Retail stocks are hurting in 2014.
The S&P retail ETF (NYSEARCA:XRT) is down 5% this year against a market that is up almost 5%. A slow holiday season for retail carried into the winter, where historically bad weather (especially in the midwest and east coast) crimped traffic trends and led to a bevy of "worse than expected" Q1 reports.
There is both opportunity and risk here. The risks are two. Retail stocks are historically quite volatile, easily swinging 20% in either direction over the course of a few months based on monthly same-store sales reports or earnings. Secondly, retail is a sector where it is difficult for firms to build sustainable competitive advantages. Barriers to entry are usually low, competition from both brick-and-mortar and online is intense, and products are essentially commoditized, meaning anyone can choose your bread-and-butter products to be a "loss leader" and underprice them to drive store traffic (for example, Walmart's (NYSE:WMT) strategies with electronics and groceries).
But there is opportunity, too. I've been seeing several extremely high quality, well run retailers that have dominant market share in their industries showing up in the Magic Formula® screens recently. Buying a high quality retail name trading at multi-year low valuations could be a good strategy for booking some big gains. The current woes plaguing the entire industry seem more like short-term challenges then fundamental structural shifts.
Here are 5 dominant stocks that look particularly enticing at current valuations:Staples (SPLS)
Along with Office Depot (NYSE:ODP), Staples dominates the office supply retail category, with over 1,800 locations. While revenues have been slightly down (-3%) recently, along with modestly slipping margins, Staples still has a lot of good qualities. The stock is at a 52-week low - in fact, it is near a 10 year low! SPLS pays an attractive 4.3% dividend yield that has been raised in 8 of the past 10 years and is still well under 50% of free cash flow - it has dividend growth potential. The company also buys back shares, with share count down almost 14% over the past 10 years. Finally, Staples does not have a particularly worrisome balance sheet, with $800 million in cash offsetting most of its $1 billion in total debt obligations.
The worry with Staples is competition, particularly from online and mass market retailers, as office products are generally not necessary to "browse". I believe the concern is a bit overblown, as Staples gets a large chunk of its sales from deliveries and uses a contract selling model that ensures repeat business.Bed Bath and Beyond (BBBY)
I've written recently about Bed Bath and Beyond, and the stock has continued to decline in the interim, giving investors an even better buy-in price to what is widely considered one of the best operated retail firms. The acknowledged "top dog" in home furnishing retail, Bed Bath controls 11% market share in this huge industry, with over 1,000 stores. The stock is at a 52-week low, the bottom of its 2-year range, and at its lowest P/E valuation in the last 5 years. Bed Bath buys back shares (5% annual share decline over past decade), has a debt-free balance sheet, and has growth potential through its buybuyBABY and Cost Plus subsidiaries. Recent weakness in sales seems more due to general retail malaise then any kind of structural or competitive shift in the industry.Coach (COH)
A brand synonymous with "affordable luxury", Coach had been chugging along, growing sales and profits at mid-teens rates, until the train screeched to a halt this past year, with sales down 4% and profits down 12% so far this year. Another company with a reputation for outstanding management, Coach's weakness can mostly be attributed to a management transition and stale product line. I see these as transitional, with a new product line created by renowned designer Stuart Vevers, and a re-invigorated retail experience designed by guru William Sofield rolling out later this year.
In the meantime, Coach has reduced share count for 9 consecutive years, pays a 3.4% dividend yield which is well supported at 30% of free cash flow, carries a debt-free balance sheet, has averaged returns on equity near 45% for a decade, is trading at a 52-week low (and lowest price since 2010), and is valued at its lowest P/E ratio in the past 5 years. A questionable downgrade yesterday makes the price even more attractive for new investors.PetSmart (PETM)
PetSmart dominates specialty pet retail, controlling 17% of total spending in the U.S., more than double its closest competitor, Petco. There are a lot of things to like. PetSmart still has growth potential, with underlying industry growth at 3-5%, and the potential for 3-5% annual store base expansion through the next 5-10 years. This is another company with top notch management - Morningstar gives them their highest "Exemplary" rating. 10 consecutive years of declining share count, zero debt, a 1.4% dividend yield with major growth potential, and margins that have improved from 8% in 2007 to 10% today are all additional testaments to the quality of the business. The stock has begun to bounce from its $55 low a few weeks ago, but there is still plenty of upside left to the mid-$70 range the stock traded in for much of the past year.GNC (GNC)
Like BBBY we recently profiled GNC, and the stock is down even more from that profile, presenting a really attractive buying opportunity. Like these other stocks, GNC dominates its industry niche, with over 10 times the store base of its nearest competitor. With proprietary products growing to 50% of sales, GNC has increased its margins from 10.6% 5 years ago to 18% today. The company has just recently entered China and is making a strong push into the lucrative (for supplements) online market. The dividend is 1.7% and at only 25% of free cash flow, has room to grow. The stock is near a 52-week low and trades at its lowest P/E ratio in 5 years (by a large margin, to boot).
The one concern with GNC is a somewhat lopsided balance sheet, with $1.3 billion in debt vs. under $200 million in cash. But with interest coverage ratio near 9, I don't see this as a huge concern in the near term.
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Disclosure: I am long PETM, GNC.