Cato's Shocking Fall Brings Old Issues Back In Focus

Jul. 5.12 | About: The Cato (CATO)

Cato Corporation (CATO), a mid-market retailer of women's clothing and accessories, fell over 10.5% on Thursday after June same-store sales fell a surprising 10% year over year.

Wall Street analysts were expecting flat comps for the month, according to FactSet (via the AP), and the miss led to strong pressure on the stock. In the previous trading session (on Tuesday), Cato had hit an all-time high of $32.32; since that trade, the stock is off over 12% in little more than a full session.

The extent of Thursday's miss should be surprising, but as I noted earlier this year, Cato has struggled with its comps for some time now:

CATO Comps by Month, 2011-2012
Month SSS Change
July 2011 (3%)
August 2011 (3%)
September 2011 (3%)
October 2011 (3%)
November 2011 (5%)
December 2011 (1%)
January 2012 (6%)
February 2012 (5%)
March 2012 flat*
April 2012 flat*
May 2012 3%
June 2012 (10%)
Click to enlarge

* Because of Easter shift from late April to early April, comp figures for March and April include both months combined; actual figures were +5% in March and -6% for April.

Going forward, Cato should benefit from easier comparisons; indeed, CEO John Cato mentioned that tailwind in the May sales release. But the problem with the continuing negative comps is that sales growth wasn't that strong to begin with. For fiscal 2012 (ending January) net revenue grew less than 1%, with comps down 1% for the year.

With same-store sales now down 3% year to date and net store additions of just seven locations YTD (from 1,288 to 1,295), top-line growth for FY 2013 looks unlikely. In conjunction with the June sales release, Cato lowered Q2 guidance to the low end of its previous range of 53 cents to 57 cents, and its full-year guidance of $2.16-$2.26 per share looks far less likely than it did after a strong Q1. Indeed, both comps (guided at flat to down 2%) and store openings (guided for a net addition of 32) are lagging Cato's 2013 guidance. This, too, should not be surprising; Cato has repeatedly overpromised on its expansion and underpromised on its earnings, a curiosity I discussed back in March.

With revenue growth seemingly unlikely for FY 2013, the question for Cato going forward is whether it can continue to post earnings growth that far exceeds its sales growth. Cato has -- to its credit -- been diligent at managing expenses and cutting costs, nearly doubling FY 2009 EPS of $1.14 in three years despite total top-line growth of just 10% over the same period.

The problem is that a company can't cut its way to earnings growth forever. Cato has done an impressive job of defying the recent recession, one that has disproportionately hit Cato's key markets in the Southeast and its typical middle-class target customer. But those headwinds have not gone away, and Cato may be running out of fat to cut.

None of this is to say that Cato is not an excellent company, or even a solid stock. At Thursday's close of $28.39, Cato still trades below 13 times the midpoint of its guidance and less than 9 times when backing out the significant cash balance (nearly $9 per share). It has raised its dividend in each of the last three years, and now yields over 3.5% based on its 25-cent quarterly payout.

But with the company continuing to struggle on the top line, earnings growth in the near term should be limited at best. In this market, slow-growth companies can't expect a multiple of much more than 10 times earnings plus cash, a valuation that puts Cato around 31.

Even after Thursday's crash, Cato is only about 9% below that level. Throw in the likelihood that Cato's guidance may be optimistic -- or cut after Q2 if the company, as expected, comes in near or below the low end of its range -- and the clear macro headwinds facing the retailer and even Thursday's new, lower price and the company lacks the margin of safety value investors seek. Cato is a well-run company, with an excellent balance sheet and a solid dividend. At a lower price level, I would love the stock -- indeed, I argued forcefully for investors to buy Cato at $22.50 back in October. But at current levels, despite Thursday's haircut, there are simply too many challenges -- and too little growth -- for investors to expect much of Cato right now.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.