Retail Fail – Three Consumer Stocks You Can’t Afford to Own

The panic is over!  After months of hand wringing, dodging catastrophe, and pulling every dime out of risky stocks, investors have turned over a new leaf.  No longer are we worried about a market falling faster than the Niagara river – instead investors are clamoring over each other to buy stocks and participate in the rally.

Over recent months the “fear of missing” has been a powerful motivator.  Stocks have been pushed to unreasonable prices by buyers who had too much money parked on the sidelines and out of harm’s way.  As the indexes moved higher, these cautious investors have seen neighbors and colleagues make significant returns and have begun to feel foiled once again by a market that has left them behind.

As frustrated investors finally throw up their hands and buy “against their better judgment” many equities are being pushed to prices that are simply unsustainable.  Investors willing to pay any price in order to once again participate in the American way of owning equities have set the stage for what could be a devastating decline for equities.

While this rally is likely nearing the final stages (and investors are likely to be severely disappointed), in a minute I’m going to show you three opportunities to profit from the coming failure in the retail sector.

Retail Rally – A House of Cards

In no sector is the optimism more removed from reality than in the retail sector.  Investors are seeing potentially positive signs of economic rebound and immediately assuming that this will lead to a better environment for consumer driven companies.  Retailers from restaurant chains to luxury stores have seen stocks pushed to levels that are twice, three times, or even five times the panic lows while at the same time the fundamental picture remains as challenged as ever.

Most recently, many retailers saw stock prices pushed higher as a result of strong earnings.  While this may sound reasonable (earnings are the foundation for any successful company), the earnings were based on measures such as cutting cost of goods, or closing locations.  The strength in earnings was by no means indicative of a better consumer environment.  Instead, the cost cutting indicated just how discouraging the current market is, and the lengths to which managers are willing to go to keep from bleeding red ink.

Consumers No Longer Carry the Economy

A commonly touted statistic is that the 70% of the US economy is driven by consumers.  The figure has changed a bit over the last several months but we’re still reliant on consumer spending to generate about 68% of economic activity.  Unfortunately, this doesn’t bode well for the current economic recovery considering the prospects for the average consumer.

There are three major issues facing consumers today which will keep personal spending from adding any meaningful recovery to the broad economy:

• Excessive Debt Levels
  I’m sure over the past five years you have received just as many credit card offers as I have.  While 2009 has seen a significant decline in the amount of mailed credit card applications, there was a time when these solicitations were sent to every man, woman, child and even dog with a pulse (and some without a pulse).

  The temptation was too much for many, and consumer debt as a percentage of net worth soared to never seen before levels.  Not only were unsecured credit lines extending capital to pump up consumer spending, but many were taking advantage of the increase in housing prices and were using home equity as an ATM machine.

  Excessive debt is now the consequence that the average consumer must grapple with and it will likely take years before the average consumer has paid down these liabilities to a reasonable level.  In the meantime, banks are pulling credit lines, and enforcing stiff penalties for those who are not able to keep up with payments.  The resulting weakness will certainly have a long-term impact on discretionary spending.

• Rising Unemployment
  The official unemployment rate is approaching 10% which in and of itself is an alarming number.  At this point there is little evidence that the rate will not continue higher, and the Obama administration has openly accepted the fact that we will see double digit unemployment before a full recovery takes place.

  But behind the headline number, unemployment is a much more pervasive concern.  After a certain amount of time those who are unemployed simply drop off the statistical role sheet because they are no longer able to collect unemployment benefits.  So while these workers are still not earning a living to enable them to spend, they are not included in the unemployment statistics.

  Finally, many workers fit into the “underemployed” category where they have taken massive pay cuts or are now working part time jobs to make ends meet.  These consumers are also not included in unemployment numbers, but they still represent weakness as far as consumer spending is concerned.

• Destruction of Wealth
  Remember those home equity loans?  Well, they were often based on the full appraised value of individual homes, and a large portion of borrowers were allowed to pull capital out up to (and sometimes above) the full value of the individual properties.  Consumers considered this home value to be stable and along with gains in investment accounts, the wealth effect caused many to spend well beyond their traditional income limits.

  As values of both real-estate investments and market related investments plummeted, this wealth effect quickly reversed and now poses a serious roadblock to recovery.  From a psychological perspective, individuals will likely break spending habits until they retake the former levels of wealth (which could take several years).  And from a practical level, the availability of spending capital is just not there anymore.

So we can see that the odds are stacked solidly against consumer spending and yet market prices appear to be overly optimistic when it comes to evaluating the risk for retail companies.  This disconnect with logic should work to our favor as markets allow us to benefit from both rising and falling stocks.

The following three short opportunities can be played a number of different ways.  You can begin adding exposure by shorting the stocks outright above the recommended prices (I say above because when shorting we want to sell high first, and buy low later).  You can also participate by buying puts on the particular stocks (puts increase in value as stocks turn lower).  There are many other strategies that can be employed with various levels of risk and different levels of return.  If you would like help setting up a strategy for  your personal situation, please email me (zds@mysoundcounsel.com) and I would be happy to work with you to develop a plan.

So without further introduction, here are my three short recommendations for the coming retail fail:

Blue Nile Inc. (NILE)

Blue Nile Inc. (NILE) is the largest online retailer of diamonds and related jewelry.  Bypassing the fixed costs of storefronts and a sharply dressed sales force, NILE was able to build a profitable business offering certified diamonds to consumers who prefer to shop from the comfort of their own home.

The stock has benefited at least in part from a misunderstanding that most stockholders buy into.  I have heard it said multiple times that the company will continue to flourish because the truly wealthy consumers will always have money to spend and will not quit buying jewelry just because of an economic depression.

We can argue whether affluent consumers will continue spending or not (and I might take the position that even they are cutting back on purchases) but the discussion has nothing to do with Bule Nile.  While there may be an occasional purchase of a high-dollar item, the majority of the company’s revenue and earnings come from items under $5,000.  Most customers are actually nervous young husbands to be who are purchasing a relatively standard engagement ring.

Management has stated that they have seen a shift towards purchases with smaller price tags leading to lower sales and even more compressed margins.  In fact, for the last five quarters straight, NILE has seen revenue decline – meanwhile, the stock has rallied from below $20 to nearly $60 at last count!

With earnings expected to come in at $0.81 per share this year and $1.01 in 2010 the stock is trading at roughly 57 times forward earnings.  The estimates for a recovery in earnings may or may not be premature, but the bottom line is that the stock price simply doesn’t reflect the challenging environment that NILE is facing.

Action to take:  Sell short Blue Nile Inc. (NILE) at a limit of $45 or better

As I mentioned, there are several different approaches one can take including option strategies.  You need to match the trade with your own risk profile, but the bottom line is that this stock should decline rapidly over the coming months.

Green Mountain Coffee Roasters (GMCR)

Our second short opportunity will likely ruffle some feathers as the stock is one of the more beloved retail equities owned by a wide assortment of growth stock investors.  Green Mountain Coffee Roasters (GMCR) has built a very successful product line by offering consumers the ability to brew a cup of coffee at a time through its patented K-Cup system.

Now from a personal perspective, I don’t understand why anyone would want a single cup of coffee since I consume the stimulating beverage by the pot…  But on a more serious note, GMCR is beginning to exhibit some of the classic signs of a late-stage fad stock.  One only has to look at a chart of Crocs Inc. (CROX) from 2007 through 2008 to understand the danger.

Green Mountain recently signed a contract with Wal-Mart to distribute products throughout the mega-retailers international network.  The deal will no doubt bring additional revenue to GMCR and is just another example of the strong negotiating abilities of the management team.  But investors have quickly priced in the good news and now the stock appears to fully (and excessively) reflect the positive fundamental change.

The company took advantage of the high stock price early in August by selling 5 million additional shares at $67.25.  The proceeds were able to be used to retire some outstanding debt which will lead to a more healthy balance sheet.  But after the stock was sold to the public, the price has subsequently dropped leaving new investors quickly under water by more than 10%.  These disillusioned stockholders could quickly liquidate out of frustration, which could lead to a sharp decline to a more fundamentally sustainable price.

Based on the expected earnings for next year of $1.77 I think a fair multiple should be 20.  This would take into account the risk associated with a weak consumer, and the likelihood of much slower long-term growth.  At this multiple, the stock would be price at $35 which would be an interesting point to consider owning the stock.

Action to take: Short Green Mountain Coffee Roasters (GMCR) at a limit of $52

Optimism is running rampant in this niche retailer.  But if any disappointing news is released, investors could quickly see their profits evaporate.

Lululemon Athletica (LULU)

As a niche apparel company, Lululemon sells yoga inspired athletic apparel.  Originally, the company concentrated on women’s apparel and had a focus on the Canadian market.  An expansion into Men’s apparel along with a more aggressive push into US cities has broadened the company’s target market, and led to a much larger geographic footprint.

During the height of the spring panic, the stock briefly traded below $5 as investors worried that consumers would quickly cut back on spending which could lead to losses for the company.  Part of that fear came true as LULU did in fact see contractions in same store sales.  However, cost cutting allowed the firm to remain profitable, although the profit levels were much lower than those seen last year.

Over the past year, inventory levels have decreased while at the same time the company has opened a number of new stores.  While the cost cutting measures keeps the balance sheet in a strong place, lower inventory means that the company will likely not participate in any significant buying by consumers because they simply don’t have enough merchandise to sell.  While management has put on a brave face, their actions prove that they have relatively conservative expectations when it comes to any rebound in consumer spending.

Investors on the other hand have not shown any signs of a conservative approach.  After trading up more than 300% from the March low, LULU shares are now valued at about 40 times expectations for earnings this year.  Bulls will say that the company should grow quickly once the economy begins to turn, but next year’s expected 25% increase in earnings does not begin to justify the expensive price tag.

A generous multiple for this specialty retailer might be 22 times forward earnings.  Considering the estimates for next year are $0.64 per share, that would lead to a stock price of $14 per share.  Now the FY 2011 earnings (the company has a Jan 31 year end) may or may not come in at $0.64 per share.  But I would be willing to guess that at some point between now and next January that there will be a market event which will cause investors to re-think their bullish assumptions.  When that happens we could easily see LULU dip below $10 which would represent a good spot to close short positions.

Action to take:  Short Lululemon Athletica (LULU) at $18.00 or better.

The bulls have had their fun pushing stocks higher, and there’s nothing wrong with making money during a rising market.  But truly successful investors must be able to protect their investments during declining periods as well.  The environment for the coming few months will likely be much more difficult than we have seen so far this quarter.

So make sure you have some defensive strategies in place, and keep your trading nimble.  Damage control is paramount, and a few key short positions to offset risk in other areas of your portfolio can be a great tool.  Once again, if you need help crafting a solid investment plan please call or visit Sound Counsel Investment Advisors.

Wishing you every investment success!

Zachary D Scheidt, CFA
678-467-7064

Principal, Sound Counsel Investment Advisors