AutoZone: Ripe for Investment at the Right Price

In today's economic and financial market climate investors have to balance a stock market that is no longer cheap and an economy that has obvious structural damage. The consensus has concluded that below-average economic growth and employment could be with us for at least several more years. Given such circumstances we must be even more careful than usual in selecting companies to invest in.

In my mind, there are four things investors should look for when choosing new investments today. The first, valuation, is the obvious one for me as a value investor. No matter how much you like the story behind a stock, if you do not pay a fair price, the odds are stacked against you if you are trying to beat the market.

With so many economic headwinds, however, investors are likely to find their fair share of inexpensive stocks. Three other factors that I think are important, in no particular order, are:

1. A predictable and stable business outlook

There is no doubt that we are currently experiencing a fragile economic recovery. Any numbers of things could reverse the trend of the last several quarters and undo much of the progress that has been made. As a result, investors should focus on businesses where the outlook is predictable and relatively stable. This will make it fairly unimportant if GDP grows by a lot, a little, or not at all.

2. A strong market position that faces very few, if any, competitive threats in the near to intermediate term

A predictable and stable overall business outlook is great, but if a particular company is unable to successfully navigate and compete in that business, it could still falter. Not only must end demand be predictable, but the company's own market position within that market is crucial as well.

3. Company management needs to put shareholders' interests first

Unfortunately, this does not happen as often as it should (which is all of the time). Corporate executives routinely flush capital down the toilet at the expense of shareholders. They seem to all too often forget that they are working for the shareholders, not themselves or their cozy boards of directors. Management teams should have a clear focus on creating shareholder value and have a strong track record of putting shareholders first, ahead of themselves.

A company that I believe fits all of these criteria, and therefore would make an excellent investment in the current economic climate (at the right price, of course), is AutoZone (AZO), the large automobile parts retailer.

In this case, both the industry (automotive repair and maintenance), and the company (one of the largest and most profitable auto parts retailers in the country) epitomize stable and predictable businesses. The auto parts industry is largely non-cyclical, as cars need to be maintained no matter what the economy is doing.

Some may even argue that a weak economy bodes well for auto parts retailers because as new car sales decline, demand should rise for parts needed to keep older cars on the road longer. This is certainly a strong argument, and an incremental positive for the story, but even so AutoZone and their competitors have not seen any meaningful cyclical upswing in sales as the economy has struggled, and I would not expect one to occur going forward.

In addition, AutoZone has a very strong market position (more than 4,000 stores in the U.S. alone) and there is little in the way of new competition in the pipeline. One of the effects of the recession was a dramatic reduction in retail-related new construction and expansion, which had become a staple during the credit bubble.

The most enticing part of the AutoZone story for investors, however, is the shareholder-friendly nature of the company's management team. Not only does management run a very tight and efficient operation (operating margins for the last fiscal year were 17% -- very high for a retailer), but they allocate capital very intelligently.

Unlike some managers who crave growth, AutoZone has grown its store base meagerly in recent years, as it realizes that its industry is mature and population growth and some pricing power are the only real drivers of sales. The company is quite pleased growing sales in the low to mid single digits each year, rather than expanding too much, cannibalizing existing stores, and earning sub-par returns on its capital.

Where does this excess cash flow go? Mostly to share repurchases, which directly translates into value creation for shareholders. In fact, during the last decade AutoZone used free cash flow to buy back huge amounts of stock. Entering fiscal 2000, the company had 150 million shares outstanding. By the end of fiscal 2009 that number had been cut by two-thirds to an astonishing 51 million. Not surprisingly, AutoZone's share price rose from $24 to $147 during that decade, for a gain of more than 500%.

Too many times managers and investors equate growth with stock price returns, but AutoZone is a perfect example of how you can create massive amounts of shareholder value without rapid expansion. The company can generate strong double digit earnings growth, while only growing sales in the low to mid single digits, if it allocates capital in shareholder friendly ways. During fiscal 2009 AutoZone's revenue grew by less than 7% but earnings per share rose by nearly 20%, largely due to an aggressive stock buyback program.

There is no doubt that the company is a strong investment candidate, especially in the current macroeconomic environment. As is always the case, however, investors need to make sure they pay the right price.

Full Disclosure: Peridot Capital was long AutoZone at the time of writing, but positions may change at any time

Five Years Later Sears Finally Licenses One of Its Brands

Long time readers of my blog know that for several years I was a long term investor in Kmart and then Sears Holdings, which was formed after Eddie Lampert orchestrated Kmart’s merger with Sears in early 2005. The bullish reasoning behind the deal, which was largely postulated in the financial media and analyst community given that Lampert keeps his plans close to the vest, was that although Kmart and Sears were eroding brands within the retail sector, they produced strong cash flows which could be harnessed to create shareholder value in ways other than building additional Kmart or Sears locations.

Given his distaste for throwing good money after bad, it was widely thought Lampert would be quick to close money-losing stores, sell the real estate or lease them out to others, push to sell the exclusive Sears brands (Kenmore, Craftsman, DieHard) in other retailing channels, buy back stock, reduce debt, and use excess cash flow to diversify the company into other businesses. Such a holding company structure would be more viable longer term, modeled partly after the model Warren Buffett has perfected within Berkshire Hathaway over many decades. Given that Lampert renamed the Kmart/Sears combination Sears Holdings and repeatedly stressed in his shareholder letters the importance of avoiding unprofitable growth simply for the sake of growing, such a strategy, although not spelled out completely by management, was hardly an outlandish basis for investment.

That was five years ago. Kmart stock was trading at $101 when the Sears merger was announced. Today, despite a share count far lower, the stock fetches only about $90 per share. I have long since given up on Sears as a long term investment after several years of waiting resulted in very little effort on Lampert’s part to truly diversify Sears Holdings. The company has closed dozens of stores, but given their base of nearly 3,500, the closings have not been significant, and many money-losing stores remain open. Real estate sales have been minimal as well.

Rather than buy other businesses or attempt to sell its own brands through other retailers (putting large Craftsman tool sections in Kmart stores was a half-hearted effort on this front), Lampert has been content with paying down debt and buying back enormous amounts of stock. These two value creation techniques are undoubtedly strong uses of excess capital, but their effectiveness is not maximized unless the overall business is, at the very least, stable. However, revenue has fallen every year since the formation of Sears Holdings, from $55 billion a year at the time of the deal to $43 billion annually today. As a result, while the share count has been reduced from 165 million to 125 million (admittedly an impressive 24% decline), earnings per share have fallen off dramatically as declining sales eat into profits (retailing is a very high fixed cost business).

Imagine my surprise then, when on Thursday February 11th, nearly five years after the Kmart/Sears merger closed, Sears Holdings announced that it had reached a licensing agreement to expand distribution of its Diehard brand of automobile batteries and other products into more retailing outlets. It only took five years!

I was certainly interested (at least mildly as a passive observer now) in this sudden shift in strategy, at least until I read the corporate press release announcing the deal. Why the muted excitement? Well, Sears has not signed on any retailers to sell DieHard products, rather they have signed a licensing deal with their own DieHard manufacturer, Schumacher Electric, to distribute them. No wonder I neither have ever heard of Schumacher Electric nor get excited when reading about this licensing deal with them.

While I would never expect a company in Sears’ position to publicly predict how much money a deal like this might bring into the company’s coffers in coming years, I cannot help but be surprised that this is the best they could do after five years. Maybe this deal does actually produce significant incremental cash flow going forward for the company, but I have to think that a deal to sell DieHard products in, say, Target stores nationwide would generate a lot more buzz and investor interest.

While it is good to see Sears Holdings finally making some promising moves to create long term shareholder value, that it took so long for a deal like this to get done, coupled with the fact that it is only with their manufacturer so far and not an actual retailer, is hardly reason to think the lofty goals many investors had for this company will actually come to fruition.

Full Disclosure: No position in Sears Holdings at the time of writing, but positions may change at any time

Amazon Now Worth As Much As Target, Costco Combined

This is just one of the market valuations that I have not understood in the past (and still do not at the present). Amazon is one of my favorite companies and I buy stuff on the site all of the time. My caution on the stock in recent years (due to a sky high valuation) has been proven wrong, as the stock keeps moving higher. Amazon continues to steal market share in the retail sector from bricks and mortar storefronts as more and more people spend more online. I would have thought most people who prefer online shopping would have already adopted it as a way of life, but evidently that trend continues unabated.

I would not consider buying the stock at current levels, however, as I simply cannot figure out why Amazon should be worth as much as Target and Costco combined when the latter two firms earn 7.5 times as much money and do so at similar profit margins. It is true that Amazon is growing faster but the valuation discrepancy seems to more than account for that. Of course, if they keep growing market share, perhaps Amazon can grow at current rates for far longer than many ever would have thought. While I surely would have loved to own the stock this year, I am content simply being a satisfied repeat customer.

Best Buy Shines Even In Weak Economy

Back in November I wrote that Best Buy would be a prime beneficiary of Circuit City's bankruptcy and given that they were already one of the best run retailers in the country, the stock was cheap at a single digit P/E (around $25 per share). Today Best Buy reported blowout fourth quarter earnings and predicted 2009 earnings of $2.50 to $2.90 per share, which is well above current estimates of below $2.50.

Best Buy shares are up $5 (15%) today to more than $38 per share, which brings the gain since November to over 50 percent. If you have been riding this trend, the shares look close to fair value from my perspective. Taking the middle of the earnings guidance range and applying a 15 P/E (a bit higher than I would choose normally, due to the recession) I get fair value of about $40 per share, so it appears the stock's huge move is largely behind us.

Full Disclosure: Peridot Capital was long shares of BBY at the time of writing, but positions may change at any time

Reducing Unused Credit Card Lines Is Probably A Good Thing For Everybody

Meredith Whitney, long time bear on the banking sector, is pointing to the possibility that reductions in credit card lines could result in a sharp drop in consumer spending over the next year or two. In a recent television interview she predicted that outstanding credit card lines in the United States would drop from $5 trillion to $2.3 trillion by the end of 2010, a drop of more than 50 percent. Having less available credit, Whitney argues, will result in even less consumer spending and major problems for the economy.

While I don't disagree that credit card issuers are going to reduce credit lines (we are already seeing this trend and there is no reason to think it will cease anytime soon), I am skeptical about how much this will really impact consumer spending. The main reason is because there is only about $800 billion in outstanding credit card debt in the U.S. right now, and that figure has not been growing as fast as may have thought in recent years. While this is clearly a large number ($2,600 per person), it is dwarfed by the credit lines currently outstanding and as a result, the credit line reductions should not really have a major impact on day-to-day spending.

Essentially, Whitney is predicting that the credit utilization rate will increase from 16% currently (800 billion divided by 5 trillion) to 35% within two years. For someone with $2,600 in credit card debt, that means their credit limit will be reduced from $16,000 to $7,500. While that may make the consumer a little less confident that they have a huge cushion of credit to fall back on in the case of an emergency, I don't really agree that it will result in a significant pullback in regular spending habits.

Additionally, this action by the nation's leading credit card companies may in fact help them as well as our consumers, who hopefully will realize that they should have a few thousand dollars in a savings account in case of an emergency rather than assuming they will get cards should something unexpected happen. This would be a welcome event for our banking system, which benefits greatly from an increasing deposit base. As for Whitney's assertion that a credit card bubble is the next shoe to drop on our economy; call me a skeptic. The data simply isn't all that scary to me and if we slowly lower our dependence on credit cards, our economy will be on stronger ground as a result.

Amazon Shares Look Expensive, Long Term Future Returns Appear Limited

In November of 2004 I wrote a piece entitled "Sleepless in Seattle" which postulated that shares of Starbucks (SBUX) were trading at such a high valuation (forward P/E of 48) that even if the company grew handsomely over the following few years, the stock's performance was likely to be unimpressive. I projected an aggressive three-year average annual earnings growth rate of 20% and a P/E of 40 by 2007. I warned investors that even if those aggressive assumptions were attained, Starbucks stock would only gain 6% per year over that three year period.

The analysis proved quite accurate. Starbucks continued to grow its profits nicely, but the stock's valuation came back down to earth. After three years had passed, Starbucks stock was actually trading 12% lower than it was when I wrote the original piece.

Today, shares of online retailer Amazon.com (AMZN) remind me of Starbucks back in 2004. Despite a cratering stock market and weak retail market, Amazon stock has been quite resilient. After a strong fourth quarter earnings report (released yesterday after the close of trading), the stock is up $7 today to $57 per share. Profits at Amazon for 2008 came in at $1.49 per share, which gives the stock a P/E of 38, which is very high, even for a strong franchise like Amazon.

I decided to do the same exercise with Amazon. I wanted to make assumptions that were both reasonable but also fairly aggressive. I decided that an average earnings growth rate of 15% over the next five years fits that mold. Projecting the P/E in January of 2014 is not easy, but given that Amazon's growth rate should slow as the company gets larger, I think a 20 P/E ratio is reasonable given where other retailers trade (less than 15x). By 2014, Amazon's growth rate should be more in-line with other retailers similar in size, so I chose 20 to be higher than average, but not in nosebleed territory like the current 38 P/E.

After some simple number crunching, we can determine that Amazon would earn $3 per share in 2013 in this scenario. Twenty times that figure gets us a share price of $60, versus today's quote of $57. Even if the company hits these assumptions, shareholders will make a total return of 5% (only 1% per year!) over the next five years. I would be willing to bet the S&P 500 index far outpaces that rate over that time.

Obviously these assumptions could prove inaccurate, but I think this exercise is helpful in illustrating how hard it is for stocks that trade at lofty valuations to generate strong returns over the long term.

There is one interesting thing about Amazon's business that I think is worth pointing out. You may recall that one of the bullish arguments for an online retailer like Amazon was that they could have a lower cost structure by eliminating the expenses associated with renting and operating large brick and mortar storefronts. Having a 100% online presence was supposed to result in higher profit margins, and therefore investors could justify paying more for Amazon's stock.

It seems that argument has not been realized. Amazon's operating margins in 2008 were 4.3%. If we look at brick and mortar retailers that are similar in business line and/or size, we find that Amazon's margins are actually lower than their offline competitors. Here is a sample list: Kohls (KSS) 9.9%, JC Penney (JCP) 7.6%, Macy's (M) 7.2%, Target (TGT) 7.8%, and Best Buy (BBY) 4.6%.

Maybe online retailers have to spend more on research and development and call center staff than offline stores do, thereby cutting into the margin advantage. Amazon also offers free shipping on orders of $25 or more, which many say they could eliminate to boost profits. Maybe so, but sales would be affected to some degree if they did that, not to mention customer loyalty.

Nonetheless, to me these statistics help make the case that a 38 P/E for Amazon is way too high. As a result, returns to Amazon shareholders over the next several years could very well be unimpressive, just as was the case with Starbucks five years ago.

Full Disclosure: Peridot Capital was long Best Buy and Target at the time of writing, but positions may change at any time

Retail Bottomfishers Have Better Options Than Saks

Last weekend's issue of Barron's highlighted a money manager's bullish stance on shares of luxury retailer Saks (SKS). The stock is up more than 10% since then, and now fetches $4.50 per share. The manager in question believes Saks has normalized earnings potential of 50 to 60 cents per share, which he thinks will translate into a stock price of between $5 and $7 per share in more "normal" times.

I took a look myself and quite frankly I think retail bargain hunters have better options. Here are a few reasons why:

1) Normalized earnings of 50-60 cents per share seems high

Saks earned $0.42 in 2007, which most people would agree was the peak in the retail cycle. Therefore, assuming Saks will earn between 20% and 45% more than that during "normal" times is not a bet I would feel confident making.

2) In the red even during Q4

I am relying on analyst estimates here, but not only did Saks lose money in the second and third quarters of this year (before retail really started to get clobbered after the market collapse and subsequent increase in unemployment), but they are projected to lose money in the fourth quarter too. Good retailers tend to make money all four quarters even though the fourth quarter is by far the strongest. Historically, sub-par retailers have lost a bit or broken even during the first three quarters of the year and then clean up handily during the holiday season (bookstores and toy retailers fall into this category a lot). Even in a bad economy, if you are losing money in the fourth quarter, that is a sign of poor management or a severely tarnished market position (the former is more likely in this case).

3) Unimpressive gross margins

A premium store like Saks should have very impressive profit margins due to the luxury items they sell. In both 2006 and 2007 Saks posted gross margins of only 39%, and that was in a very strong retail cycle. For comparison, JC Penney (JCP) also had a 39% gross margin for both of those years. This signals some deficiencies in merchandising at Saks, as they should have more pricing power (less of a need to discount) than a lower tier department store.

4) There are competitors that are doing better and also have cheap stocks

I picked Nordstrom (JWN) here as an example. Their market sits between JC Penney and Saks, but they are viewed as a little higher end, approaching if not matching Saks. Nordstrom has made money every quarter this year and will continue that trend in the fourth quarter. Their stock price is similarly depressed, as are most retailers, so you are getting both value and what appears to be a better run company.

All in all I think there are better bargains than Saks on the retail racks right now.

Full Disclosure: No positions in any of the companies mentioned, but positions may change at any time

Abercrombie Chooses Fewer, More Profitable Sales Over Lower Margin Bargain Bins

Last month I mentioned I thought Abercrombie and Fitch (ANF) stock looked undervalued. A December 8th Wall Street Journal article entitled "Abercrombie Fights Discount Tide" discussed ANF's strategy to maintain its premium brand image by choosing to accept higher rates of sales decline, relative to lower priced competitors, in order to hold up profit margins and not risk losing pricing power when the economy recovers.

The company has taken some heat on Wall Street for employing such a strategy, but it worked just fine for Abercrombie in the last recession. As an investor, I much prefer fewer sales at higher margin to higher volume (and less profitable sales) because it minimizes the risk of a retailer falling into the red.

The WSJ cites November same store sales drops of 28% for Abercrombie versus only 10% for Pacific Sunwear (PSUN) and 11% for American Eagle Outfitters (AEO) as evidence that markdowns boost sales in the short term, which is certainly true. But the key here is margins. While gross margin collapsed for the latter two retailers (Pac Sun from 34% to 29%, American Eagle from 47% to 41%), Abercrombie's held steady at a stunning 66%.

Gross margins of 66% are usually reserved for software and medical device companies, not mall retailers. With retail markups of 50% above cost, Abercrombie clearly has a premium brand. It is expected that during tough economic times that many of its customers will trade down to cheaper clothes, but that does not mean the company should completely rebrand itself. ANF is debt-free with 66% gross margins, so sales can drop pretty significantly without jeopardizing profitability.

"We hear your concerns," ANF Chief Executive Michael Jeffries said during an earnings call, but "promotions are a short-term solution with dreadful long-term effects." Abercrombie's general counsel, David Cupps, added that the company is "well positioned to deal with a tough market," adding that cutting prices would be cutting the quality of merchandise. "We're not going to follow the promotional pied piper," he said.Given the amount of bad news already priced into ANF shares, they look very cheap even if sales continue to drop throughout 2009. Even if you assume earnings fall 50% from their 2007 peak level, never recover at all, and the stock only fetches a 10 P/E, investors buying today will make a 30% return from current levels. That is a risk-reward scenario that looks very favorable.

Full Disclosure: Peridot Capital was long shares of ANF at the time of writing, but positions may change at any time

Financial, Retail Weakness Mask Underlying Core Profitability

Simply judging from the stock market's performance over the last couple of months, you might think the entire U.S. economy is teetering on the brink of disaster. In reality though, the sheer ugliness of the financial services and retail sectors is masking the other eight sectors of the market that, while certainly weaker than they once were, are actually holding up okay given the economic backdrop. The easiest way to illustrate this is to show earnings by sector for the last three years; 2006, 2007, and 2008. Keep in mind the 2008 are estimates based on nine months of actual reported profits and estimates of fourth quarter numbers.

As you can see from this graph, earnings in areas like telecom, healthcare, staples, or utilities are doing just fine and can withstand further weakness in 2009 and still more than justify some of the share price declines we have seen in recent months.

The selling has been indiscriminate but the business fundamentals are quite differentiated, depending on sector, which is one of the reasons that the U.S. equity market has not been this cheap relative to earnings, interest rates, and inflation since the early 1980's. It is a gift for long term investors.

Sears Holdings Has Squandered An Opportunity

The last four years or so for Sears Holdings (SHLD) and its shareholders would make for quite an interesting Harvard Business School case study. I have been writing about the company since 2005 and was an early investor in Kmart, even before Eddie Lampert used it as a vehicle to buy Sears.

The early success was very impressive. Lampert bought loads of Kmart debt as it filed bankruptcy and gained control of the company's equity when it reemerged in 2004. In 2006 Sears Holdings earned a profit of $1.5 billion, or $9.58 per share, quite a turnaround for a retailer that had been bleeding red ink.

Lampert accomplished this not by turning Sears and Kmart into strong retailers like Wal-Mart (WMT) and Target (TGT) (sales and profit margins still lagged those competitors), but rather simply by running the companies very efficiently and milking them for cash flow. Even if you earn a 3% margin instead of 6%, that is big money when you bring in $50 billion of sales annually.

The Wall Street community was sold on the idea that Lampert would use the cash flow from Sears Holdings to diversify its business away from ailing retail brands. Maybe he would close down stores and sell the real estate, or lease it back to other retailers who wanted the space. Maybe Kenmore and Craftsman products, which are owned by Sears, would show up on other retailers' shelves. Maybe Land's End, also owned by Sears, would be expanded as an independent retail brand. Maybe Lampert would buy other companies outside of retail altogether. The possibilities seemed, were, and still are, endless.

And yet none of this has materialized. Sears continues to operate as a sub-par retailer and uses excess cash flow to repurchase stock. As the economy has faltered, so has cash flow. Adjusted EBITDA year-to-date has fallen to $700 million, from $1.5 billion last year. The only positive has been the reduction in share count. Sears earned $1.5 billion in 2006, or $9.58 per share. If they somehow are able to earn that much again when the retail environment improves, earnings per share would be nearly $12 per share because of the lower share count. With the stock at $31 today, you can see that the stock would trade back above $100 in that scenario.

But how will that happen anytime soon if Sears continues as is has? It won't, which is why Peridot Capital has been steadily selling Sears stock over the last year. It used to be a very large holding, but is now one of our smallest. Eddie Lampert evidently was convinced he could do more with the retailer's operations even after the low hanging fruit had been picked. That was a bad decision.

As long as the economy remains weak, Sears will likely use it as an excuse for its poor operating results. That is a shame, because they had a perfect opportunity to diversify out of retail and they chose not to, even when it was widely accepted as the right strategy for investors. The truth is, however, that Sears and Kmart are not strong retailers and likely never will be, at least not in their current form.

To me, Sears is in the same exact position as General Motors (GM) right now. They are operationally inferior to their competitors, but refuse to dramatically alter their business plans to adapt to the market. Today the Big 3 CEOs will testify in front of Congress and explain that the economy is the source of their problems. They need annual auto sales of 13 million units to earn a profit, far from the 10 to 11 million run rate we are now facing.

I don't need to tell you that GM's business model is the problem, not the economy. If the U.S. auto market shrinks due to higher job losses and tighter credit standards, managers need to make changes to ensure they can survive in such an environment. In that case, a stronger economy would mean higher profits, not just survival.

I heard a GM dealer on television complaining that he can finance customers with credit scores of 650 or higher today, whereas last year someone with a 550 could get a loan. He implied that the banks were at fault for cutting credit for people with bad credit (the average credit score in the U.S. is 680). Was it not the fact that 550 credit scores qualified for car loans in the first place that got us into this kind of financial crisis? We should give loans to low quality borrowers to save the Detroit auto industry? I think not.

The bottom line is, if your company adapts you will likely be a survivor. When times are bad the weak die out and the strong not only survive, but they come out of the downturn even stronger than they were before. In today's market, when nearly every stock is down tremendously, there are fewer reasons to invest in Sears or GM when you can buy a stronger company like Target or Toyota on sale. When Target fetched a 20 P/E I preferred to buy the more undervalued Sears. Combine disappointing execution by Sears and a 50% drop in Target stock, and given the same choice I will take Target at a 10 P/E, which is what I plan to do.

Full Disclosure: At the time of writing Peridot Capital was long shares of Sears and Target and had no position in GM or Wal-Mart, but positions may change at any time