Time To Take Profits In Zumiez

| About: Zumiez Inc. (ZUMZ)
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Summary

Zumiez has nearly doubled since its 2014 lows.

Shares are trading for an unsustainable valuation at present.

Investors should take profits and wait for an entry point in the $20s.

Shares of action sports retailer Zumiez (NASDAQ:ZUMZ) have certainly been on a volatile ride in the past few years. The company, which serves the surfing, motocross, skateboarding and surfboarding crowds, has seen its shares boom and bust repeatedly. After hitting $40 in 2012 shares were more than cut in half, only to rise again recently to $39 with plenty of bumps in between. I have been bullish on Zumiez since 2013 where I concluded that the company was worth adding on a pullback from $28. We got our pullback in a big way at the beginning of 2014 when shares once again tanked to $21, offering a terrific entry point. But after nearly doubling once again, are shares expensive? In this article I'll take a fresh look at ZUMZ to see if there could be more in this rally or if investors would be wise to take profits.

To do this I'll use a DCF-type model you can read more about here. The model uses inputs including earnings estimates, which I've borrowed from Yahoo!, dividends, which are zero forever and a discount rate, which I've set as the 10 year Treasury rate plus a risk premium of 6.75%.

 

2014

2015

2016

2017

2018

2019

2020

Earnings Forecast

             

Prior Year earnings per share

 

$1.46

$1.66

$1.87

$2.09

$2.34

$2.61

x(1+Forecasted earnings growth)

 

13.70%

12.70%

11.80%

11.80%

11.80%

11.80%

=Forecasted earnings per share

 

$1.66

$1.87

$2.09

$2.34

$2.61

$2.92

               

Equity Book Value Forecasts

             

Equity book value at beginning of year

 

$11.08

$12.74

$14.61

$16.70

$19.04

$21.66

Earnings per share

 

$1.66

$1.87

$2.09

$2.34

$2.61

$2.92

-Dividends per share

 

$0.00

$0.00

$0.00

$0.00

$0.00

$0.00

=Equity book value at EOY

$11.08

$12.74

$14.61

$16.70

$19.04

$21.66

$24.58

               

Abnormal earnings

             

Equity book value at begin of year

 

$11.08

$12.74

$14.61

$16.70

$19.04

$21.66

x Equity cost of capital

9.00%

9.00%

9.00%

9.00%

9.00%

9.00%

9.00%

=Normal earnings

 

$1.00

$1.15

$1.31

$1.50

$1.71

$1.95

               

Forecasted EPS

 

$1.66

$1.87

$2.09

$2.34

$2.61

$2.92

-Normal earnings

 

$1.00

$1.15

$1.31

$1.50

$1.71

$1.95

=Abnormal earnings

 

$0.66

$0.72

$0.78

$0.84

$0.90

$0.97

               

Valuation

             

Future abnormal earnings

 

$0.66

$0.72

$0.78

$0.84

$0.90

$0.97

x discount factor(0.09)

 

0.917

0.842

0.772

0.708

0.650

0.596

=Abnormal earnings disc to present

 

$0.61

$0.61

$0.60

$0.59

$0.59

$0.58

               

Abnormal earnings in year +6

           

$0.97

Assumed long-term growth rate

           

3.00%

Value of terminal year

           

$16.23

               

Estimated share price

             

Sum of discounted AE over horizon

 

$2.99

         

+PV of terminal year AE

 

$9.68

         

=PV of all AE

 

$12.67

         

+Current equity book value

 

$11.08

         

=Estimated current share price

 

$23.75

         

As you can see the model is pretty pessimistic, posting a fair value estimate of about $24. That stands in stark contrast to the $39 shares are currently trading for and I think it's pointing us to a red flag in terms of the valuation. The model's intention is to provide a price at which investors can achieve some margin of safety but even with what I would characterize as a modest discount rate for a small retailer, ZUMZ is very expensive.

ZUMZ is a great retailer. I said as much in June of 2013 when I first profiled the company as it has exploited a niche in the retailing landscape to great effect. It has loyal customers that keep comp sales booming quarter after quarter and that trend is looking to continue into 2015. Analyst estimates for earnings growth are very reasonable at about 12% a year as ZUMZ continues to open new stores, make acquisitions and continues its streak of strong margins. In short, if you don't look at the stock price, you'd want to buy ZUMZ hand over fist.

But therein lies the problem; ZUMZ is a case of a terrific business that has simply been bid up too much. This happens over and over again countless times every year where a great business has investors that are too optimistic and bid the stock up to unsustainable levels. It happens on the downside too as great businesses hit hiccups but are unduly punished for them. Both scenarios have played out for ZUMZ in the past three years and I think we're at the top of a euphoria cycle right now at $39. Investors would do well to take profits in ZUMZ and wait for a reentry point.

ZUMZ is nearing what it has called its saturation point for stores in the US. That means that growth from Zumiez-branded store openings will be muted in the years to come as the build out part of the company's growth plans comes to an end. Comp sales are still strong so I'm not suggesting growth will cease but it will be slower. In addition to that, however, ZUMZ is a strategic acquirer of brands that fit its strategy. This will be the source of growth in the future and while that's fine in general, acquisitions are tough to make successful and are very expensive, further muting earnings growth. In general I'm not in favor of growth by acquisition for those reasons but so far, so good with Zumiez.

I like ZUMZ very much if you don't consider the price. However, we must consider the price and when doing so, we can see ZUMZ is just too expensive. At 21 times forward earnings I just can't justify the price given that ZUMZ' store build out is winding down and that margins are static. It will be difficult to continue to post double digit EPS gains in the future without margin growth and I don't see a viable way for ZUMZ to grow them right now. Its margins are already pretty strong and have been steady for years, leaving little to no upside for them. I think we'll see ZUMZ trade down into the $20s once more after the euphoria is broken again and at that point, I'd be interested in taking a look once more. But right now, for me, the price is far too high given the company's growth prospects.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.