When I wrote in late January that I thought Stage Stores (NYSE:SSI) was an undervalued retailer about which the Street was too bearish, I didn't expect such a quick change in sentiment. The core retailing environment has not gotten all that much better in the intervening time, but the Street was very glad to hear that the company is moving on from the Steele's off-price format. Stage Stores management hasn't revealed the terms of the deal, but I believe the combination of weaker near-term results and less capital needed to support the growth of Steele's do improve the fair value a bit since late January.
A Tough Quarter
The best thing about Stage Stores' fourth quarter is that it's over. Revenue fell 5% as reported, with comps down 3.4% (the reported number includes an extra week in the year-ago period). Stage Stores also reported a "shifted" comp number of negative 1.1% for those who follow that approach. The company's traffic and transaction trends have held up better than pricing as an insanely aggressive promotional environment in retail is thumping prices across the industry.
Margins were also weak. Gross margin declined four points from last year, as those promotions hit the company's profitability. The company recaptured some of that through leaner expense management, but operating income fell 29% and operating margin fell almost three points.
Baby, It's Cold Outside
Weather hurt results in the fiscal fourth quarter of 2013 (ended Feb. 1) and it's only gotten worse. While Stage Stores has stores in most states, the store base is particularly concentrated in the South and Southeast where the weather was nasty in February. I know Northerners roll their eyes at stories of how things shut down in the South when a snowflake is sighted, but speaking as a transplanted Yankee I can say that it really does have an impact in terms of stores closing and people staying at home.
Management did acknowledge that weather was hurting comps in the first quarter, and full-year guidance for comp growth was in the range of 0% to 2%. That isn't too far off sell-side expectations, though I'd note that a lot of estimates appeared to be clustered both above and below that range. Management was also more optimistic about gross margins, and the company will continue to roll out Estee Lauder (NYSE:EL) counters in its stores, a move that typically increases overall store sales.
Stage Stores also appears to be holding its own against J.C. Penney (NYSE:JCP), despite that company's efforts to restore traffic and comp growth. In those locations where J.C. Penney and Stage Stores overlap, the Stage Store locations actually outperformed those stores not overlapping with J.C. Penney.
Stage Stores started its Steele's off-price format store concept about two-and-a-half years ago, but disappointing traffic had led the company to slow down its store expansion. Now the company has decided to punt altogether, announcing that it is selling the concept to Hilco Global Retail Group. Management didn't discuss any terms for the deal (apparently the deal was signed literally the night before the earnings announcement), but they did say it will be cash flow-positive and accretive.
Steele's was sub-scale, so I would not be surprised if the margins were poor and dilutive to the whole. While the basic business plan may have long-term merit, this is a challenging environment in which to launch a new concept, and shedding Steele should improve margins in the near-term and reduce long-term capital spending needs.
A Good Plan With Long-Term Potential
The basic Stage Stores plan has merit. Two-thirds of the company's store base is in small towns (less than 50,000 population) where the primary shopping alternative is often Wal-Mart (NYSE:WMT). With that, Stage Stores can stand out by offering premium brands like Nike, DKNY, CK, and Michael Kors that may not otherwise be available locally, as Stage Store customers often have to drive 30 miles or more to get to the nearest shopping mall.
My long-term revenue growth forecast is still 4%, composed of ongoing same-store sales growth (2% to 3%) coupled with ongoing store additions. I do have some concerns that the retailing market has changed on a structural level, bringing long-term gross margins into question for all of the players, but I think margins will improve from this level and lower capital spending needs down the line (relative to the existing store/revenue base) will allow for mid-single digit FCF margins.
The Bottom Line
Discounted back, those free cash flow streams are worth about $27 today even with an elevated discount rate to account for the risk of the retail environment and competing with the likes of J.C. Penney and Wal-Mart. I would also observe that current price/sales, price/book, and EV/EBITDA ratios are on the low end of industry historical norms.
Thursday's big reaction in the stock takes out a sizable chunk of the undervaluation I saw in the shares, but not all of it. I still believe these shares are undervalued and worth consideration for value-oriented investors.
Disclosure: I 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.