profits and cash flow for BBY. In other words, to be overly bearish on Best Buy you almost have to bearish on technology stocks and the economy in general because Best Buy is trading for 25% of the market multiple given to Amazon, (IWM), (QQQ), (LNKD), and others while selling similar product.
Because Best Buy is cheap at 6.7X forward earnings, we feel the shorts will be squeezed over the long run and that BBY is a better investment than shares of AMZN because of valuation. The fact that much of Best Buy's revenue comes from www.bestbuy.com is also completely discounted by the bears. Some of the bears go as far as to argue that BBY's rising online sales are a symptom of a failed business plan. We disagree and think that Americans will still shop outside of their homes.
To the stock trading community, however, it's as though Amazon can only do right while Wal-Mart (WMT) is a dinosaur worth shorting because "it's in a failing business model" - brick and mortar retail. With all of the headwinds in the industry, it may take a while for intrinsic value to be reflected in the following names and clearly they entail a good degree of risk. That said, throwing away perfectly good stocks because they operate in industries that are currently unpopular is pretty ridiculous and from a counter-intuitive standpoint is the exact opposite of contrarian investing. A company called Hastings Entertainment (HAST) which sells everything from books to DVD's, for example, is trading below net current asset value and for just 17% of tangible book value.
In my view, one should look at Mr. Market as if he was a group of high school kids - right now they hate anything brick and mortar retail based, unless one of their friends shops there regularly. In my view, finding overvalued pump and dumps is a much wiser and approachable strategy than shorting the convenience store down the street and going all in long on Salesforce.com (CRM) - but hey, over the past two months my strategy would be underperforming the stock market. While it is true that growth is a huge component of estimating intrinsic value, we think companies that can earn a steady and stable net income deserve a 9X multiple on earnings. Ben Graham felt that 8.5X earnings was the right number for companies that don't grow but maintain steady earnings over a ten year period.
If BBY is truly trading at 6.7X next year's earnings, then shares are undervalued by around 25% assuming that BBY will earn the same earnings as next year over the next 10 years consecutively. Obviously, this "quick and dirty" or "back of the envelope" type of analysis is filled with assumptions, but the idea is to get a conservative value estimate for the company and work from there. If BBY actually grows earnings over the next 10 years (and I think it will), then shares could be even more undervalued. Over time, the gap between value and price usually closes. The hope with Best Buy is that the value increases over time while you wait for shares to reflect their true intrinsic value.
Right now, BBY investors just can't catch a break. Everyone thinks the company will be gone in five years and that their product lines will one day soon be purchased entirely online. I think the shorts here are too comfortable in this dogmatic view of Best Buy's future. Stores are not going to be returned to pasture anytime soon, and Best Buy is a cheap stock at 6.7X forward earnings and fairly valued on its 8.5X trailing earnings multiple.
The overall market trades for multiples twice as rich as BBY and investors are completely discounting Best Buy's online business which is hugely successful. Look, value investors make money buying when there is blood in the streets. It's hard to find any pockets of pessimism in the marketplace right now where valuations are this depressed. Because physical retailing of electronics and packaged media is so out of favor, we think BBY shares have become remarkably undervalued based on the forward PE of 6.7X and the fact that the rumors of the death of retail have been highly exaggerated. In other words, Best Buy is a good buy because the stock carries an extremely depressed valuation thanks to all of the negativity surrounding their business model in the financial press and on Wall Street (which is usually a good contrarian indicator).
In fact, one wonders what the shorts are thinking, as they have locked up 13.5% of BBY's float. One thing is certain, if the company can execute its strategy of high customer service and a hands on shopping experience the shorts will lose money in Best Buy. The bears will throw around all types of revenue per square foot metrics, try to convince you that the leases should be counted as liabilities and therefore BBY is already insolvent, etc. In the end the profits, book value and cash flow will determine who is right and who is wrong on the deep value retail stocks like BBY.
Barnes and Noble (BKS) - Another obvious trade is to short the bookstores. They are going bankrupt, right? Not so fast. Barnes and Noble actually did well at retail store locations during the third quarter of 2011 and revenues were actually up 5% for the company with a strong showing on the cash flow statement, as net income plus depreciation showed $53MM in owner earnings for the quarter.
Look, I'm not saying that BKS is immune to the "smart-phone" and Kindle revolution, but the shorts are simply coming on a little too strong here as 60% of the float is currently sold short. Approximately $220,000,000 of known equity is short BKS right now and the company has a market cap of just $750,000,000. That's a pretty crowded trade if you ask me, and the shorts better be right on the E reading boom. Literacy and the classic appeal of the physical book may have more longevity than the shorts and bears assume, but I could very easily be wrong.
Books are historically a higher margin retail item, and we think that BKS is not on its deathbed just yet. In other words, the death of BKS is all that the shorts rely on because as a going concern the stock is reasonable at 7X last year's free cash flow. While we aren't recommending buying the stock, we do think that there are many more overvalued names trading at large premiums to free cash flow and book value that investors should be shorting instead of BKS. Contrarian value investing is about shorting things that everyone loves and buying things that everyone hates, and not the other way around.
While BKS is starting to look reasonable on free cash flow, keep in mind that there is little to zero margin of safety for investors based on net book value. While I cannot recommend buying shares in BKS, I certainly wouldn't short this stock at this cheap of a free cash flow multiple. Yes, Barnes and Noble is a company in dire straights, but the worst case scenario is starting to be priced into the stock. Any deviation from the expected outcome of bankruptcy would in our view significantly revalue the stock at higher prices over time. Barnes and Noble has to turn the corner or it's game over. My argument is that they have better than a 50% shot of fixing their business and burning short sellers over the long run.
Gamestop (GME) - One thing is certain in today's stock market. Everyone wants to keep up with the Jones's and the herd is long technology and short companies like Gamestop. The in crowd thinks that video games have only a year or two left before all video games will be internet based and therefore there will be no need for a "video game store" ever again. Many of the shorts haven't stopped to consider whether GME management can adapt to the needed changes ahead and not only survive but also thrive in an online only gaming world. The packaged media revolution is real, but it's not as detrimental to Gamestop as most think and it's happening a lot slower than most people imagine. GME's web business grew by 50% last year and is on pace to hit $1.4 Billion by 2014. The amazing thing is that many of the same people short GME are long a Pandora (P), even though Pandora would be lucky to do half of GME's digital revenue by 2016.
In other words, investors are trying to go long "new" media and short "old media" when in reality they are shorting a dirt cheap business moving online rapidly while going long an incredibly over-valued issue which is a bad trade. GME's float is more than 40% short, which suggests to me that the short side is an extremely crowded trade.
For me, Gamestop and Best Buy make the most sense as long-term investments out of these three stocks because both businesses are adapting to changes in their industry and because both of these companies have managed to weather storms in their markets in the past.
Overall, investing GME and BBY is a bit risky, but the valuations in our view more than makes up for those risks. Investors looking to buy these stocks should consider strategies such as covered calls, buying leap puts to protect long positions, selling puts instead of buying shares, and other options strategies which can either lower risk or create income.