Irrational Retail Valuations
Before the onset of a recession and consumer pullback, investors rarely had to spend a lot of time ascertaining revenue visibility. After all, a rising tide lifts all boats. Find a hot stock, read all the glowing analyst recommendations, and buy knowing that it shouldn’t be too hard to hit forecasts. In a negative growth environment, revenue visbility becomes a much more important aspect of your investment analysis. Cloudy outlooks mean tentative investors which usually equates to two very scary results – volatility and loss of market premium. But, this also means that time spent researching revenue drivers can provide that much more of an edge as panicked and confused investors dump their shares.
Nowhere is revenue visibility more of a problem than for apparel retailers. After all, it’s easy to defer clothing purchases especially when consumers are feeling poorer and poorer. And, it’s anyone’s guess when pocketbooks will open up again and where that money is going to flow. The trendiest retailers before the recession may not necessarily be the trendiest retailers after. Take a look at the following table:
I’ve divided the table into three categories. Growth retailers – Urban Outfitters (URBN), The Buckle (BKE), and J. Crew (JCG). A turn around story – Gap (GPS). And, established “mature” retailers – Abercrombie (ANF), Ralph Lauren (RL), and Guess (GES). You’ll notice a decided growth premium being paid for the growth group with P/Es in the high-20s just a year ago. And, for the more well established retailers, P/Es were just in the low to mid teens.
Interestingly enough, stock performance has hardly been correlated to EPS performance. Using forward earnings like I discussed in my previous post on multiple valuation, we find that forward P/E premiums are all over the place and no longer neatly in their general categories. Has something fundamentally changed about the retailers in the list? Or, is something else at work here?
The first culprit is probably the fact that analyst estimates are all over the place. No one really knows how much these retailers will make next year. Will there be a rebound? Will they have fresh designs despite massive inventory build ups? Will they be able to win back old customers? But, even in trying to smooth this by averaging P/Current FY earnings and P/Forward earnings, we still see rather skewed multiples being paid.
The truth is, a lot of these companies are not fundamentally changed by the recession. Their inability to sell clothes is not unique to each store but a result of a systematic scaling back of consumer spending. If and when apparel demand returns, the fundamental growth vs. mature vs. turn around stories will remain in place yet Mr. Market seems to care little about this fact right now. That means there have to be some great opportunities for someone who can see through the haze.
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