Apparently No One Has Told The Market That The Retail Sector Is Cyclical - The Entire Industry Looks Overvalued

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Summary

  • At current valuations, in aggregate, the market is pricing in expectations for the Retail industry to see profitability sustain above historic all-time highs, with steady growth.
  • When screening, even though the entire industry appears expensive relative to profitability, market expectations for a few names in particular jump out as excessive.
  • While for some companies this may be warranted, there are many that might warrant a closer look, including ULTA, POOL, and BURL (to name just a few).

After the most recent holiday season, there have been a lot of discussions on if retail is under pressure with the changing consumer patterns. With Amazon and other online focused retailers capable of replacing the need for the functionality many legacy brick and mortar retailers offer, and with consumers focusing more on experiences as opposed to objects when spending discretionary income, one might expect market expectations for Retail to be for an industry under pressure.

On the other hand, market expectations for the Retail sector appear irrationally high, meaning the SPDR S&P Retail ETF (NYSEARCA:XRT) itself may be set up for downside. Also, there are a couple names in particular that jump out, including Ulta Salon, Cosmetics & Fragrances (ULTA), Pool Corporation (POOL) and Burlington Stores, Inc (BURL). Using many of the same tools we've used to analyze individual companies, below we highlight why we think the entire industry looks expensive, and how you can still find interesting individual ideas to execute on, even in that situation.

The entire Retail industry looks expensive

US Retail Industry Performance & Valuation Prime Chart

At current valuations, the market is pricing in expectations for the Retail industry, in aggregate, to see peak profitability levels, with growth continuing at a pace in line with averages since the Great Recession. This industry has historically been somewhat cyclical, with UAFRS-based ROA (ROA') ranging from trough 8% levels during the early-2000s and Great Recession, to peak 10-11% levels in 2004-2006 and 2012-present.

Based on current valuations, with an aggregate UAFRS-based P/B (V/A') of 2.2x, the market is pricing in expectations for the industry to see ROA' improve past prior peaks and reach 12%, with Adjusted Asset growth of 5% in line with levels seen since 2008. While the industry may reach these expectations at the peak of this cycle, to assume the industry will maintain peak performance and not see mid-cycle ROA' at levels closer to 9-10% levels appears overly optimistic, and far too aggressive.

This analysis uses Uniform Adjusted Financial Reporting Standards (UAFRS) metrics, or adjusted metrics, which remove accounting distortions found in GAAP and IFRS to reveal the true economic profitability of a firm. This allows us to better understand the real historic economic profitability of a firm as well as allows for better comparability between peers. To better understand UAFRS, please refer to our explanation here.

In an expensive peer set, relative valuation analysis can help identify which opportunities are worth acting on

A major benefit of adjusting as-reported financial statements is to clear away accounting distortions, to allow for more accurate peer-to-peer comparisons. This analysis uses Uniform Adjusted Financial Reporting Standards (UAFRS) metrics, or adjusted metrics, which remove accounting distortions found in GAAP and IFRS to reveal the true economic profitability of a firm. This allows us to better understand the real historic economic profitability of a firm as well as allows for better comparability between peers. To better understand UAFRS, please refer to our explanation here.

Looking across industries, markets, and time, there has been a very strong relationship between a company's Uniform Adjusted ROA (ROA') relative to the corporate average (6%) ROA', and the multiple the market will pay above the value of the company's UAFRS-based Asset (Asset') base, in terms of a cleaned-up P/B multiple (V/A'). A company that generates a 6% ROA' will tend to trade at a 1.0x V/A', and company that generates an 18% ROA' will trade at a 3.0x V/A', etc., within a growing band of variance. This heteroscedastic pattern is a result of higher ROA' firms having more variables (including growth rates) that can affect valuations relative to low ROA' firms.

It is also important to note that there is a very clear spline at one point of this scatter, in which this relationship does not hold, firms generating returns below the cost of capital. These firms often trade on much different factors, generally things such as the recovery value of assets and the risk of default.

This phenomenon is depicted visually in the chart below:

Quality to Valuation Scatter - Valuations Explained

We have used this relationship to point out numerous potential long ideas, including THRM and LRCX over the last month, as well as several ideas that look overvalued, including ADBE and TXN.

Quality to Valuation Scatter - Recent Ideas Highlighted

Often, when looking at industry specific scatter, there will be a couple outliers to either side worth investigating, but with most names falling within that acceptable band. However, there are points in time when an entire industry can start looking overvalued, with even the cheapest names being aggressively priced.

With the entire Retailing industry looking expensive based on an embedded expectations analysis, the Retailing industry is currently lining up as a candidate for this scenario. When looking across US companies in this industry, not only is it difficult to find value, but a majority of companies actually look like they are priced too aggressively relative to their profitability. If we overlay the above chart on the Quality to Valuation Scatter from Valens Research comprised of 58 companies in the US retailing industry, we see the below result:

US Retail - Quality to Valuation Scatter

Of the 40 companies in this universe currently generating a return above the cost of capital, 30 of them fall above what can be considered the "fair-value" line, and while there are a multitude of reasons that companies above this line are not definitely overvalued, the fact that 75% of the names are trading at premium valuations is telling.

To be able to see an active Quality to Valuation Scatter, click here. This will take you to the Quality to Valuation scatter for one of the companies in the analysis, ULTA. If you then want to adjust the universe, to something similar to the universe defined above, you can customize the universe by:

1) Choosing the top 4 market cap options (everything above $500m market cap)

2) Choosing Retailing from the Industry drop-down

3) Choosing United States from the country drop-down. Then hit Apply Filters

4) Lastly, when the page loads, you'll notice some sizable outliers (you can click on the dots on the chart and it will give you information on the company, such as company name/ticker, the ROA', V/A' and Asset' growth of the company, and the ability to navigate to that individual company page, and lastly the ability to remove that company from the scatter you're looking at) - click on the big outliers (PCLN, W, SHLD, GRPN,FTD, LTRP.A) on the scatter and select "remove"

When looking at the scatter, as mentioned above, a lot of the names look expensive. That being said, when looking at the outliers, some outliers stick out more than the rest. These names don't just look expensive on the scatter, they also look expensive when analyzing the company's profitability trend historically. For many of these companies, the market is expecting ROA' and Asset' growth to divert from long-term trends in an overly positive manner, which appears unrealistic.

ULTA, POOL and BURL look to be particularly interesting short ideas

ULTA

After seeing profitability expand significantly from 2009 through 2012, ULTA has stabilized ROA' at 12-13% levels since. Meanwhile, the firm has also seen growth in Assets' subside somewhat, though still remain robust as the firm continues to expand its footprint in the US. At current valuations, the market is pricing in expectations for this growth to remain robust, but with ROA' starting to expand once more, to new historical highs nearly 1.5x current levels. Given the company's inability to improve ROA' from these levels over the past 5 years, market expectations for a sudden ROA' inflection appears overly optimistic. Should the firm face any hiccups in terms of growth or even just maintain profitability where it is now without seeing a massive ROA' jump, material downside may be warranted.

To see ULTA's full Performance and Valuation Prime and other insights on Valens Research, click here.

ULTA - Performance and Valuation Prime Chart

POOL

As a distributor of leisure equipment (specifically pool supplies and related products), POOL has generated cyclical profitability historically, largely in line with macroeconomic cycles, as stronger economies have led to increased discretionary spend, and vice versa. Recently, the firm has improved ROA' from 11% levels seen during the Great Recession, back to 18%, near the peak 22% levels generated by the firm in the early aughts. However, the firm has also slowed Asset' growth materially as their market has matured, a weaker homebuilding cycle have limited growth, and they've grown in scale. After seeing Asset' growth of 10%+ annually from 2000 through 2006, the growth range has dropped to -5% to 6% since 2008. At current (peak) valuations relative to both earnings and assets, the market is pricing in expectations for the firm to sustain recent profitability improvements, and buck the cyclical trend, driving ROA' to double to astronomically high 36%, while maintaining growth around average 3% levels going forward. Given the firm's inability historically to push above 20-22% levels, the clear cyclical nature of the business and expectations for unprecedented performance, once more, equity downside is likely warranted.

To see POOL's full Performance and Valuation Prime and other insights on Valens Research, click here.

POOL Performance & Valuation Prime Chart

BURL

Since going public, BURL has generated an ROA' roughly around the cost of capital, ranging from 6-9%, while growing their Asset' base at a modest 1-10% annually. At current valuations, the market is pricing in expectations for profitability to jump materially, to 14%, with continued 5% Asset' growth going forward. Given these expectations, unless an investor has insight as to how BURL is going to materially change their business model, downside is warranted, as slow and steady will not keep pace with market expectations.

To see BURL's full Performance and Valuation Prime and other insights on Valens Research, click here.

BURL Performance & Valuation Prime Chart

It's more widespread than just these names

POOL, BURL, and ULTA were just examples of how market expectations for many companies in the retail sector are completely dislocated from the companies' actual operating profile over the last 5 and 15 years. This is apparent in other names too, including HD, ROST, TJX, GPC, LOW, BNED, and on and on. 75% of the names in this sector are priced like they are expecting profitability to not just sustain at historic business cycle peak levels, but rather that the companies will all have massive operational improvements beyond historic peaks. While this may be justified for some unique names, it is highly unlikely that all of these firms have fairly priced equity considering excessively high expectations across the industry. Prudent investors should be cautious when looking at any names in Retail, and those with a healthier appetite for risk may want to consider betting against the market should they expect any hiccup in the economic recovery.

To find out more about the companies listed in this report and how their performance and market expectations compare to peers, click here to access the open beta of the Valens Research database.

Our Chief Investment Strategist, Joel Litman, chairs the Valens Equities and Credit Research Committees, which are responsible for this article. Professor Litman is regarded around the world for his expertise in forensic accounting and "forensic fundamental" analysis, particularly in corporate performance and valuation.

This article was written by

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Valens Securities is a boutique research firm with 90+ professionals, housing truly unique, disciplined, and unbiased research systems for equity analysis, corporate credit, and macroeconomic strategy.Valens provides institutional investor clients with various tools designed for each level of the investment process.Sign up for our daily newsletter hereAssociated Accounts: Valens Research provides data to SA contributor Altimetry

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.

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