Retail Survivor

Last week I worked on DSW Inc. (DSW), the shoe retailer. I often think of DSW as the Home Depot of footwear. For a shoe retailer, their stores are huge, averaging 21,000 square feet and carrying 22,000 pairs of shoes. I’m a former shareholder and customer of the company. DSW has been on my possible buy list for over a decade. Although I do not own DSW at this time, rising retailer pessimism and DSW’s declining stock has increased my interest.

DSW’s stock traded below $17/share last week after reporting earnings. Similar to many retailers, DSW’s operating results were on the weak side with same-store comps declining 3%. Gross margins also declined (180 basis points), partially due to an added rotation of “clearance activities”. Although same-store comps and margins declined, the company maintained its earnings guidance of $1.45 to $1.55 for the year. However, management noted they expect sales comps to be near the low-end of their prior guidance.

Management made a few comments on their quarterly conference call that caught my attention. Specifically, management noted that while the environment is challenging, they expect DSW to survive the ongoing consolidation in retail. In effect, as competing stores close, DSW expects to gain market share. That’s the good news. Of course the bad news is initially store closures, along with tepid and inconsistent consumer spending, could lead to further inventory mark-downs, liquidations, and margin pressure.

In my opinion, the great retail washout could eventually lead to some interesting investment opportunities, especially for survivors with strong balance sheets. I consider DSW’s balance sheet to be healthy and liquid with $254 million in cash, $533 million working capital, and no debt (excluding leases). At this time, I agree with management. Assuming the company does not get overly aggressive on buybacks, dividends, store openings, and acquisitions, I believe DSW will be a survivor. While balance sheet analysis will help investors predict which retailers will remain in business, I believe margin and normalized free cash flow analysis will determine what the winners of “retail survivor” are ultimately worth.

During the last recession and the end of its last profit cycle, DSW’s operating income declined sharply from $100.7 million (7.9% EBIT margin) in fiscal 2007 to $42.8 million (2.9% EBIT margin) in fiscal 2009. In its current profit cycle, operating margins have ranged from approximately 3% to 10% (peaking in 2012-2013; currently near 7%). What will DSW’s normalized revenues and margins be after the majority of its weaker competitors go bankrupt or consolidate? Answer this question and I believe you can determine if an investment in DSW’s equity will generate adequate future absolute returns.

Normally I prefer buying consumer discretionary businesses in recessions. During economic downturns, investors often extrapolate weak operating results too far into the future. While I often talk about extrapolation as a risk, investor extrapolation can also lead to excessive pessimism and opportunity.

The last time I felt a group of stocks suffered from excessive pessimism and presented opportunity was in 2013-2015, when the precious metal mining stocks were annihilated. Near their lows, precious metal equities were simply too embarrassing and contrarian for most professional investors to own. For those willing to assume perception and career risk, miners represented wonderful opportunity, in my opinion.

As investor sentiment on retailing stocks turns increasingly negative and the retail shakeout progresses, will the retailers of 2017-2018 eventually resemble the miners of 2013-2015? While I don’t believe the retailers are nearly as inexpensive as the miners near their lows, it’s a group I plan to monitor and study more closely.

While growing pessimism and declining equity prices may eventually create opportunity, the retailing industry has historically been filled with value traps (admit it, you know you worked on Radio Shack!). I prefer avoiding overused phrases, but absolute return investors will need to be very selective, especially as it relates to financial strength. Similar to the miners, I believe it will be very important to focus on consumer discretionary stocks with strong balance sheets given the cyclicality of their businesses.

As stated in past posts, I believe it’s important to avoid combining operating and financial risk – it’s one of the easiest paths to bankruptcy. Remember, as absolute return investors, we want to avoid buying stocks that eventually resemble goose eggs. I believe avoiding retailers that bought back stock with debt may also be a good idea, or at least considered a red flag. I’m hesitant to own businesses with boards of directors that do not share my beliefs regarding operating and financial risk or that placed unnecessary strain on balance sheets in an attempt to reach EPS goals.

Lastly, if retailers eventually become as disliked as the precious metal miners, it’s important to understand these are two very different investments. The margin of safety of the precious metal miners came from their hard assets and inventory in the ground. Near their lows, investors could buy high-quality miners at significant discounts to the replacement cost of their long-lived assets. The assets of most retailers are not nearly as “solid” or as difficult to replicate. For instance, I have little interest in owning stores or warehouses of depreciating pants, sandals, and sweaters selling at 0.5x book value. As such, most retail valuations should be calculated by discounting normalized free cash flow, with cash coming from profitable operations, not inventory liquidations.

It’s an interesting market cycle. While equity valuations are expensive and overvaluation is very broad, there have been bear markets within sectors such as energy, precious metal miners, and certain areas of retail. In addition to creating possible opportunity, rotating sector bear markets are a refreshing reminder of how free markets and capitalism are meant to function – some companies survive and some do not.

As the great retail shakeout unfolds, I hope to identify and accurately value many of the survivors. Whether or not prices cooperate and provide investors with sufficient opportunity remains to be seen. Nevertheless, I find the negative trend and sentiment in retail stocks encouraging, especially for absolute return investors shopping for lower asset prices!