Fashion and retail is a tough sector; skepticism in this sector is perhaps warranted more than in most other sectors. I am especially critical of shrinking businesses with brick-and-mortar exposure.
In this article, I am going to try to find which companies – in the fashion and retail space – are probably the “better” bets, and which companies will probably underperform. I am going to consider both quality and value in this “stock screening” project.
The methodology, explained briefly later on, is a simple point-scoring system. If a company meets a positive test, it accrues a point, and if it passes a negative test, a point is subtracted. At the end, I outline the net score found for each company in the top 10 and bottom 10.
Finding Good Bets
Firstly, to find the positive situations, I want to see organic revenue growth in the last two fiscal years. I want to see a higher gross margin in the most recently reported fiscal year vs. the fiscal year that was three years before; the same goes for operating margin. (Note: if I cannot access such information, I will use the fiscal year that was two years before instead.)
Additionally, return on assets (on a trailing twelve months (TTM) basis) should exceed 7% at a minimum, and the debt/equity ratio should be less than 2 (in the last reported fiscal year).
Furthermore, I want to see days inventory outstanding of less than 65 days, and days payable outstanding of less than 65 days. These are somewhat arbitrary limits, yet they allow us to identify companies with super-high inventory figures, and also those that are unsustainably relying on generous credit terms from suppliers.
Free cash flow (operating cash flow minus capital expenditures), averaged over the past three fiscal years, should be above the average net income for the past three fiscal years.
I also prefer to see goodwill and intangible assets as a percentage of net assets, at a rate below 50%.
As a valuation failsafe, free cash flow yield (TTM free cash flow vs. current equity value) should be higher than 5%, and EV/EBITDA (Enterprise Value divided by EBITDA) should be lower than 15x (to serve as a “ceiling” to valuation/risk).
Finding Bad Companies
To identify the future “underperformers,” I am looking for close to a mirror image of the above characteristics, with some minor adjustments. Firstly, there should be negative or flat organic revenue growth in the most recent fiscal year (in this case: less than 0.5% growth), with lower gross and operating margins in the last fiscal year compared to the average figures of the two years before that.
Additionally, return on assets should be less than 7% in the trailing twelve months (TTM). If it is less than 7%, a negative point is assigned. If it is also a negative return, two negative points are assigned (in total).
Bad companies do not necessarily need to have a high debt load; therefore, I will omit any filter here. However, I will look for a stretched days inventory outstanding figure of over 90 days. For days payables outstanding, since both above-average and below-average figures can indicate issues of different types, I am not going to run another check here (besides the positive check for less than 65 days, as noted above).
Another check I am doing is for goodwill and intangible assets, which on the short side should ideally exceed 80% of net assets.
An additional check will be made for each stock’s free cash flow yield, which should be less than 5% (for underperformers), and EV/EBITDA should at least be above 12x (indicating overvaluation or a lack of consideration for the company’s weaknesses).
It would also be nice to see some recognition from other traders; therefore, I will also want to see a level of short interest that is above the median percentage of float for the sector as a whole.
I am using the median short interest as a base rate rather than, say, an arbitrary rate like 3% or 5%, since there is quite a strong level of short interest across the retail sector. My research suggests the median short interest is actually close to 10% among retail companies listed in the United States. I have decided to use a base rate of 8%: therefore, if a company’s short interest is above 8%, I will assign to it one negative point (see next section for methodology).
To establish which companies are good and bad, I have assigned a score based on the above criteria to each company that I have screened. If a criterion is ‘passed’, I add a point (+1). If the company passes one of the negative criterions, I subtract a point (-1). (If neither are applicable, I do not add or subtract any points at all.)
Note that a measure like EV/EBITDA will cancel itself out if the multiple is between the range of 12x and 15x (e.g. one point for being lower than 15x, but one negative point for being above 12x). I am happy with this “mid-range.” The theme of this research is to find anomalies on both the upside and downside.
Overall, this points-based system should be a pretty effective filter. It is not guaranteed to be an accurate forecaster, but an interesting way to identify long/short opportunities in fashion, apparel and retail. Although not exhaustive, I have manually checked 85 relevant companies across the globe for the purpose of this research.
At last, the results are as follows. (Note: 'Positives' is the number of positive points, 'Negatives' is the number of negative points/red flags, 'Net Score' is Positives minus Negatives, Percentile is the percentile rank of the company's Net Score in my small sample, and Ratio is simply Positives divided by the absolute (positive) value of Negatives - the greater the Ratio the better.)
The top 10 companies, whose scores were the highest, are as follows:
Children's Place (PLCE) is an American retailer which sells children's apparel and accessories. Brands include Children's Place, Place, and Baby Place. The company was founded in 1969, and revenue reached almost $1.9 billion in FY 2017. The company is growing, its margins are improving, its return on assets (ROA) is almost 9%. The company has a flexible capital structure, and its EV/EBITDA ratio is less than 10x. The only negative was its high short interest; perhaps traders have got this one wrong.
Ross Stores (ROST), or simply Ross, is the largest American chain of off-price (discount) department stores. Of course, without knowing anything more, this would not sound like an attractive business. Yet short interest is, by the way, very low for the sector (about 1%). And I think traders have this one right. The company's debt is low/manageable, while it is growing and its margins are improving. Further, its ROA exceeds 24%, and it is efficient in shifting inventories and paying suppliers.
Tilly's (TLYS) is an American retail clothing company which sells branded apparel, accessories, shoes, and other products. Founded in 1982, revenue in its 2017 fiscal year was about $575 million. Indeed, it is not a particularly large company (its market cap. is about $340 million). Right now, its revenues are stable, and its margins are generally stable, although perhaps it could do better (trailing ROA is about 5%). Still, its working capital cycle is healthy, it basically has no financial debts, and the company's EV/EBITDA multiple is less than 5x, which makes it an attractive acquisition target.
Gap (GPS) is a household name; an American clothing and accessories retail. Founded in 1969, the company now does almost $16 billion in revenue. ROA is safely over 10%. However, it is not a growing business, and its margins are not improving. Nevertheless, its working capital cycle is healthy, its capital structure is manageable, and its EV/EBITDA multiple is close to 5x, once again making it a likely acquisition target. Recent share price downside notwithstanding, I believe there's a chance Gap will rebound over the next 12 months.
J. Jill (JILL) is a newly-listed retailer, based in the United States, which sells women's apparel, accessories and footwear. Despite growing revenues and a trailing ROA of around 9% (with a healthy working capital cycle and a free cash flow yield of almost 15%), the company is not in favor among investors. Its EV/EBITDA multiple is less than 5x. Sure, there are risks associated with management's ability to execute, but the company still seems fundamentally underestimated and undervalued. Short interest is about 8% at the moment.
American Eagle Outfitters (AEO) is another household name; a well-known American clothing and accessories retailer, with revenues of around $3.8 billion in its last fiscal year. With ROA exceeding 11%, it is also efficient in shifting inventories and paying suppliers. Modestly valued at around 8x EV/EBITDA, its margins are nevertheless improving, as it grows steadily (safely above the rate of inflation). There are some downsides, like its margins are not at all-time highs, but looking across the sector, American Eagle looks like it will be an out-performer. With short interest exceeding 9%, I think traders are overly pessimistic.
Oxford Industries (OXM) is an American retailer of high-end clothing and apparel. The company carries major labels such as Tommy Bahama, Lilly Pulitzer, and Southern Tide. With revenues of about $1.1 billion, the company is not one of the largest companies in its sector, but its trailing ROA of 9.5% is well above average. While margins are not improving over time, they are relatively stable, while the company's revenues are growing over 5% per year. It looks like a healthy company that is stronger than most in its sector, and looks like it will out-perform. The EV/EBITDA ratio is about 11x; I anticipate some medium-term upside.
Hugo Boss (OTCPK:BOSSY) is a German luxury fashion house. Founded in 1934, Hugo Boss is a well-known brand. Perhaps owing to this, its operating and gross margins are above average (around 66% and 13%, respectively). Hugo Boss's margins are mostly stable, and its trailing ROA exceeds 13%. Its EV/EBITDA multiple is under 11x. Overall, it looks like a potential long. My only worry with this one is the company's very high inventories figure, which translates into a crazy days inventory outstanding of about 218 days.
Zumiez (ZUMZ) Zumiez is an American specialty clothing store. Founded in 1978, the company sells apparel, footwear, accessories and hardgoods for young men and women. With revenues of over $900 million, it is still growing, with a gross margin of around 33%. While its operating margins have not improved (they have actually slipped from over 8% to under 6%), its EV/EBITDA of less than 7x and overall positive picture makes this company a probable long opportunity in the medium term.
Chico's FAS (CHS), or simply Chico's, is a retailer of women's clothing, headquartered in Fort Myers, Florida, United States. Its last fiscal year showed revenues of almost $2.3 billion, however revenues are declining year over year. Still, its low EV/EBITDA multiple of under 5x and short interest of almost 10% makes this an enterprising long opportunity. Sure, there are risks, but the company's balance sheet and working capital cycle seem to both be intact, and if the company can stabilize there could be some medium-term upside. It could also be an acquisition target.
The bottom 10 companies, with the worst scores, are as follows:
Canada Goose (GOOS) is an Canadian manufacturer of outwear apparel. Founded in 1957, it is a well-known brand, although it is not a large company. In Canadian dollars, its revenues were just over $300 million in its last fiscal year (about $230 million in USD). Its top-line (revenues) are growing quickly (over 30% per year for the past two fiscal years), with improving gross margins. However, its operating margin is weakening, and its growth is probably unsustainable. The company's EV/EBITDA multiple is well over 70x. Execution risks aside, the company is overvalued. Short interest is about 8%.
Under Armour (UA) is an American brand; a manufacturer and seller of footwear, sports and casual apparel. Revenues have climbed quickly to almost $5 billion in its 2017 fiscal year, however revenue growth slowed to around 3% in FY 2017. Meanwhile its EV/EBITDA multiple stands at over 20x, for a company with weakening gross and operating margins, and more recently negative net income (and thus negative trailing ROA). I think short interest of around 10% is justified. I don't foresee a crash, but I expect Under Armour to under-perform.
Stein Mart (SMRT) is an American chain of discount department stores. They sell both men's and women's clothes. The company's last fiscal year saw negative revenue growth of -3.1%. Gross margins are low, due to the nature of its business (about 25%, down from past years). Operating income in its last fiscal year was negative -$31.23 million. With a short interest approaching 13%, I think traders agree that this shrinking, low-margin business (with a debt-equity ratio of over 3x, and negative net income/ROA), will resume its fall going forward.
Lands' End (LE) is an American clothing retailer that specializes in casual clothing, luggage, and home furnishings. The company mainly sells online and through mail order, although they run less than 20 retail operations too. Revenues were $1.4 billion in FY 2017. While the company grew over 5% in FY 2017, they declined by almost 6% in the prior fiscal year. Gross margins are weakening, and so have generally the company's operating margins, although they are at least positive more recently. The company is not finding it easy to grow sustainably, and it has not been able to generate healthy returns.
The company's EV/EBITDA multiple of almost 18x is optimistic, despite short interest of over 24%. I think the short sellers will probably win this one.
Richemont (OTCPK:CFRUY) is a luxury goods holding company based in Switzerland. The company owns numerous high-end brands which most people will probably not be familiar with. It mainly sells jewellery, watches, and writing instruments. I think this stock will under-perform, as the company's revenues of around $11 billion are roughly stable, its margins are modestly weakening, and its EV/EBITDA multiple of about 15x leaves little upside in this picture. Once again, I don't foresee any type of share price crash; but I imagine my simple model is correct in identifying Richemont as a future under-performer.
Luxottica (OTCPK:LUXTY) is an Italian eyewear company. It is the world's largest in the eyewear industry. They sell numerous brands of glasses, including Burberry, Chanel, Coach, DKNY, Michael Kors, etc. I didn't see the short interest for this stock, but I think it is despite its high gross margins exceeding 60%, its margins are weakening and its growth is weak. To be fair, its trailing ROA exceeding 10% is good, but its days payable and days inventory outstanding of 103 days and 96 days, respectively, together with the low growth, lower margins, and EV/EBITDA multiple of almost 15x, make this a probable under-performer.
Boot Barn (BOOT) calls itself "the largest and fastest-growing lifestyle retail chain devoted to western and work-related footwear, apparel and accessories in the U.S." (investors.bootbarn.com). Indeed, it has grown from $346 million in annual revenue in FY 2014 to $678 million in revenue in FY 2018, a compound growth rate of 18.31%, although much of that growth occurred in FY 2015 and FY 2016. Growth was down to 7.6% in FY 2018.
Boot Barn's gross margins are holding up at over 30%. Its operating margins are in the 6-9% region (in FY 2018 they were 6.8%). Trailing ROA was 5%. Overall, the company looks promising, with potential for further business upside and improvements. The company's inventories were quite high in FY 2018 (with days inventory outstanding of 114 days). Nevertheless, their days payable outstanding were under 50 days. The question is, how sustainable is this business's trajectory, and will the company ultimately be able to generate strong returns (enough to justify its valuation)?
The case of Boot Barn is tricky since it is a growing business, and you have to give them credit. Yet the company is probably overvalued. To me, it looks like it should probably be priced at closer to $400 million tops, which is 40% lower than its current market capitalization. BOOT's EV/EBITDA is almost 14x. Short interest is high at almost 25%. I will side with my screening criteria and side with the short sellers on this one.
Wolverine World Wide (WWW) is an American footwear manufacturer based in Rockford, Michigan, United States. It is known for its Wolverine Boots and Shoes, and its subsidiaries which market the Hush Puppies and Merrell brands. In FY 2017 and FY 2016, growth was negative -5.8% and -7.3%, respectively. Gross margins are stable at just under 40%. Operating margins have taken a hit with the falling top line, however, with razor-thin (though positive +0.9%) operating margin in FY 2017. As a shrinking business that is struggling to turn a profit, I think this business is overvalued (notwithstanding the recent run-up). Short interest is currently 6%.
Christopher & Banks (CBK) is an American retailer which specializes in women's clothing for the age 40-60 demographic. Short interest of almost 9% would suggest further downside. Indeed, operating income was negative in its most recent fiscal year, with negative revenue growth in the past two fiscal years. Gross margins have also weakened, down to 31%. This company seems like it will continue to under-perform over the long term. Note: this is a small-cap stock, with a market cap. of only $41 million, due to its share price falling 85% over the past five years.
V.F. Corporation (VFC) is an apparel and footwear company that sells more than 30 brands, which are mostly sports and outdoors oriented. This would be a contrarian short, as short interest is currently less than 2%. My model has picked it up due to the company having an EV/EBITDA ratio of about 20x, trailing ROA of 6.5% (below my 7% limit), a FCF yield below 5%, and some other reasons such as a weakened operating margin.
Overall, I probably wouldn't short VFC stock, but it does seem overvalued. I would have thought it would be trading at closer to $23-25 billion; investors are obviously counting on more growth (revenues grew +7.12% in FY 2017, and 12.70% on a trailing twelve months basis).
These findings are not to be interpreted as any kind of investment recommendation. However, there could be an opportunity here to create a market neutral portfolio for the fashion and retail space based on this kind of screening approach. If we were to go long the top 10 companies I've identified, and short the bottom 10 companies (with equal weightings), we might do well over the medium to long term.
In this regard, I am going to track a hypothetical $1,000 exposure against the share prices of each of the companies above – “going short” the bottom 10 and “going long” the top 10 companies (i.e. 20 positions; a notional $20,000 portfolio). I will revisit these “picks” in future to see how they perform (simply based on movements in the stocks' share prices over time).
Stay tuned, and wish me luck!
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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