MagicDiligence
Magic Recipe -0.63%
Deep Value -0.34%
Star List 1.14%
S&P 0.05%
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Looking for Retail Diamonds in the Rough

Frequently, stock ranking screens are as good at picking out trends as they are at unconvering interesting investment opportunities.

For example, consider our two value-based ranked screens (known as "Spells"): the Magic Recipe Spell and particularly the Deep Value Spell.

Perusing the two lists of around 80 unique stocks, one stark trend jumps out: the sheer number of traditional, "brick-and-mortar" retailers whose stocks now trade at far below-market levels against their trailing 12 month earnings and free cash flows.

A full 20 stocks - about 25% of all the positions - are brick-and-mortar retailers.

This raises 2 questions. One, what is causing this "retail recession" and is it a trend likely to continue, abate, or even accelerate? And two, are any of these stocks "diamonds in the rough" - e.g., are any of these companies likely to survive or even thrive in the conditions leading to these depressed valuations?

What's the Trend, Friend?

As to what is causing the "retail recession", the answer is pretty simple to discern.

Retail sales overall are not declining. In fact, overall sales of hard goods in the U.S. grew almost 4% in 2016. So this is not a case of consumers pulling back spending in response to hard times. The market is growing, not declining.

But the market is also changing. And that change is away from physical store shopping and into online shopping.

Consider these facts. In 2007, e-commerce accounted for just over 3% of retail sales in the U.S. Last year, that rose to nearly 10%. E-commerce sales have been increasing at a rate exceeding 15% a year over that decade - with no signs of slowing (2016 came in at 16%).

OK, great. So the trend is towards online sales and away from stores. We can also discern that this is a trend that is likely to continue or even accelerate given the statistical history. That answers our first question. Now, what about the second?

Braving the Amazon

With the problem identified, the next question is: are any of the stocks in our value screens worthy of consideration and likely to survive or even thrive in the move to online retailing?

You might think this could be fairly easy. If we can identify which one of those 20 companies have a strong and growing e-commerce operation in place, we might have found some potential "diamonds in the rough".

But this question is more complicated than that. Because there is a little more to the problem in the first place.

You see, there is one company that is gobbling up a lot of the growth in e-commerce sales. Yep, you guessed it: it's Amazon.com (AMZN). Amazon grew retail sales over 30% in 2016 - about double market growth. It now accounts for 43% of U.S. online retail sales, up impressively from an already-dominant 25% in 2012.

This indicates that competing in online retail increasingly means competing with Amazon. So, we not only need to find strong and growing e-commerce businesses, but also ones that either exploit areas Amazon is not strong in, or have some reasonable competitive edge that Amazon cannot match.

Finding the Diamonds in the Rough

Let's look at those 20 stocks. I'm going to start by quickly identifying the "no-nos", the companies that don't appear to even have a decent online strategy to compete with, despite carrying product categories that are moving online. Let's throw out:

1) Macy's (M)
2) Kohl's (KSS)
3) American Eagle Outfitters (AEO)
4) DSW (DSW)
5) Gap (GPS)
6) Dillard's (DDS)
7) Chico's FAS (CHS)
8) Michael Kors (KORS)
9) Michael's (MIK)
10) Sally Beauty (SBH)
11) GameStop (GME)

Great. That's over half we are able to eliminate. These companies do not report any data about their online operations, which essentially means... they don't have a very meaningful online operation, or are not focused on it. That is going to make it difficult to compete in this new era of retail.

That leaves a number of cheaply valued retailers that are actively pursuing an online presence as a core business focus. Here they are, along with their most recent quarter growth in online sales, and their percentage of online sales as total:

1) L Brands (LB) - -13% decline, 15% of total
2) Foot Locker (FL) - +12% growth, 14% of total
3) Best Buy (BBY) - +22.5% growth, 13% of total
4) Dicks Sporting Good (DKS) - +11% growth, 9.3% of total
5) Target (TGT) - +22% growth, 4.3% of total
6) Bed Bath and Beyond (BBBY) - "over 20% growth", % of total not given
7) Urban Outfitters (URBN) - "double digit growth", % of total not given

I'm going to go ahead and toss out those last two, as a company not willing to publish hard numbers on the size of their online business probably means it isn't meaningful enough to do so.

That leaves #1-5 (LB, FL, BBY, DKS, TGT). Does that mean these 5 are the "diamonds in the rough" we are looking for?

Perhaps. 3 of these firms - FL, BBY, and DKS - all reported modest same-store sales growth last quarter, which usually lumps in online sales, meaning they continue to grow even in difficult times for retail. Foot Locker and Dick's both compete against Amazon by having focused product categories from a limited number of suppliers, allowing them to offer greater selection. Best Buy is one that surprises a lot of people - myself included - but their price matching program seems to be the key to their success, eliminating one of the main drivers behind online purchasing of electronics.

As for the other two, the story seems less enticing. Target has no discernible competitive advantages that I can see, with product categories similar to Amazon, earns only 4% of revenues online, and facing strong physical competition as well from Walmart and others. L Brands is more difficult to get a read on. It has a strong consumer brand in Victoria's Secret, but 30% of the business is in Bath and Body Works, a very competitive online category.

In addition to these, I left out two companies where their store retail operations are a minority part of the business. Both are office supply retailers. Office Depot (ODP) earns slightly over half of revenue from their direct-to-business delivery operations, while for Staples (SPLS) that number is closer to 65%. The direct shipping model is less susceptible to Amazon-like competition (as it is business-to-business focused), so these two stocks might be two to dig deeper into as more "Amazon-proof".

Conclusion

In conclusion, the shift in retail is clearly moving to online sales, and retailers are going to need a strong online presence to survive. A lot of the retailers in our value screens do not. Not good.

On the other hand, I think that a handful of these - FL, BBY, DKS, ODP, and SPLS - could represent potential bargains at current valuations. These retailers have all shown an ability to operate successfully online, and/or have other competitively advantaged businesses outside of store retail.

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