The path to success of e-commerce has been heralded, among others, by Amazon (AMZN) years ago. Brick-and-mortar retailers consequently saw their top lines shrink due to significant competition from online retailers. Their margins contracted in an effort to remain competitive, but also to fund initiatives reigniting growth. In these days, investors are worried by another uncertainty weighing on the entire sector, and that is import tariffs. Recently, trade rhetoric has become more aggressive, and hence, nobody dares to think of the tariffs being eased or lifted in the foreseeable future. The Great Recession is still in investors' short-term memory, and realizing that we are probably close to the end of a roaring bull market, it is understandable why fear currently outpaces greed.
As there is definitely blood in the street of retail and valuations have come down quite a bit, a closer look is warranted as to whether the market has thrown a few babies out with the bathing water.
I will review Tailored Brands (TLRD), Macy's (M), Chico's FAS (CHS), GameStop (GME), Bed Bath & Beyond (BBBY), Target (TGT), Lowe's (LOW), The Cato Corporation (CATO), Dillard's (DDS), Nordstrom (JWN), Kohl's (KSS), Home Depot (HD) and Foot Locker (FL) in a very concise manner, detail a few key issues and compare the retailers in terms of profitability, financial stability and from a current yield perspective.
From a housekeeping perspective, I would like to emphasize that the companies' market capitalizations have been recorded on May 27th, 2019, and all financial data has been taken from the respective 10-K statements.
From the pool of companies under review, a few developments have struck my attention. For one, M disappointed investors, cutting its FY2019 guidance recently. This and the reignited trade fears have resulted in a sharp drop of 50% off the August 2018 high. CHS has been on my radar for quite a while, and the fact that everything becomes too cheap at some point has been confirmed by a buyout offer of Sycamore Partners. GME is a story in itself, and hence, I link to my article and the excellent review by Justin Dopierala. Briefly, the buyout has not worked out but some value has been unlocked, and together with the recent sell-off, GME is actually trading at a negative enterprise value (EV). I also wrote an article about BBBY, but the last earnings reports shifted my interest away from the company. Mr. Temares finally stepped down, and probably the ship can still be righted. TGT is currently loved by Wall Street due to a very nice earnings report. The converse is true for LOW, DDS, JWN, KSS and FL. CATO is an interesting smaller retailer with a net current asset value per share (NCAVPS) of almost $8 (i.e., >50% of the current share price). The same holds true for GME with an NCAVPS of $4.1.
Table 1 compares the mean 10-year operating margin of the aforementioned retailers. For comparison, the most recent operating margins are given as well. Operating margin takes into account cost of goods sold and sales, general and administrative expenses (SG&A), both varying quite substantially among the retailers. Finally, I deem it important to evaluate the percentage of leases in terms of sales. Understandably, companies owning their property and/or executing efficiently deliver the lowest percentages.
Table 1: Profitability-related metrics of selected retailers (data derived from the respective company's 10-K statements, table arranged in Microsoft Excel by the author)
It is glaringly obvious that BBBY's operating margin has fallen off a cliff, whereas HD has been able to even build on its success. This is clearly reflected in the share price of both companies. Since I associate a solid operating margin with downside protection, I would choose HD, KSS, FL, M and LOW, given that the valuations are appropriate. GME's operating margin recently contracted due to decreased sales in its pre-owned segment. The company also suffers from excessive SG&A expenses, as outlined by Justin Dopierala. The operating leases of FL are quite substantial, but its operating margin appears stable. DDS, on the other hand, obviously owns most of its real estate but suffers from margin contraction. In this context, M is worth mentioning, since the company has been deleveraging over the past years, selling part of its real estate. Its operating margin has contracted as well, and management is investing a lot of money in growth initiatives. CHS and CATO score the worst in terms of profitability. With CHS, I find its low operating margin alarming in the context of its subpar lease/sales percentage. CATO unsuccessfully tried to diversify away from its loyal customer base, and both its top line and operating margin have suffered since. Management remains cautiously optimistic.
In fact, I see two possibilities for a retailer to survive alongside e-commerce. Either the business is run on thin margins, trying to keep pace with online retailers. Giving customers a bargain experience is risky (e.g. BBBY) but seems to work out pretty well (e.g. TGT). The other route involves the creation of a shopping experience (e.g. M) and/or excellent goods sourcing capabilities (e.g. CATO before it tried to address another audience), giving the customers exactly what they want. GME, which currently trades as if it is going bankrupt tomorrow, has reduced its lease commitments over the past, and most of its stores are cash flow-positive.
Indebtedness, Lease Flexibility and Dividend Safety
Table 2 sets forth current net debt-to-EBITDA figures (also including operating leases). Lease flexibility, NCAVPS, current ratio and the current payout ratio in terms of the last three years' mean free cash flow (FCF) are also given.
Table 2: Financial stability-related metrics of selected retailers (data derived from the respective company's 10-K statements, table arranged in Microsoft Excel by the author)
TLRD is currently considered uninvestable due to its substantial debt and its mediocre lease/sales quotient. At least the company's dividend seems stable, assuming the business continues to produce ample FCF. M has deleveraged quite a bit, and I consider its current net debt/EBITDA appropriate. The company's payout ratio is moderate, and hence, I deem the dividend safe as well. Compared to other retailers, M, TGT and KSS have quite inflexible leases, which is, however, no problem as long as the stores remain profitable. Conversely, CHS, GME and CATO exhibit tremendous flexibility in terms of operating leases. Since the payout ratio of CATO is a bit on the high side, I suspect the dividend would be trimmed a little if business conditions were not to improve. On a more positive note, due to his large stake in the company, John Cato (who controls the equity via supervoting shares) will likely not trim the dividend unless necessary. GME and CATO shine in terms of NCAVPS. DDS scores the highest due to its low payout ratio and conservative financing. The sound balance sheet of GME lets investors sleep sound at night, even though the company is currently being punished by Wall Street.
Valuation and Yield Metrics
Tables 3 and 4 compare several enterprise value-based valuation metrics and current FCF and dividend yields of the retailers under investigation.
Table 3: Valuation multiples of selected retailers (data derived from the respective company's 10-K statements and Yahoo Finance, table arranged in Microsoft Excel by the author)
Table 4: FCF and dividend yields of selected retailers (data derived from the respective company's 10-K statements and Yahoo Finance, table arranged in Microsoft Excel by the author)
It is glaringly obvious that GME is cheap. The company's business model is apparently broken, since gaming studios are gradually shifting towards online content distribution, essentially cutting out the middle man. While I believe that GME's business model is indeed in secular decline, I doubt that the company is going out of business within the next few years. Note that GME is a cyclical business, and the next console generation will surface sooner or later. Likely, the next Sony PlayStation (SNE) will still have an optical drive due to its confirmed backward compatibility with PS4 games. If management is able to drastically reduce SG&A expenses and repurchase a significant amount of shares at current valuations, investors are likely to be rewarded handsomely. A dividend cut is debated for obvious reasons; however, in terms of cash flow, the annual dividend of $1.52 is sustainable. TLRD is similarly cheap, but as mentioned before, I currently consider the company uninvestable due to its debt. M is not glaringly cheap, but I consider it cheap enough, taking into account the company's balance sheet and its margins. I also share the opinion that the company's growth initiatives, despite being far from cheap, will work out eventually. BBBY is very cheap, however, the company is plagued by uncertainties. Its balance sheet has been compromised due to share repurchases at elevated valuations. The FCF yield of TGT, LOW, CATO, FL and JWN is nothing to write home about.
Summary and Conclusion
In conclusion, the retail sector indeed provides value for the risk-tolerant investor. Companies like TGT, HD, FL and LOW are certainly solid but currently too expensive. I consider M, KSS and also CATO to have arrived in value territory, exhibiting limited risk. CATO could be looking at above-average downside due to its uncertain outlook. KSS and M might see some more margin contraction, but there is still headroom. GME is a special case which I deem too cheap to ignore, even though the business model is in secular decline.
Thank you for taking the time to read through my article. If you have any comments or criticism, I would be happy to read from you in the comments section below or via private messaging.
Disclosure: I am/we are long GME, KSS, M. 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.
Additional disclosure: I wrote this article myself and the content only serves an information purpose and may not be considered investment advice. I cannot be held responsible and accept no liability whatsoever for any errors, omissions or for consequences resulting from the enclosed information. The writing reflects my personal opinion at the time of writing/publication.