News Analysis date published New: 
Monday, August 22, 2011 - 12:00
New Date created: 
Thursday, September 1, 2011 - 07:21
New Date last updated: 
Monday, August 22, 2011 - 12:00

3 Retail Stocks Thriving in the Downturn

Monday, August 22, 2011 - 12:00pm

In the current stock market environment, bargains are showing up wherever you turn. Thousands of stocks are now trading at close to two-year lows, although many of them should be avoided since business can get even worse in a slowing economy. This is why it pays to focus on companies that are doing well right now -- because they have the best shot of posting major gains when investors start buying again.

I've been tracking three small firms in the retail sector that have recently delivered solid quarterly results and remain every bit as cheap as their less successful peers. It's only a matter of time before investors separate the wheat from the chaff and start buying again. Here they are...

1. Casual Male (Nasdaq: CMRG)
I've been tracking this retailer for about five years because it dominates a niche of retail and had been underperforming relative to its potential. In other words, the stock had room for improvement. In the ensuing five years, the weak economy has kept this from becoming a great investment, but management has done a great job of improving all aspects of the retail operation, setting the stage for real gains when spending finally turns up.

Just-released results tell the tale for this purveyor of extra-large menswear (known as "big and tall" in the retail trade). In the second quarter of the year, same-store sales rose roughly 5% from a year-ago, largely due to price increases. Management now keeps each store stocked with 15% less inventory than a few years ago. It's easier to put through price increases when you manage inventory well, since there is less need to mark down slow-selling goods. The lack of stale inventory meant gross margins were able to expand to 48.3% in the quarter. This is the highest expansion rate in 10 years, and well above the 42% to 44% gross margins seen in 2007 through 2009. You usually only see such a big jump when times are good and consumers are spending freely, so this current gross-margin gain portends well for when the economy is stronger.

Rising sales and firming margins helped net income to rise 17% in the second quarter of 2011 compared with a year ago, and management expects full-year profits to rise by a commensurate amount.

But the lousy stock market is a key reason why this stock has fallen more than 30% from the 52-week high -- despite a big jump on Thursday, Aug. 18, which put the stock back to about $4. It now trades for just five times cash flow and nine times projected earnings per share (EPS). It's important to focus on the fact that these metrics are being generated in a brutal economic environment. Look ahead to better days, and the stock would trade for closer to three or four times "normalized" cash flow and five times normalized EPS.

2. Christopher & Banks (NYSE: CBK)
This provider of women's apparel strayed from its tried-and-true merchandising approach during the past few years and paid the price for it. Edgy fashions failed to resonate with its fairly conservative customer base, so sales have steadily fallen from $561 million in fiscal (March) 2008 to $448 million in fiscal 2011. Christopher Banks routinely earned $0.75-$1.00 a share each year in the past decade, but hasn't made a dime since fiscal 2008.

This is why it was such a surprise when the retailer delivered an unexpected profit in the fiscal first-quarter results on June 30, even after analysts had expected a loss. A revamped line of clothes got the credit and management noted foot traffic is starting to rebuild at its stores.

Shares shot up 14% to $6.43 the day after results were released, but the subsequent market rout has erased those gains, pushing the stock down to a two-year low of $4.52 and well below the $30 mark reached back in 2006. The key question is whether the fiscal first quarter was a fluke. Management appears to understand the importance of sticking with what the customer wants: "We remain extremely focused on evolving our merchandising strategy to update our assortment to better align with our customers' tastes, which will be fully reflected in our fall deliveries," noted CEO Larry Barenbaum in a press release.

Does this mean that fiscal second-quarter results, slated for release in late September, will also be strong? It's hard to know in this uncertain economy. What is clear is this stock can't get any more washed out. The whole company is worth $160 million in the market, yet the company has $100 million in net cash and $164 million in tangible book value. Trading at less than six times the average profit rate of the past 10 years, this turnaround has a clear floor in place with perhaps 100% upside.

3. Rent-A-Center (Nasdaq: RCII)
Even healthy retailers are getting little credit right now. This company, which rents furniture and appliances to lower-income consumers (giving them an option to buy), has been putting up steady financial results. Free cash flow has ranged from $100 million to $300 million in each of the past 10 years -- a true "rain or shine" business model.

The top line has been less inspiring: sales peaked at $2.9 billion in 2007 and have been slipping modestly. To restore growth, management is pursuing a pair of initiatives. First Rent-A-Center is moving into Canada and Mexico, with a combined 33 stores thus far, and plans to double or triple the store count in a year or two. Second, other retailers are starting to house Rent-A-Center kiosks within their own stores (known as RAC Acceptance). There were roughly 350 of these stores-within-stores at the end of last year. This figure is on track to exceed 700 by the end of this year.

These expansion efforts are crimping profits since management has to invest in inventory and marketing. As a result, 2011 profits are likely to be flat at around $2.85 a share, before an expected 15% jump to $3.25 in 2012. Shares trade for just 6.5 times this projected 2012 figure. While shares remain in a funk, Rent-A-Center is buying back stock while supporting a dividend that now sports a 2.6% yield.

Action to Take --> All three of these retailers are trading poorly even though their underlying businesses are on the mend. This makes a perfect combination for value investors -- bargain prices and huge upside potential (up to 100% for one of them). When the market stabilizes, all three look poised to make up much of the ground they've lost in recent weeks.

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David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.